Out of clutter, find simplicity

Posted by on Aug 26, 2015
  1. Out of clutter, find simplicity.
  2. From discord, find harmony.
  3. In the middle of difficulty lies opportunity.

Albert Einstein

The stock market’s dramatic decline of Monday August 24th, 2015 (with the Dow closing down 588 points after opening Monday’s trading session down 1,100 points) is a significant stressor to the sleep and digestion of any normal human being. After all, when we are inundated with news of all sorts on our smartphones…and when anyone can call in trades over their lattes at Starbucks, even the smallest disturbances can swell in importance.

And the trading fluctuations of the next two days seem equally nerve-wracking with the Dow Jones moving hundreds of points up and down during the day and opening up hundreds of points from day-today as well. But don’t confuse the movement of the Dow Jones in ‘hundreds of points’ with ‘percentage moves’. I was in the business in October of 1987 when the Dow Jones dropped almost 23% on the 19th of that month. These moves are relatively minor when compared to that dramatic day.   The Dow Jones Industrial Average (DJIA) fell exactly 508 points to 1,738.74 (22.61%). What’s the current level of the Dow? Almost an order of magnitude higher! So, the market has certainly ‘recovered’.

The real question is: is the sky falling? Or put another way, is this correction the beginning of a huge bear market, a repeat of the 2008 credit crisis? And what any normal human being wants to know is: should we do anything about it? I think the quotes from one of the smarter human beings in history are useful—these quotes are taped to my computer screen to remind me not to panic when all around me are falling prey to the hyperbole of the moment.

“Out of Clutter, Find Simplicity”—The US Stock Market versus the Economy

What’s the source of the clutter? First, like broken clocks which are right twice a day, there are some market pundits, TV commentators, CNBC and squawk box experts who are consistently bearish—and they do not, in my opinion, let the facts interfere with their opinions. As Churchill purportedly one said: ‘You’re entitled to your own opinion, but not your own facts.’

In my experience when we see a huge down day like yesterday, people are panicking and they associate the dramatic decline in stock market prices with a more fundamental anxiety about the economy itself. Please remember this—and many of you have heard me say this repeatedly—the stock market and the US economy are NOT the same thing.

So, is this the second coming of the big bear market of 2008 and 2009? Of course no one knows for sure. Let’s check the facts. According to Brian Wesbury, Chief Economist at First Trust—the current facts about the US economy sure doesn’t seem to support that conclusion.

  1. US GDP growth figures are due out this week. The expectations are for 3.1% growth…and some are projecting 3.3% growth.
  2. Existing home sales in the US have been doing very well lately as evidenced by an almost 10% increase over a year ago, and a dramatic drop in ‘all-cash’ sales from 32%-22%. This means that the financial mortgage/banking system is stabilizing—not at all the picture we may remember from 2008-2010 when the entire mortgage system in the country practically shut down.
  3. Payment rates on credit cards are the highest on record (dating back to 1992) while delinquency rates are at an all-time low.
  4. Auto sales have fully recovered from the 2008-2009 disaster. Over the past year, Americans have bought cars and light trucks at a 17 million annual rate. To put that in perspective, the all-time high dated back to the dot.com boom in 2000, when people bought 17.5 million new automobiles.
  5. Monetary policy shows that M2 (the money supply) is growing at a healthy 6% and commercial lending at 11%. Interest rates continue to be low.
  6. Unemployment claims are as low as they have been—with layoffs at approximately 0.2%. Currently, that unemployment rate is 5.5% of the labor force. Private sector payrolls have grown steadily for the past 65 months in a row…the most in history with data going back to 1934.

If the economic picture is actually better than is being focused upon, what about the fact that the stock market is fluctuating so much? Attached you will find two charts that you might find instructive in keeping the fluctuations of the stock market in perspective:

  • S&P 500 Performance After Its Worst Days (Since 1950)—and the performance of the index for the 1, 5 & 10-year periods that followed.
  • Staying in the Game (Since 1980)—showing the difficulties of trying to ‘time’ the stock market which has an average inherent volatility of approximately 14% annually.

‘From discord, find harmony’—China’s Stock Market decline

One thing I can say without hesitation is that after 30 plus years of watching the markets, the business cycles, and the news outlets which report daily on these parts of our consciousness, there’s always something out ‘there’ to fear—at least according to those ‘reporting’ on these daily issues.

China’s stock market drop is what my partner Mike Maehl’s favorite phrase calls the ‘worry du jour’. So what’s that about? Why is the dramatic decline of China’s stock market looming so large for those of us in the rest of the world? Here are some things to keep in mind when considering that question.

  1. China’s economy is not a free-market economy…and neither is their stock market. It is not something that we can invest in directly, it was recently revealed that the government had encouraged naïve investors who had no previous experience to ‘invest’ in the Shanghai stock market—it had the effect of a 30% pop in the value of the Shanghai exchange…only to find that people panicked, sold stock and their stock market declined just as sharply as it had jumped. Ironically, after this decline, about ½ of the ‘listed’ companies on China’s exchange chose to de-list.
  2. China’s economic growth rate has been peaking at a reported (their reports, mind you) at a 10% annual rate. They are a huge exporter to the US, much like the Japanese were huge exporters to the US in the 1980s when everyone in business schools in the 80s were told to read Japanese management books and learn Japanese.
  3. So, if China were to collapse (and I don’t think they will) like the Japanese did in the 1980s, would that indicate that the US economy would collapse as well? The answer is no—the US economy boomed in the 1990s, despite the strong feelings of many who felt that the world’s economic management methodology should be a blind acceptance of the superiority of the Japanese model.
  4. China is NOT a huge market for US goods. According to Goldman Sachs, S&P 500 companies generate roughly 67% of their aggregate sales from inside the US. Just 8% of overall revenue comes from the Asia-Pacific region. US exports in general account for roughly 13% of total US gross domestic product, with China representing 0.7% of US GDP.

‘In the Middle of Difficulty likes Opportunity’—Low Oil Prices and Federal Reserve Rate Hikes

It seems now that folks are really worried about the effects of the dramatic drop in oil prices and the pending (and long overdue in my opinion) rate hikes in the Federal Reserve’s Fed Funds rate. Why? In my opinion, both of these are not the cataclysmic threats to domestic peace that some people are now projecting.

In the case of low oil prices, unless you live and work in an oil producing state that depends on its tax revenues from the oil industry for its sustenance, this is not an issue for most Americans. Cheaper oil means that folks can more readily afford heating oil, gas for commuting—leaving those funds they would otherwise have spent on these fundamental costs for other things. For a long time people have decried our dependence on foreign oil—and the dramatic sea-change represented by the ability of the US to be virtually a net oil-exporter within 5 years is not a bad thing for our economic security.

Now, that doesn’t address the environmental costs and issues surrounding the burning of fossil fuels—but economically, this is not a bad thing. Regardless of one’s perspective on the environmental issues (and they are not insignificant), one cannot argue that it costs less at the pump to fill up your vehicle.

With respect to the impending Fed Funds rate hike and the suspension of quantitative easing, there is a lot of misinformation and questionable panic in my opinion. First, not all rate hikes are created equal. It is one thing to hike rates from 3% to 5-6% to cool down an overheated economy—quite another indeed to raise rates from 0% to 3%.

The current rates for Fed funds are from 0-0.25% and the debate is whether Chairman Yellen will increase rates from those historically low levels to a whopping 0.25% to 0.5%. Behind that concern is an almost axiomatic thought that if the Fed increases rates it will have a dramatic impact on the US economy.

Will Apple really decide not to release a new iPhone7 because Janet Yellen increases the fund’s rate? Will Uber not go public? Will 3M not invent a new post-it note product? Obviously not.

Don’t forget that the Fed is commonly thought to ‘control’ interest rates and inflation. They don’t. They have three tools at their disposal: 1). Set margin requirements for member banks; 2) set the Fed Funds rate which is the rate their member banks can borrow from the Fed; 3) Open Market operations—which is buying and selling securities in the open market to dampen the effects of dramatic swings primarily in the bond markets.

While they haven’t changed much using tool number 1, and they have left tool #2 largely along at 0% for the past six years, they have dramatically used tool #3 in their ‘quantitative easing’ (QE) over the past 6 years. However, they have stopped QE, and may stop reinvesting the money as the bonds come due. Just because they have ceased interceding in the bond markets doesn’t necessarily mean that the sky will fall…and just because they might and probably will increase the use of tool #2 (increasing the Fed Funds rate)—that is NOT the same thing as controlling interest rates.

Conclusion

An interesting phenomenon occurred with yesterday’s dramatic decline in the stock market—the yield of the bellweather 10-Year Treasury bond which had dropped to below 2% before trading yesterday, actually increased back to 2.05%. Why? Because investors were fleeing to ‘quality’—and quality in this case are the 10-year US Treasury bonds.

So, before you jump to any conclusion about needing to take action, or sell all your stocks in exchange for stockpiling gold, remember that the best solution in our opinion is to have a globally diversified portfolio, which is well designed to reduce overall portfolio risk and focus on your own goals and personal situation. We often say and reiterate to our clients that we don’t tend to make decisions about changes to your portfolio based on what the markets do—we tend to make changes when your personal situations change (like health, a windfall, loss of a job, etc.). If we have done our job well, we will continue to help our clients stay true to their path toward accomplishing their goals.

And like Albert Einstein said, we’ll use ‘difficulty’ to take advantage of opportunity. Or put more simply, when other people panic, we will use the bargains that are created as a buying opportunity. If you have questions or would like to discuss your portfolio in more detail, please feel free to call or email us. Feel free to pass this along to anyone you feel that might benefit from our perspective.

Cheers,

Jim

Securities and Investment Advisory Services offered through KMS Financial Services, Inc.

To get an overview of economic conditions, use this link. It’s updated monthly. http://www.russell.com/helping-advisors/EconomyMarkets/EconomicIndicatorsDashboard/EconomicIndicatorsDashboard.aspx

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