Posts published in October 2015
It’s never too early to start thinking about next year. Sure, we still have a holiday season and a Fed decision, among other fun-filled events, to get through before 2015 rings out. But now is when we start to focus on our strategic allocation models and plan out scenarios for what the year may, or may not, have in store. Unfortunately, the calendar-gazing habit tends to bring out the silly side of investing. No small number of “experts” habitually hold forth on the airwaves with a gravitas-laced analysis of the January effect or some other variation of “when X (calendar event) happens, expect Y (stocks to go up, down, all around)”. Next year is 2016, meaning of course that it is once again time to elect a US president. And presidential years take calendar-centric silliness to a whole new level. Not only is there an imagined pattern to presidential election years, as the pundits would have it, but there are “rational” explanations as to why this is so. Fact or fable? Let’s do what we always do, and examine the data.
Presidential Years and Market Math
It is true that recent elections have not coincided with great times for investors. We looked at rolling twelve month returns for the Dow Jones Industrial Average going back to 1900, and found that the average nominal return for this period (through the rolling twelve month period ended September 30, 2015) is 7.7 percent. Compared to that average, the twelve month periods coinciding with the calendar years of 2012, 2008, 2004 and 2000 have all been below average (3.7 percent, -33.8 percent, 3.1 percent and -6.2 percent respectively). Case closed, right?
Not so fast. Humans have a tendency to seize on easily-recalled data and make generalized conclusions from them. It’s called the “availability bias” in the lexicon of behavioral economics. Most of us have a better recollection of the Obama-McCain election of 2008 than of, say, the Hoover-Smith campaign of 1928. That does not make the 2008 outcome a whit more statistically relevant than that of 1928. And in case you are wondering, the Dow delivered a 48.2 percent return that year, at the giddy height of the Roaring Twenties.
In fact, the average return for all presidential election years since (and including) 1900 is 7.3 percent – statistically indistinct from that 7.7 percent average for all 1,387 rolling twelve month periods since January 1900. Please keep this in mind the next time some portentous pundit solemnly holds forth on the “facts” of presidential years and the stock market. Lots of things will impact the market next year, of which the election will be just one variable.
The Law of Small Numbers
How about mean reversion? Are we “due” for a better-than-average election year given the recent streak of poor performance? Sadly, no. The presence of an improbable recent streak does not affect the odds of the next outcome. If you roll a die and it comes up with the six facing ten times in a row, the probability of getting a six on the eleventh roll is still 1/6. The law of large numbers says that mean reversion works over time, with large numbers of observations. The law of small numbers, by contrast, cautions against reading anything meaningful into a small handful of outcomes.
So where does that leave us as we look ahead to 2016? As we noted in our commentary last week, we see a reasonably compelling case for further upside before the current bull run peters out. That could take the form of leadership by high quality stocks or an end-of-cycle “melt-up” (or something else entirely). Among the factors we consider critical are: monetary policy divergence, emerging market growth trends, commodity prices, and geopolitical flashpoints in the Middle East and the South China Sea, among others. Yes, we will also be closely following the US election, the policies articulated by the contenders and the sentiments of the voting public. But we discount any kind of a foregone effect the election year will have on market performance.
Investors in US large caps have more treats than tricks in their candy bags so far this October. Since testing the current correction’s lows in late September, the S&P 500 has rallied by a bit more than 9 percent, and seems poised to extend those gains even further heading to the Friday close. The index has managed to repair much, though not all, of the technical damage sustained during this pullback. The chart below highlights some of the salient features of this pullback and recovery period.
Back to Black
Notably, as the chart illustrates, the S&P 500 has moved back above its 2013 trendline (i.e. the trend off the previous low water marks going back to 2013) and also above the key 200 day moving average. Always remember that there is nothing magical about any of these trendlines or moving averages. But in the perception-is-reality world of short-term trading they do tend to call the algorithm bots to action, and are thus useful as technical metrics. Next obstacle to surmount is the trendline from the last correction of more than 10 percent, in 2011. That’s also right about where we are likely to experience some resistance from the sideways corridor that kept stocks range-bound from February to the August pullback.
Volatility has also subsided rapidly. Compare the performance of the CBOE VIX index, the market’s so-called “fear gauge”, in the current environment with that of the 2011 correction:
The magnitude of the VIX’s spike was similar in the 2011 and 2015 corrections, but the fear gauge stayed higher for much longer in the former. Fully three months after the initial shock in August 2011, the VIX was still habitually closing over 30 (indicating an unusually high risk environment). This time around, the index is back in the docile mid-teens just two months after the initial onset, and has not risen above 20 since October 6. In many ways, this pullback looks somewhat more like the 2014 flash in the pan – the famous “Ebola freak-out” – than it does the more substantial 2011 correction.
With all that said, the key question on everyone’s mind is what happens next. We have a handful of potential scenarios in play as we look through the rest of this quarter and start to plan for next year. Although we certainly cannot rule out another downturn, we think there is a reasonable case for more upside ahead. Two possible variations of an upside scenario are: a rally led by high quality large caps; or a broad-based melt-up. Which of these (if either) may plausibly be more likely?
The Case for Quality
In some areas of the market we are already seeing a quality rally – or at least an environment where shaky business models are feeling the heat. In other words, the market is starting to do what it did not do very much of during the peak Fed-driven rallies of 2013-14: make a distinction between companies with a demonstrated competitive advantage in a rapidly changing economic landscape, and those more vulnerable to the potential negative consequences of such change.
This trend is particularly notable in the consumer sector. Consider the relative performance of two competitors which have been prominent in the news of late: Amazon and Wal-Mart. The chart below shows their respective price trends over the past seven months.
Now, this comparison is only one slice of the market and does not necessarily a dominant trend make. But we are starting to see the market make sharper distinctions between potential winners and losers in the war for consumer dollars and brand loyalty. Wal-Mart knows this terrain well: arguably the last major paradigm shift in consumer retail was its own domination of the big box space through its tight, efficient control of every stage of the supply chain. For that it has been amply rewarded by the market over the years. But Wal-Mart is a laggard as online becomes the dominant trend – barely 2.5 percent of its total sales come from e-tail. Investors appear increasingly skeptical about the company’s ability to make a serious bid for share against the Amazons of the world.
As this dynamic plays out in consumer, tech and other key sectors, 2016 could be the year of the old-fashioned rally where fundamental analysis and stock selection actually pay off. But that is not the only possible outcome.
The Case for Melt-Up
Alan Greenspan memorably uttered the phrase “irrational exuberance” in 1996, a time when the stock market had been soaring along without a care in the world for nearly two years. The sentiment was right, but the timing was off. The market would hit some event-driven speedbumps in the next two years, including a major event-driven correction of more than 19 percent in 1998 that caused immense amounts of hand-wringing. As we all now know, those who panicked in ’98 missed out on one of the great melt-ups of all time in 1999. Melt-ups happen when the money that has sat on the sidelines during an extended bull run finally decides to get in and make up for lost time.
While it would be a stretch to make too much of a comparison between 1999 and 2015, there are some factors which could help pave the way for a melt-up. Easy money leads the way: from the Eurozone to China, and possibly Japan later this month, the central bank spigots are poised to flow at maximum strength. The bond market appears increasingly doubtful that the Fed will follow through with a rate hike in 2015, or even into the first quarter of next year. In this environment a short-term cyclical recovery in emerging markets would be plausible, with hot money flowing back into recently beaten-down destinations in Latin America and Asia Pacific. In this case the quality rally we described above may not materialize, as the Johnny-come-latelies indiscriminately chase anything that moves.
The rational side of our brains tells us that the quality rally is the more logical scenario to plan for. But we also know that markets are generally far from rational, and we cannot rule out the possibility of a wild melt-up. Or, of course, something else entirely. These are interesting times, to say the least.
In what has become an increasingly event-driven year for capital markets, Monday looms large on the calendar with the expected announcement of China’s third quarter GDP growth. Given China’s front-and-center role in the recent stock market correction, investors will want to see what the data say about how things are really faring. Not that the data will necessarily tell them much. The longstanding debate over the extent to which China manipulates its headline data continues apace, with the spectrum of opinion ranging from “a bit” to “entirely.” To grasp what is going on in the Middle Kingdom requires a careful focus on the likely source of whatever growth is in store: the Chinese consumer.
How We Got Here
For an understanding of how central the Chinese consumer is to the growth equation – and by extension to what may be in store for global asset markets in the coming months – it is worth a brief visit back to the path of China’s rise to economic stardom. The chart below shows the country’s real GDP growth for the past fifteen years, encompassing its meteoric rise in the early-mid 2000s, the market crash and Great Recession, and the post-recession recovery.
There are three distinct economic stories to tell over this fifteen year span of time. While the Chinese economy was kicking into gear in the 1990s, it was really in the first decade of this century that we saw it rise to become the preeminent supplier of all manner of goods to the rest of the world. Demand in key developed export markets in Europe and North America recovered after the 2001 recession. China’s growth trajectory was largely export-driven, with soaring industrial production and equally soaring imports of energy and industrial commodities.
The Great Recession of 2007-09 brought an end to those good times, but only briefly. With cooling demand in its major export markets China turned inward, commencing a massive, debt-fueled stimulus program in late 2008 that continued through the early years of the present decade. Construction and investment, focused primarily on property development and infrastructure projects, drove this second wave of growth. Even while the rest of the world struggled with low-to mid-single digit growth, China continued to grow at or close to ten percent during these years. But consumer spending lagged, accounting for an unusually low 35 percent of GDP as compared to 70 percent in the US and more than 60 percent in most European economies. Eventually the investment boom ran into the headwinds of oversupply. Visitors to China are rife with anecdotal tales of sprawling, eerily unoccupied commercial and residential real estate projects. As investment waned, China’s policy leaders explicitly acknowledged the need to rebalance the economy away from its traditional growth drivers towards something else. Enter the consumer.
Let a Billion Consumers Bloom
Stimulating domestic consumption has thus been a top priority for the government of Xi Jinping ever since coming to office in 2012. What do the results to date tell us? Well, the news headlines over the past several months, not to mention the ham-handed debacle of the government’s trying to control the stock market’s rise and fall and the subsequent devaluing of the currency, would seem to indicate that all is not well. But there are some indications that consumer activity is perking up rather nicely.
Overall retail sales are up more than ten percent this year – faster than the economy overall. Key consumer sectors like furniture and home electronics are up more than fifteen percent. Yes – again, one has to handle published China economic data with some skepticism. But there are enough positive appraisals from those close to the country’s consumer markets to give some support to the numbers. Recall Apple CEO Tim Cook’s sanguine appraisal about his own company’s China prospects amid the panic of the late August market selloff. Nike’s China sales grew by 27 percent in the most recent quarter – the strongest market in a very strong quarter for the company.
We are certainly not Pollyannas when it comes to China. There is plenty that could go wrong with its ambitious rebalancing plan, not the least of which is the massive debt overhang that looms over the economy. China’s debt to GDP ratio, already high, grew by more than 80 percent from 2007-14 according to a study by consulting firm McKinsey. And China’s rebalancing has other implications elsewhere in the world. For one, stocking the shelves of department stores and supplying trendy apps and gadgets to discerning young Chinese technophiles will not replace an import base weakened by declining demand for aluminum, zinc and nickel ore. That’s bad news for resource exporters like Brazil, Russia and Australia.
Nonetheless, we do believe the whirlwind of panic that sprung up in August was overblown. We will study Monday’s GDP numbers carefully, but are much more interested in how these consumer trends will continue to fare in the coming weeks and months. So far, two cheers. Let’s hope for three.
Those brave enough to wade into the markets on August 25, at the depths of the recent pullback in risk assets, have been amply rewarded. The S&P 500 is up 7.8 percent since then (as of the 10/8 close). But oil bulls have fared even better. Spot prices for the key Brent and West Texas Intermediate crude benchmarks have jumped by more than 25 percent since late August amid a growing sentiment that the collapse in energy prices has finally found a floor. Is this sentiment justified, or is this just a repeat of the false dawn we saw earlier this year? Consider the chart below, which plots the price trend for Brent spot crude over the last twelve months.
Impressive though this latest rally may be, prices actually rose faster and higher back in February. A strong jobs report jolted risk assets back to life after a volatile January. Brent crude jumped 29 percent between January 14 and February 19 as part of this broad-based rally. But the rally ran into headwinds around the $60/barrel level. The structural factors of oversupply and weaker demand have proven resilient, making it difficult to see a clear path for prices to regain the $100-plus level where they traded for almost the entire stretch of time from 2011 to midsummer 2014. Even the usual tailwind of summer demand failed to boost prices much past the mid-60s, and then the China story moved front and center to deflate animal spirits and push prices to new six year lows.
Supply Side: Cuts Ahead
US domestic energy companies have surprised observers, continuing to pump out volume in the face of sharply lower upstream price realizations. That may be changing. A report last month by the International Energy Agency predicted that US production will fall sharply in 2016 as the effects of the long price winter finally force decisions on project viability. Experts estimate that some $1.5 trillion of global energy investment is unlikely to be viable in the $50/barrel price area. Industry executives at this week’s Oil and Money conference in London cautioned that a supply contraction from projects switching off may lead to a sudden spike in prices down the road, as spare capacity disappears. Such a spike, though, does not appear imminent. Reduced supply will take time to work its way into the price equation; indeed, the latest figures last week pointed to yet another rise in US crude oil stocks.
The Return of Geopolitics
Another factor, which has been notable for most of this year by its absence, is geopolitics. Instability in the Middle East often leads to higher oil prices, but the volatile conflicts raging across the region this year have had little impact. That may be changing, though, with Russia’s military intervention adding a new dimension of complexity – and risk – to the situation in Syria. The so-called “moderate” Syrian rebel groups Moscow appears to be targeting in its air-to-ground operations have been the beneficiaries of support by the US and some of its key Gulf State (and oil producing) allies. There is continued concern in some policy corners about the potential for a proxy war. A “geopolitical premium” is arguably one of the factors at play in this week’s leg of the crude price rally.
The Demand Puzzle
Hanging over the question of how sustainable this latest energy price rally can be is demand – or, rather, the continued lack thereof. The International Monetary Fund has reduced its forecast for global growth in the wake of growing concerns over the size of China’s slowdown. Its current forecast for China’s real GDP in 2020 is 14 percent lower today than it was three years ago. China’s problems are having a visible effect around the world; for example, Brazil’s exports to China (now its largest trading partner, having supplanted the US) have fallen by 23 percent this year and factor heavily into Brazil’s negative growth environment. A vicious cycle of low growth in developed and emerging markets feeding off each other will be at the top of the list of concerns for international policymakers as they meet for the annual World Bank and IMF meeting in Lima, Peru this week.
The average price of Brent spot crude oil from January 2011 to June 2014 was $110. We do not see the current environment favoring a return to those levels within a 2015-2016 time frame. Investors game enough to put their short-term money at play could perhaps do well by a strategy of “buy at $40, sell at $60.” For those contemplating their annual asset class exposure rebalancing, we would continue to recommend staying modestly underweight oil and industrial commodities more generally. False dawns look rosy, until they fall back into night.
A cold, wet rain has been falling along the Eastern Seaboard for the past couple days, and that proved to be an appropriate climate for this morning’s September jobs release. If there was any good news to be found in the report it was not apparent in the headline numbers. The 142,000 payroll gains for September, along with surprising downward revisions for August and July, pulled the average monthly job growth figure for the year to date down to just below 200,000, seen by many as a critical threshold for the overall economic growth equation. As the chart below shows, the job creation cadence is at its lowest level since the first half of 2012.
Meanwhile, average hours worked per week fell slightly, as did hourly wages. And once again the unemployment rate held steady partly due to another decrease in the labor participation rate, which remains firmly mired at levels last seen in the 1970s. Now, we are always ones to caution against reading too much into one data release, or even a couple successive data releases. Statistical margin of error and all that – you’ve heard it from us a hundred times. But at some point it becomes reasonable to ask a very simple question. Seven years after the Fed opened its monetary floodgates to try and return the economy to normal, is this as good as it gets?
Money, Myths and the Real Economy
To deal with that question we need to start with a closer look at what the Fed actually did, as opposed to what lots of people think it did. The popular view is that, after realizing that taking short term interest rates down to their zero lower bound was insufficient to the task at hand, the Fed flooded the economy with money via the three successive quantitative easing programs carried out from 2009 to 2014. That, in fact, is not what happened. The misunderstanding comes from how money is defined in its popular usage versus the much more complex terminology at play in the world of Fed monetary policy mechanisms.
When the Fed purchased government and mortgage backed bonds through the QE programs it did not “print money” as the popular myth goes. It bought the securities from banks, and paid for those securities by crediting the reserve accounts these banks held on deposit at the Fed. Bear in mind that banks are required by law to maintain a certain percentage of their outstanding deposits in the form of these Fed reserves. By increasing the banks’ reserves, the Fed was effectively giving the banks the means to go out and make more loans, thus stimulating economic activity. That was the point of QE.
Except that it didn’t happen. What happened instead is that the overwhelming majority of those newly created reserves never went anywhere. They stayed in the banks’ Fed accounts and added not a single cent’s worth of stimulus to the real economy. To illustrate this, consider the following. The US monetary base – which consists of currency in circulation plus bank reserves held at the Fed – was about $875 billion in August 2008. In August 2014 the monetary base surpassed $4 trillion and it has mostly remained above $4 trillion since then, even after QE3 wound down. The monetary base, in other words, is more than 4.5 times greater in 2015 than it was in 2008. Almost all the growth came from the reserve account increases proceeding from QE.
Now consider that M2 – a broad measure of money in the economy that includes currency, checking and deposit accounts and money market funds – grew from about $7.7 trillion in August 2008 to $12.1 in August 2015. This means that M2 is less than twice as big today as it was in 2008, while the monetary base is more than four times as big. What this tells us, in turn, is that most of the growth in the monetary base failed to translate to growth in money actually moving through the economy. Economists call this the “velocity of money” – the extent to which money created through monetary policy translates to real economic activity. What these figures tell us today is that, despite the Herculean efforts of the past seven years, monetary policy hit speedbumps and never got out of second gear to achieve its expected velocity.
Growth Is Still Growth
What does all this have to do with today’s job numbers? Mainly, it helps us understand the context in which inflation, wage growth and labor force participation have stayed muted for so long, despite all that hard work on the part of the Fed. Banks didn’t rush out to create lots of new loans with the fruits of their pumped-up reserve accounts because the demand wasn’t there – households were paying down debt and businesses were gun-shy about making new investments into productive assets. Those are the conditions a financial recession produces. The resulting behavior on the part of banks and households was rational and at least to some extent predictable.
This does not mean that we will never get back to normal conditions, though. Today’s growth remains below historical norms, but it is still growth. The payroll numbers released today did not show a decline in new jobs – just a smaller than expected increase. GDP, consumer confidence and other data points continue to move mostly in the right direction. We will see in the coming weeks whether problems elsewhere in the world show up in a larger way on our shores. For now we are not inclined to read too much doom and gloom into the picture. To answer the question posed earlier, we do not think this is as good as it gets.
At the same time, though, the rationale for Fed action in their desired 2015 time frame does not seem to be getting any stronger. We are increasingly of the opinion that less calendar-speak by FOMC members at their various conferences and confabs would be immensely helpful. Let the data speak, not the calendar.