Market Musings Blog

The media’s preoccupation with China’s slowing economy is the crucible for a stock market correction, but it’s not the whole answer.

Until today, stocks’ decline was about in line with the 5% to 7% declines that happen every calendar year for no particularly good reason, but today the Dow cracked into official ‘correction’ territory at -10%. Of course, the market has been bearish for months now; it just hasn’t shown up in the market averages until the last few days. When Intel and Oracle are down double digits, and Apple and Facebook are up double digits, there’s something fishy going on.

Everyone wants to know why, of course. We can blame China, but the reality is that valuations for a select few stocks are on the very high side especially in light of mediocre revenue growth, and those high valuations make stocks vulnerable. The trigger for the correction could have been almost anything, but China is handy, especially since its market is vaporizing in a much bigger way. How does a 60% decline feel? Be Chinese and you’ll know.

And there isn’t much other good news to counter the China threat, either. Two weeks ago when Apple said, ‘well, we had great earnings but China looks soft’, and the stock lost a swift 10 points, opinions about stocks – what was good and bad, what should be at what price – changed. We are in the midst of that change now.

In the last few years, we’ve seen certain municipalities in the US fail to pay their debts, Detroit being the largest. On August 3, Puerto Rico defaulted. Around the same time, Greece defaulted.

This is the tip of the iceberg. While the debt crazed real estate bubble is largely in the rear view mirror, problems with pension and other retiree obligations promised by politicians all over the world are on countdown to explosion. Many of these were papered over in the bear market, with more debt being issued to cover the then-current debts, making the problem worse. Pension liabilities in the US have increased 400% in just the last ten years, and we doubt it’s much better overseas. And I am not even addressing everyday budget deficits in Japan, Europe, and the US;  or the giant debt bubble forming in China.

Issuing debt to cover obligations brings trouble if the borrower is not principled, or the lender is not.

By all rights, Detroit, Greece, and Puerto Rico should be disciplined by the markets, which should refuse, for many many years, to lend to them. But the markets are way too forgiving, which is one reason we have debt problems on a routine basis. Greece has now defaulted on its sovereign debt well more than 50% of the time since it has been independent. It’s a puzzle as to why anyone would lend to the country, but they do.

No one contemplates the humanitarian cost of debt loads. In Stockton, in Detroit, in Puerto Rico, in Greece, in every place where debts are too high, people are suffering. Somehow it is seen as noble to pursue debts in order to cover services and payments to the have nots, but as the tide turns, it is those projects and payments that are cut in order to fund debt service. Consequently, a new group of ‘have nots’, who may not have even been alive when the cycle started, suffers. The morality of debt loads is skewed. It is ok to borrow at first to make life better for citizens, but then it somehow becomes ok to cut those same benefits after everyone is used to the better life.

Will we ever be wise enough to strike a balance between current wants and having a more secure future tomorrow, which might mean saying ‘no’ to politicians’ promises? As debt problems proliferate, it’s easy to see we have not yet acquired this wisdom.

After the credit crisis of ’08/’09, Americans decided they didn’t like banks. Ever willing to oblige, politicians highjacked the populist uproar and created a behemoth of a regulatory morass, called Dodd Frank. If your community bank has closed its branch near you or completely merged out of existence, you can blame Dodd Frank. If your community bank still exists, just wait a while, and very possibly, it won’t.

Community banks had nothing to do with the credit crisis. They are less leveraged than big banks. They are less profitable than big banks – except during the crisis itself when big banks collapsed and small banks sailed through relatively well. They serve small populations – towns with farmers for instance – where often there is no other choice. They will make loans because they know you; large banks make loans that fit in their numerical parameters. They don’t know anything about you, except what their computer profiles tell them you should look like.

Community banks have tight underwriting standards, and in many categories, lower loan charge offs than big banks. Even though community banks make up a smaller share of the overall banking market than other banks, they make over 50% of small business loans, and over 50% of agricultural loans.

Before the credit crisis, small banks were losing market share, albeit slowly. After Dodd Frank passed, in just a few years, community banks’ share of banking assets has shrunk by 12%, a huge decline in a short time. Consolidation – which means mergers – has ramped up. While you thought bank failures ended shortly after the crisis, that hasn’t been true for small banks. From 2010 through 2014, 338 community banks have failed.

The beneficiaries of these market share losses are, of course, big banks. In the effort to ‘punish’ the banks for the credit crisis we have effectively hollowed out the best of the banking business, and made the perpetrators even more successful.

Dodd Frank is over 2200 pages long. Its regulations were set to evolve over years, serving up an incredibly complicated, ever-changing banking environment. When JP Morgan needs to hire 5000 compliance personnel, it is annoying, but JP Morgan will survive. When Bank of Anytown must hire even one compliance attorney – if it can even attract one – the cost can be enough to put it under. Furthermore, compliance personnel do not make loans or get to know borrowers.

The aftermath of the credit crisis has caused a big chill, not just in banking. What we have set forth here can be multiplied over many other industries, as regulations have skyrocketed in the last few years. Some are simply impossible to comply with. All fall hard on small business. We reap what we sow, and that has been a very slow recovery in employment, and virtually no income growth. Perhaps America has decided she wants the ‘bigger is better’ approach, because that’s certainly the trend.

At some point in every market cycle, investors forget the last cycle and get too frisky. We can tell when this happens because it usually coincides with so-so performance for value managers, and great performance for growth managers. Value managers toil in the leaky basement, sifting numbers and history, tripping over stuff that didn’t sell at the last garage sale. Growth managers sail around in the sun, grinning and telling wonderful stories about what is going to happen next to their favorite stock.
While value managers fret about the one thing investors can control – risk – growth managers are creating spreadsheets out forevermore, showing how earnings and revenue will double! triple! And their stocks rise and rise and rise, shaming those of us who are saddled with dopey telecom stocks or plunging energy stocks, and have no interesting stories to tell.
Disappointment sets in. You might be making a little money in your value portfolio, but everyone else is making a LOT! TONS!
Eventually growth gets whacked when the market decides it’s had it with going up and needs to go down for a while. All those stories vanish, and there’s no safety net. No high dividends, no solid cash flow.
That’s where the devastation comes in. When growth gets whacked, it doesn’t do it by half measure. Instead, it does the same thing it did while going up: with vigor, it seeks the bottom of the barrel.
Sometimes, even, a former darling falls into the leaky basement, and hits the value guy on the head. But that’s another story.
Value stocks will fall, make no mistake about it. In a bear market everything will fall. But the degree will be less, and sometimes just holding on to most of your money is the best you can expect.
We vote for disappointment, rather than devastation. Devastation from your investment program is pretty rough when you’re just trying to live your life.