Market Musings Blog

When Will We Know When Stocks Are Done Going Down?

The tough part about predicting the stock market is that it’s not only reacting to what’s happening today, it’s looking forward to tomorrow. And sometimes it’s not exactly tomorrow, it could be six months from now, or twelve months from now. The other tough issue is that the market is going to dish out several good days on the way to completing its bear phase. Those head fakes will tempt some investors to put cash to work.

It’s not a bad thing to miss the first part of an improving trend to make certain that the trend is actually in place. In other words, let’s say you are interested in Apple stock, but it’s been falling every day. One day, it turns around and rises 5 points. Rather than buying right at that moment, it might pay to wait until you can associate the rise with some positive news.

Speaking of news, one sure sign that the market is ready to turn around is that instead of the market reacting as if all news is bad, it starts to rally on bad news. So to take Apple again, let’s say the expectation is that next quarter’s earnings will be down by a dollar, and instead earnings are down only seventy five cents. On the face of it, it’s bad that Apple’s earnings are down. But the market is going to read that as, ‘it’s not as bad as we thought! Buy!’

As far as market action these days, we’ve got small tailwinds going for the economy in lower oil prices and a declining yield on the long bond. Even the ten year yield – which is important for mortgage pricing – is down in yield. But stocks are not going to give us a turn until we see a few earnings reports that show that companies are able to handle higher materials and labor costs and possibly slowing growth. Some relief on the macroeconomic front might help temporarily, but that has to flow through to earnings at some point before investors will pay more for stocks.

Bonds and the Stock Market:

How Do They Talk to Each Other?

It’s no secret that the stock market is unhappy about something – and that there are many things to be unhappy about. However, one item is dominant in our minds, though much less intuitive than trade problems, earnings issues, and the latest tweets. We’ve mentioned interest rates and their impact on stock market valuations many times in the past, but here we will give you a round up of what the bond market is trying to say and how that relates to stocks.

First off, an interest rate is just the price of money. If your bank charges you 5% for a mortgage, that is the price at which they are willing to lend. So with that in mind, what does the price of money have to do with stocks?

Trade issues and tweets have been on the table for months with nary a hiccup in stocks. However, the one incident that can be directly  and immediately tied to the stock market decline is the jump in long term interest rates that began on August 24th. While the long bond shifted up in yield for a week or two in somewhat desultory fashion starting then, it really got going on September 12th, when it broke to the upside and raced to 3.45% from under 3%. This move is both fast and far.

The long bond yield figures large in the valuation of stocks. The higher bond rates are, the lower stocks are valued. On the other hand, higher rates was a positive judgment on the economy, the same as the Fed is broadcasting, which is: things are strong. Competition for money is considerable, and so the market can charge more for those funds.

In some ways, this was comforting. We had the Fed saying, essentially, ‘the economy is still growing and we just want to feather the brakes a bit to avoid a crash so we’ll give you a few rate hikes’, and we had the long bond saying, ‘strength is in the cards, money should be more expensive because demand is strong’. Stocks should like that, but what investors didn’t like was the rapid change. From under 4%, mortgage rates jumped to 5%, and financing for all sorts of transactions shot up, all in about a month.

And then, a funny thing happened on the way to more rate hikes. A few soft economic statistics emerged, showing that housing had cooled considerably, some layoffs were announced, several earnings conference calls contained warnings about next year’s results. These warnings were not relegated to companies that must buy tariff-ridden steel, either. Bank managements, for instance, mentioned housing and the fact that middle market customers have slacked off borrowing again.

In reaction, the trend in the long bond reversed, and its yield began to fall. Rates in the middle of the interest rate curve, from two year to five years, inverted, so that the shorter maturities yield more than the longer maturities.

All of a sudden, the narrative switched from ‘too strong’ to ‘hey wait a second, maybe things are weak! Weaker than we thought!’ And that, right there, was enough to give stocks another leg down.

It’s hard to blame investors for reacting first to the surge in interest rates, and then to their sudden sinking and the inversion of a big hunk of the yield curve. This kind of action in bonds is like a normally soft spoken person suddenly starting to swear and shout. It’s alarming, and now you feel like you no longer know what that person will do next. Consequently, we think it will take some time for volatility in stocks to ease. It will also take a few weeks to determine if the downward direction is a new trend, or just an interruption in the old upward trend. We suspect the answer is the latter, and that we will look back on this time frame as marking the change to a slower growth trajectory, but no disaster.

October Proves a Fright

Not unusually for an October, the market is giving investors fits. Talk of recession and bear markets is burgeoning. However, market corrections within calendar years are completely normal. We’ve forgotten that these past few years, as stocks have been remarkably stable. Here are some stats:

  • In the last 40 years, declines of -5% to -30% have happened in 32 years – by far the majority of the time
  • Since WW II, the average number of years between bad bear markets is about 4.8
  • “Corrections” of 10% or more come around every 3 years
  • Smaller declines of 5%- 10% arrive virtually every calendar year
  • Recovery time from declines of 10%-20% has been as short as a month and as long as 10 months.

Corrections offer the opportunity to engage in tax loss selling (important this year since much of the year was spent at higher prices), improve a portfolio from marginal names to higher quality issues, even increase income flows.

Will Tariffs Sink the US Economy?

Aside from the Kavanaugh nomination and Hurricane Florence, the news lately has been dominated by ‘tit for tat’ on the trade front. Meanwhile, the stock market powers ahead. What gives? Isn’t it important to our economy if traded goods are more expensive and supply chains are disrupted? Won’t stocks eventually ‘wake up’ and fall because of trade policies?

To lay the groundwork, understanding how trade affects the US economy is critical. Our economy is actually relatively closed. About 12% of US GDP is associated with exports while imports make up another 15%. (Compare this to Germany, where 40% of GDP is exports; in Japan, it’s 17%.) The net of these two is a component of GDP calculation, and since the 1990s, we’ve run deficits consistently. If the US dollar were not the primary currency of trade, the US would have undergone an economic adjustment long ago to account for these persistent deficits, likely taking the form of a lower currency value, inflation, a difficult job market, or all of the above and then some. However, the station of the US currency is significant in this calculus, so we must think of this issue as the world is, rather than what it might be. As it is, we import capital to accommodate our consumption and we do not experience the kinds of dislocations that smaller less developed countries do.

A substantial portion of our goods and services are made and consumed in the US. The Chinese import US goods only to the tune of about 0.7% of our GDP. Exports from China to the US are about 4.1% of its GDP; when considering the effect of this number in China, remember that it does not capture local benefits from plant utilization in China by American manufacturers, such as employed Chinese workers.

Our two major trading partners are Canada and Mexico. There, NAFTA is in renegotiation. But despite tariffs, trade with Canada increased in the last few months, and Canada’s trade deficit narrowed. Through July, 2018, we were importing more from Mexico than in the last several years for the same period. Thus far, it’s pretty difficult to see any material impact on the economies in North America from trade talks.

At the consumer and industrial level, metals tariffs, much ballyhooed, have resulted in higher aluminum prices in the US for certain, but steel prices have barely budged. Stainless prices are up, but are at 61% of early 2012 values. Nickel alloy is at 82% of 2012 values. Lumber, nearly constantly subject to tariffs, has fallen in price dramatically since January. Soybeans, hit by Chinese tariffs, are down in price, but the other side of that coin is that consumers benefit from lower soy prices. At General Motors, costs of steel are on track to increase by $1 billion this fiscal year. But that’s 0.6% of GM’s latest annual revenue number. Looking at its cost of goods sold quarter over quarter for June, excluding depreciation and amortization, the number was DOWN, not up. The company’s conference call indicated that it was finding places to save even while bearing higher materials costs.

Meanwhile over in China, a decline in the yuan is ameliorating tariff impacts on the consumer. Ditto the Canadian dollar and the Mexican peso. So while taxes in the form of a tariff makes goods coming to the US cost more, the decline in source country currency values can offset that tax.

Tariffs are also happening in the context of a strong US economy where the Fed is still somewhat accommodative. Consequently, consumer demand has only grown stronger this summer. Of course, the threat of higher prices on imported goods may be front-loading demand into this quarter; time will tell. We tend to believe that strong employment bears the larger responsibility for solid demand figures.

Supply chain disruption is another common complaint around tariffs. But supply chains have been building in flexibility for years, in order to deal with wars, natural disasters, and of course, financial disruptions like tariffs. Companies can and do switch suppliers from country to country. It does take time, but it’s not impossible. We think GM, which should be particularly vulnerable to tariffs, is showing the results of supply chain maneuvers that will neutralize the effects of tariffs to a large extent. The much publicized plight of soybean farmers is overdone. There are only two major producers of soybeans in the world, and we are one of them. Our crop will be sold to countries that do not tariff it, and next spring, farmers can once again make a choice to plant grasses or corn instead of the bean.

That said, the latest round of tariffs does pose a threat on one front, and that’s inflation. The first set of goods taxed were business to business items, while this next round is nearly all consumer goods. We’re going to pay more at WalMart, no question about it. The effects of higher prices will probably become evident around the holiday season, but with tariffs so far set at just 10%, it remains to be seen how much of that will pass through.

We have discussed many of the commonly publicized negatives surrounding tariffs. But it’s conceivable that there will be positives. These might include manufacturing moving to the US; better trade agreements that then cause tariffs to be cancelled; or increased sales at US firms that become more competitive with imported goods. The Wall Street Journal wrote a story recently on Allen Edmonds, which makes shoes in the US and always has. Pricey, yes, but they last forever and the company will virtually rebuild your old pairs multiple times at no charge. This kind of service and product is overlooked in the US, but perhaps no more.

Considering all the possible points of pain from tariffs, our conclusion is that given their current extent, the effect on the US economy will be mild, with more extreme well-publicized disruptions here and there. Should the trade war worsen, we’ll have to revisit the subject, but for now, we conclude that the market is right to look past trade talk.

The Great Emerging Markets Swindle

Unfortunately, the longer I practice as a portfolio manager, the more cynical I become regarding certain aspects of our business. The great push to include emerging markets funds in a ‘diversified’ portfolio has become my favorite annoyance lately. Granted there should be no doubt that I am reacting to the very poor performance of these funds lately, but this missive is about more than that.

In our industry, practitioners are taught that markets are efficient and diversification rules. I won’t go into the various problems with those theses – which are only that: theses, as they cannot be proven like the law of gravity is proven. Instead, we’ll lay groundwork by reminding readers that ‘diversification’ means including lots of different ‘asset classes’ in your portfolio to reduce risk. In the 1980s, policy wonks at a division of the World Bank came up with the idea of emerging markets. Later, Wall Street decided these constitute an asset class, and by the way, making these markets accessible to the average guy resulted in very high fees paid to these selfsame Wall Streeters. Industry academia jumped on the bandwagon, plotting ‘efficient frontiers’ including emerging markets funds, purportedly to show that a dollop of these investments added to a portfolio would reduce risk for only a small give-up in return.

The experience of the last few years must be disappointing to owners of these portfolios. In fact, the experience of the last ten years should be disappointing. Emerging markets funds as measured by Morningstar’s classification of rated funds have returned 1.95% per year over the last five years, versus 9% to 14% for the various categories of US stock funds. Using 10% as the return on US stocks (on the low side) and rounding up the emerging markets return of 1.95% to an even 2%, that’s a difference of almost $51,000 on a $100,000 investment over five years.  Even diversified bond funds had a better showing at 3.28%. Over ten years, the MSCI Emerging Markets ETF (EEM) returned just 3.26% per year. Worse, the long term variation in return (standard deviation) of emerging markets funds has been 22%, versus just 16% for the S&P 500. If you want to severely dilute your return to seek lower risk, bonds are a better choice than the riskiest stocks on the planet.

Aside from the horrific returns and high risk in emerging markets, I take issue with the underlying intellectual reasons given for utilizing these investments. Here’s why:

  1. Better growth in emerging markets and a larger slice of world GDP does not lead to high stock market returns. Consistently, evidence shows that economic growth is only slightly correlated with stock market returns. And good growth overseas comes with strings attached, such as lower political stability, uncertain effectiveness of financial controls in a US dollar dominated world, and expanding choices for investments in these economies. In other words, as economies grow, they offer more investment opportunities, which in turn cannibalizes funds from existing opportunities, restraining returns on all public companies. William Bernstein pointed out in 2009 that markets in low growth, stable countries performed best over the last 20 years, partly because the public-company opportunity set could expand so rapidly.
  2. In my lifetime, not one ‘emerging market’ has ever emerged. Markets that remain underdeveloped for decades are not attractive prospects.
  3. The rule of law is deteriorating worldwide, not improving. Property rights are unique to developed markets. China has no property rights. Africa has limited to no property rights; ditto many countries in the Middle East. Where property rights do not exist, high quality collateral does not exist, hampering large scale entrepreneurship. In the US, many small business owners get started by pledging their homes as collateral for a loan to expand. That alchemy is much more difficult if you don’t own property.
  4. Judicial processes, such as bankruptcy, are extremely inefficient and take a long time, preventing reallocation of capital to better uses. This goes for some developed countries as well, by the way. Italy is a notable example.
  5. Related to number 1, the opportunity set of public companies in emerging markets is undiversified. Many traded stocks are financial companies or extractive industries such as mining or energy. Few are consumer related. There is no place to run for cover should the stock market in Malaysia falter – except getting out of Malaysia. We won’t even get into the various accounting rules that dictate how earnings and sales are reported overseas – suffice to say there can be shocking disparity versus American rules.
  6. In some significant percentage (which varies according to whose numbers you use), participating in emerging markets means being a minority owner alongside countries’ governments. Governments are poor economic stewards. They are not innovative, they can prevent efficient capital allocation, they can insist on rules such as labor laws that are not in the interest of shareholders. Sometimes they can simply appropriate your asset without payment.
  7. Wall Street pundits have taken to saying that emerging markets are now ‘cheap’ – after years of sluggish returns. But we see this differently: perhaps they are cheap because investors are beginning to understand that the knocks against these markets are significant and not improving, making the entire asset class worthy of avoiding. Perhaps in fact, emerging markets should always trade cheaply.

As an alternative, we prefer accessing emerging markets exposure by owning companies headquartered in North America that sell to emerging markets customers. These companies are better managed, and still benefit from growth overseas. And if that’s just not enough for you, you can create an imbedded portfolio tilt by seeking only US companies that generate significant earnings from emerging markets. You will end up with a well diversified portfolio at a reasonable level of risk.