January thus far has hit investors hard with a steep stock decline. We hear this decline blamed on China, but that’s not likely. Let’s review the real reasons for why investors are taking so much value away from stocks.
First, the bear market didn’t start in January. As value managers, we are the canary in the coal mine. If we are not doing well, it is likely because valuation in the market is too high, and the market is narrowing around fewer and fewer stocks. This process started some time ago. Institutional Investor has written that it started five years ago. We really noticed it in the last half of 2014. Last year, 75% of S&P 500 stocks closed out the year below their 200 day moving average prices. A substantial majority of stocks were down. The NYSE Composite was off -6.4% and the Russell 2000 sank -5% in 2015. This is a replay of 1999, when the market indices were up strongly, but only because a few tech stocks were still surging, while all around us, the rest of the economy was fraying.
Second, China, the whipping boy for the blame-meisters, has been giving us fits for months. This didn’t start in January, either.
Furthermore, earnings, which actually do count, have been flat for two years, and look to be down to flat again this year.
While we can’t answer the question – why January 4, exactly? – we can say this is the normal progression of a market when values need to adjust downward to account for a variety of uncertainties. Those uncertainties now include: what do crashing oil prices really mean; who will be our next President; when will the Fed stop raising rates; when will earnings start picking up again… It starts with a whomping in some part of the economy where capital misallocation begins to adjust to normalcy – read ‘energy’ – and it proceeds to more benign bystanders – industrials – then it widens to infect everything, including the nine stocks in the S&P 500 that performed well last year.
No one knows how long this will last or how far down stocks will go. It could be over next week, or it could persist for some time. But the whole point is to make stocks cheap enough to tempt buyers again, and someday, that will happen. At some point, even if earnings are not picking up this minute, investors will be tempted by a dividend yield, or by an asset base, or by future earnings.
The very best way to tell when the selling is about to stop is the reaction to news. If a company reports lousy earnings and the stock goes up, we are shifting from ‘bad news is bad and good news is bad’ to ‘good news is good and bad news is good’. When the market is able to overlook today’s bad news, that is a sign it is finally seeing beyond the end of its proverbial nose, into the future, when things will improve.