Saturday, August 29, 2015

Your Weekly Update AND Correction History AND A Contrary View on the Prospects for Emerging Market Equities

At last, and halleluiah!!, a correction!

While every one of our clients has heard me preach from the get go that corrections are healthy bull market phenomena, clearly---as they occur---not everyone buys that line. Here are a few of the inquiries/comments I've fielded over the past few days:

"Should I build a bigger cash position?"

"What strategies do we need to take in order to stop the bleeding in our portfolio?"

"I'm afraid it'll take two years to recoup."  (I have no clue where the 2 years came from)

"Should we get out and buy CDs?"

"At our age we're afraid we won't live long enough to recoup."

Actually---believe it or not---I think that's all of them (the fearful ones). Although, I strongly suspect many more have been having similar thoughts.

Then there are those who couldn't rush in fast enough with extra cash to take advantage of what they viewed as a rare buying opportunity.

As I've expressed ad nauseam of late, while I make no guarantees, I don't see a bear market looming---because bear markets are typically things of recessions. And the preponderance of data---and, not to mention, present Fed policy---strongly suggest that a recession in the foreseeable future is highly improbable.

The chart below makes the recession/bear market case. The red areas are all of the recessions since WWII, the arrows are the bear markets (20+% declines). The arrows circled in green represent the three occasions where the S&P 500 dipped into bear market territory either after, or out of reach of, a recession. The red-circled arrows represent the bear markets we can attribute to recessions.     click to enlarge

Bear Markets and Recessions

Notice the length of the arrows: As you can see, those that occurred firmly outside of recessions were relatively short-lived. Per my recent audio commentaries, a bear market to me is one where stocks linger below that 20% dip for more than just a few months. I.e., in my view, while those three non-recession bear markets satisfy the official definition, the fact that they lasted only 6, 8 and 3 months respectively made them merely deep correction phases---and monster buying opportunities!

As for the dreaded, and inevitable, bear markets---while they are indeed painful experiences---when pictured against history's bull markets, as Business Insider has done below, we see how dangerous it can be to try and time the ups and downs.      click to enlarge

Bull & Bear Market Chart

What the above chart doesn't show is all of the 10+% corrections that occurred within those blue-shaded bull markets (see the S&P, Deutsche Bank chart below). Talk about the risk of market timing!!!!

Is it really all about China?

So is it really China that's got the market all riled up? Well, the action would suggest as much. But, as I've been stressing of late, China does not pose the systemic risk the headlines and scaremongers would have us believe. And, therefore, I have to believe the smart money knows better.

Is that arrogant of me? Am I asking too much for you to adopt my view when the rest of the world says you should be worrying big time? Well, then, let's consult someone with some academic clout. In last Thursday's CNBC article Relax: China's Fundamentals are Sound, Warwick Business School Professor and senior editor of the Journal of World Business Kame Mellahi expresses the very points I've been pounding the table on. Here's a snippet:
The Chinese economy has hit some rough weather for sure, but the government still has $4 trillion of bank deposits to play with. The fact that it has decided not to use this financial firepower is perhaps an indicator that China has finally decided to let market forces play a bigger role in deciding the value of its stock market and its currency. 

The Chinese government has more levers than most that it can pull and, with such strong reserves, it still has the ability to rebalance its economy. Next year, I expect to see reforms and loosening of controls on the markets to deepen.

So if it's not China, what is it? Well, actually---all of my lecturing notwithstanding---I think it is China. But only because China's recent bungled effort to intervene into its stock market, and its ill-timed, but completely understandable, widening of the Remnimbi peg to the U.S. dollar occurred when the market was ripe for the picking. Meaning, the market, in my view, was staging for a correction; I think a Fed-induced correction.

You see, when the market's jittery, any "bad news" can send it reeling. I.e., had "China" occurred when stocks were on firmer footing, we may very well have experienced a far milder reaction. Here's the Bank of International Settlements making that point (HT Rockefeller and Schmelzer):
“Bad news in a market situation where investor risk appetite is already low is likely to result in a much greater repricing of risky assets than in periods where it is high. The dynamic stance of the risk appetite of market participants as a sentiment could thus serve as an important contributing factor in the transmission of shocks through the financial system. Furthermore, as it might itself be influenced by the situation in financial markets, it could work as a multiplier. Accordingly, taking into account the risk appetite/ risk aversion of investors and its evolution has become an important element of assessing the condition and stability of financial markets.”

Now if this "correction" got you rattled to begin with, you may now be feeling a bit relieved given the last few days' snap back. Well, please, don't! While maybe we have seen the bottom and it'll be blue skies from here, history suggests that there's a good chance the market will at least test last Monday's lows before it regains its footings. And, sincerely, I think that would be the healthiest scenario. Plus, the Fed still hasn't moved the needle on its benchmark interest rate and, alas, the government's about to bump its head on the debt ceiling once again. Yep, we're within a month or two.

The good news is we're not talking recession, we're simply talking volatility---which is the nature of the market, and the concern of only the short-term investor (whom we don't counsel).

One last note on corrections: You've heard me---and the TV pundits---say time and again that 10+% dips are, historically, annual happenings. Being that an unusually long period has elapsed prior to the one we're presently experiencing---and that the 90s saw several years without one---I figured I better update my story: According to American Funds, a 10+% correction, if we go all the way back to 1900, remains a once-a-year occurrence. According to S&P and Deutsche Bank (see below), since 1960 the number of trading days separating such downturns has averaged 357. While that's about a year's worth of trading days, when we throw in the weekends we're talking 499 calendar days between corrections. So, if we use 1978 as our starting point, the market has corrected once every 16.4 months---on average.     click to enlarge

Days Separating Corrections

Suffice it say, we were way overdue!

A quick note on emerging markets:

A good friend sent me an email last evening where he made an intelligent case that emerging markets have more pain coming. He referenced the headwinds posed by the impending Fed rate hike, the strong dollar and China's easy monetary policy. Yep, my friend has unusual insight into what moves global markets.

In a nutshell, here are his concerns:

A Fed rate hike, China's easing and the strong dollar concerns are all essentially one in the same. The idea is that an increase in the Fed funds rate and an increase in newly printed Chinese currency will bolster the dollar---as higher yields will make dollar-denominated debt securities more attractive, and as a central bank's easy monetary policy can serve to reduce the value of its nation's currency, thus increasing the value of other nations' currencies (read U.S. dollar). Now a strong dollar can pose severe headwinds for select emerging market economies for a couple of reasons: One, an emerging market has a problem if it holds much dollar-denominated debt, as a stronger dollar means it takes more---in home currency terms---to pay off the debt. And two, foreign investment can scurry in a hurry if the destination currency runs into trouble---which is what happened back in March 2013 when Ben Bernanke sparked the "taper tantrum". I.e., when he said that the Fed will begin to taper its asset purchases, the world viewed that as a bullish move on behalf of the dollar. And if you had borrowed dollars for virtually nothing and invested them in, say, Turkey, to net a much higher interest rate (plus, you made a killing if the dollar declined against the lira)---it's called a "carry trade"---you had to get that money back to the U.S., and in a hurry; as a rising dollar meant you'd need to come up with more lira than you originally exchanged for to pay off that U.S. loan. Emerging markets stocks literally tanked over the next several weeks.

Here's why I think that maybe my friend---while his concerns are perfectly textbook logical---will find his emerging market positions performing better sooner than he thinks. For one, everyone seems to be on that textbook-logical side of the boat. And it's been my experience that when everybody's on one side of the boat, you want to move to the opposite side---and collect a toll when the other side begins to sink and everybody runs to your side for safety. For two, while the textbook says the interest rate differential is a major currency driver, history at times says otherwise. The arrows on the chart below show periods when the U.S.'s benchmark interest rate and the dollar moved in opposite directions:     click to enlarge

Fed Funds Hikes and the Dollar

For three, the dollar's already up 17% over the past 12 months. I assure you, there's been far fewer of those carry trades these days. Yes, emerging markets have indeed seen capital outflow as the prospects for higher U.S. interest rates increase, but that has to be more about equity and currency traders anticipating a textbook currency scenario playing out.

Ah, but what if the dollar actually begins to decline soon after the Fed raises rates (it's happened before)? Well, you'll likely see capital flow to foreign currencies in a hurry---exacerbating the dollar decline. And why might the dollar decline to begin with? Well, Europe's economy is picking up, and the ECB is desperate to create a stimulative wealth effect by boosting asset prices. And other central banks are in, or considering, similar modes as well. It's not much of a stretch to think that there's a good chance we'll see dollars flow to Europe, and emerging markets, in a big way---as investors look to invest where central banks are most hospitable. Plus, emerging market equities have seen some real pain of late and, therefore, are trading at ridiculously low valuations. Should the dollar waver, and should emerging market economies begin to, well, emerge from their doldrums, you may see one of those classic huge bounces that have followed so many of the emerging equity bear markets of the past.

Lastly, I should add that---contrary to popular opinion (and recent market action)---a stronger U.S. dollar isn't nearly all bad for emerging markets, as their exports become more attractive to their U.S. customers.

The Stock Market:

Non-US developed markets (EFA and FEZ below)—even after their recent pummeling—have outperformed the U.S. major averages (save for the NASDAQ Composite Index) year-to-date. Given many foreign markets’ cheaper valuations, early-stage recoveries and, yes, accommodative central banks, I remain constructive on non-U.S.. That said, there are a number of potential international hot buttons (as we've recently experienced) that could easily delay the narrowing of the gap between the valuations of U.S. and non-U.S. securities (particularly emerging markets [VWO below]). That’s why we think long-term and stay diversified!

Here’s a look at the year-to-date price changes (according to CNBC) for the major U.S. indices---and for non-U.S. indices and U.S. sectors---using index ETFs as our non-U.S. and sector proxies:

Dow Jones Industrials:  -6.62%

S&P 500:  -3.40%

NASDAQ Comp:  +1.95%

EFA (Europe, Australia and Far East):  -0.69%

FEZ (Eurozone):  -2.69%

VWO (Emerging Markets):  -13.52%

Sector ETFs:

Here’s a look at the year-to-date results for a number of U.S. sector ETFs:

IYH (HEATHCARE):  +6.29%




XLK (TECH):  -1.81%



XLU (UTILITIES):  -8.62%

XLB (MATERIALS):  -10.25%

IYT (TRANSP):  -13.33%

XLE (ENERGY):  -16.95%

The Bond Market:

As I type, the yield on the 10-year treasury bond sits at 2.18%. Which is 13 basis points higher than where it was when I penned last week's update.

TLT, an ETF that tracks an index of long-dated U.S. treasury bonds, saw its share decline a whopping 3.20% over the past 5 trading days (down 2.83 year-to-date).  As I keep repeating, I see bonds in general sporting a risk/return trade-off that makes going out on the yield curve not worth the risk.

On Volatility and Timing:

Each week I share with you the very short-term (year-to-date) results for major indexes and sectors. I do this with a bit of hesitation, as I in no way want to give the impression that you, nor I for that matter, should base our long-term investment decisions on short-term movements in markets or their sectors. It can, however, serve as a reference point for how the markets are, or are not, responding to the data (which is why I, as a professional, track the short-term). While my beginning of the year optimism over non-US (developed markets that is) and the housing sector, and my pessimism over utilities, appears to be justified by recent results, I need to strongly (very strongly!) emphasize that I was not predicting what we’ve experienced thus far in 2015. Plus, while we maintained our healthcare exposure I in no way expected the gains that sector has experienced this year. Same goes for energy and materials, only in the other direction.

My optimism or concerns over a given sector or region are based on factors such as valuations, trends, supply and demand, monetary policy and cyclicality—and my comfort in making allocation recommendations rests on the view that our clients are not short-minded investors (it can take awhile, if at all, for the market to reward what I believe to be good fundamental logic) who mistakenly believe that any human being possesses a capacity for market timing. Some people get lucky from time to time, but without exception, market timers are wrong far more often than they are right. The path to long-term investment success is fraught with bumps and potholes. The ones who successfully make the journey take it slow and never over-compensate when steering through and around the inevitable obstacles along  the way.

Last week's U.S. economic highlights:

AUGUST 24, 2015

THE CHICAGO FED NATIONAL ACTIVITY INDEX came in strong for July, with its first positive reading for the year. Here's Econoday:
Production, as expected, was July's strongest component, swinging to plus 0.28 from minus 0.14 on a big upswing in the auto sector where sales are very strong. The contribution from employment was steady at a constructive plus 0.11 while the component for sales, orders & inventories slipped from 0.06 in June to only 0.01. The only component in the negative column in the month is personal consumption & housing at minus 0.06 which is, however, up from minus 10.00 in June.

AUGUST 25, 2015

THE JOHNSON REDBOOK RETAIL RECORD budged .1% last week, to 1.7%, which remains a disappointing reading. The report suggests that this year's late Labor day may be delaying back-to-school purchases.

THE ICSC RETAIL REPORT came in at 2.0% last week, which, like the Redbook's report is not historically consistent with expansionary readings. No doubt the 14.1% increase in year over year online sales is showing up in the brick and mortar numbers.

THE FHFA HOME PRICE INDEX rose only .2% in June. Year-on-year growth came in at 5.6%.
Given the recent pace of sales vs inventory, this indicator should rise noticeably going forward.

MARTKIT'S FLASH SERVICES PMI FOR AUGUST shows continuing expansion in the sector, although at a slowing pace, at 55.2. Here's from the press release:
At 55.2 in August, the seasonally adjusted Markit Flash U.S. Services PMI™ Business Activity Index1 dropped from 55.7 in July to its second lowest since January. That said, the latest index reading – which is based on approximately 85% of usual monthly replies – was well above the neutral 50.0 threshold and still close to the average since the survey began almost six years ago (55.8).

NEW HOMES SALES rose solidly in July, which confirms my continued optimism and speaks to the view that U.S. economy is indeed in a nice, albeit not robust however, expansion mode. The number came in up 5.4% at a 507k annual pace, versus 482k in June.

THE CONFERENCE BOARD CONSUMER CONFIDENCE READING FOR AUGUST showed marked improvement over July's reading.... 101.5 vs. 90.9... However, the respondents were downbeat on future spending plans!! Here's Econoday:
Enormous improvement in the assessment of the current labor market drove the consumer confidence index well beyond expectations, to 101.5 in August for a more than 10 point surge from July. A rare 6.5 percentage point drop to 21.9 percent in those describing jobs as currently hard to get points to outsized gains for the August employment report. This reading will have forecasters scratching their heads. The gain for this reading lifts the present situation component to 115.1 for a more than 11 point increase from July that points to consumer power for August.

The expectations component also shows major strength, up more than 10 points to 92.5. Here the gain reflects improving expectations for the employment outlook were optimists are back out in front of pessimists. The outlook for income also remains positive.

Buying plans, however, are downbeat with fewer planning to buy a vehicle and, in what could be an ominous indication for housing, many fewer planning to buy a house. Inflation expectations are dormant, down 2 tenths to only 4.9 percent which is very low for this reading.

The Yellen Fed has put great emphasis on the importance on consumer confidence readings and this report points to job-driven strength ahead for household spending.

THE RICHMOND FED MANUFACTURING INDEX came in at 0 vs. July's 13. The regional manufacturing reports are sending mixed signals, but, on balance, they point to continued weakness in the sector.

THE STATE STREET INVESTOR CONFIDENCE INDEX dropped to 108.7 in August from 114.6 in July... Clearly the global dynamics are doing a number on sentiment of late.

AUGUST 26, 2015

NEW PURCHASE MORTGAGE APPS rose 2% last week, up a very strong 18% year over year. Refis were off 1%. The average 30 year rate fell to 4.08%.

THE JULY ADVANCED DURABLE GOODS REPORT, while showing a large decline year over year, isn't so bad when the effect of huge aircraft orders a year ago are stripped out. The report was far above economists' expectations and showed significant growth in capital goods orders over the past few months. This is an extremely encouraging economic sign, as capex has been a sorely-missed ingredient in this current expansion...

CRUDE OIL INVENTORIES actually came down 5.5 million barrels last week. This would be short-term bullish for the oil price. GASOLINE inventories rose 1.7 million barrels and DISTILLATES were up 1.4 mbs.

AUGUST 27, 2015

SECOND QUARTER GDP, the 2nd reading, came in at an impressive 3.7% annual growth rate.  This speaks to my recent commentaries where I've expressed my view that the economy is in better shape than many would have us believe. Note the 2.1% increase in the price index in Econoday's commentary below.
The second-quarter did show a big bounce after all, up at a revised annualized growth rate of 3.7 percent which is 5 tenths over the Econoday consensus and just ahead of the high estimate. The initial estimate for second-quarter GDP was 2.3 percent. This report points to better-than-expected momentum going into the current quarter.

Consumer demand was strong with personal consumption expenditures at a 3.1 percent rate led by an 8.2 percent rate for durables, a gain that was tied to vehicle spending. Residential investment was very strong, at plus 7.8 percent, as was nonresidential fixed investment which, boosted by an upward revision to structures, came in at plus 3.2 percent. Inventories contributed to second-quarter growth as did improvement in net exports. Final demand proved very solid, at plus 3.5 percent. The GDP price index, unlike many other price readings, is showing some pressure, at 2.1 percent and just above the Fed's general policy goal.

The economy's acceleration is now much more respectable from the first quarter when growth, at only 0.6 percent, was depressed by heavy weather and special factors. Splitting the difference, first-half growth came in a bit over 2 percent which, as it turns out, is right in line with the similar performance of 2014 when first-quarter growth, again depressed by severe weather, fell 2.1 percent followed by a 4.6 percent surge in the second quarter. Growth in the third quarter last year was 4.3 percent which would be a very good performance for this third quarter.

The impact of today's report on Fed policy for September's FOMC is likely to be minimal. Focus at the upcoming meeting will be on the state of the global financial markets and, very importantly, the strength of next week's employment report for August.

WEEKLY JOBLESS CLAIMS remain well under that 300k threshold, which signals real strength in the labor market.... coming in at 271k last week.

CORPORATE PROFITS FOR Q2 rose 7.3% year-over-year. However, when properly adjusted for inventories and depreciation, they're contracting. I.e., profit margins have been coming down of late. Here's Bespoke on the topic:
... corporate margins continue to decline to levels we haven’t seen in quite some time. In the long run, this is indicative of two things, in our view: pressure on asset prices backed by corporations (equities and credit) and higher wages. On the second point, at left we show the share of gross domestic profit that goes to workers through wages and benefits. As shown, the share is highly cyclical; it tends to peak during the depths of recessions, as workers wages are typically much “stickier” than output. But we would note that the current expansion has stopped that trend, to a degree. Wage share has been moving sideways, and that’s one of the reasons the economic cycle hasn’t been moving sharply higher. Low worker shares are a weight on inflation, and the fact that they aren’t rising indicates that we haven’t seen those pressures mount. Yet. If this chart does start to leg higher consistently, it’ll be a very big deal, signifying that price pressures have once again returned to the economy. Finally, at right we show a chart that also appeared in The Closer on 7/14/15. As we discussed in that note, the depreciation of capital assets has stayed near all-time-lows as a percentage of GDP; business are continuing to see their capital base eroded much faster economically than they are accounting for financially. All else equal, this is a tailwind for growth going forward and a negative for accounted profits. Overall, the backdrop we see is very positive for: more investment spending, higher wages, less profit, and higher inflation, all relative to the past few years.

THE BLOOMBERG CONSUMER COMFORT INDEX logged its second weekly increase, coming in at 42 vs 41.1 the week prior.

PENDING HOME SALES were up .5% in July. This was a decent, but not great, showing.

NATURAL GAS INVENTORIES rose 69 billion cubic feet to 3,099 last week.

THE KANSAS CITY FED MANUFACTURING INDEX shows the KC region still stuck in teh mud. See Econoday's second paragraph below for the conditions unique to the region:
Factory activity in the Kansas City Fed's region remains in deep contraction, at minus 9 in August vs minus 7 in July and deeper than the Econoday consensus for minus 4. New orders are also at minus 9 with backlog orders at minus 21. These are deeply depressed readings that point to a long run of weak activity in the months ahead. Production is already far into the negative column at minus 16 with hiring at minus 10. Price readings in the August report are in contraction.

This report speaks to significant distress for the region which is getting hit by the oil-led fall in commodity prices. Taken together, regional reports have been mixed to soft so far this month, pointing to slowing for a factory sector that got a bit of a boost from the auto sector in June and July. The Dallas Fed report, which like this one has been badly depressed, will be posted on Monday.

THE FED BALANCE SHEET decreased by $2.1 billion last week to $4.475 trillion. RESERVE BANK CREDIT rose %70.8 billion.

M2 MONEY SUPPLY increased yet again last week by $33.4 billion...

AUGUST 28, 2015

PERSONAL INCOME AND OUTLAYS FOR JULY show real strength on both fronts. The .4% rise in personal income was the best reading since last November. Spending, led by a 1.1% gain in durable goods, jumped .3%. The personal savings rate even rose by .2%, to 4.9%. This is very good news for the outlook on the consumer-driven U.S. economy.

THE CORE PCE PRICE INDEX rose at a very tame .1% month-on-month rate in July. Year-on-year it remains entirely unthreatening, at 1.2%. Despite the fact that this the Fed prefers this measure over CPI, I believe its members see, as do I, the potential for inflation to pick up noticeably in the not too distant future. Which, on top of relatively good economic data, is, in my view, enough to allow them to nudge the Fed funds rate off of the zero lower bound this year.

An early reading on the effect of global volatility is downbeat as the consumer sentiment index came in well below expectations, at 91.9 for the final August reading. The mid-month reading was 92.9 which roughly implies a pace near 91.0 over the last two weeks which is the softest since May.

But the effect isn't enormous as the current conditions component, where the immediate impact of market events is most felt, slipped only 2 points over the last two weeks to 105.1. This is a respectable level but is slightly lower than the 107.2 for July and points to a slight slowing in consumer activity for August.

The expectations component is only marginally lower, at 83.4 for final August for a 4 tenths dip from mid-month and a 7 tenths dip from July. Expectations for inflation are flat, at 2.8 percent for the 1-year outlook, which is unchanged from both mid-month and July, and at 2.7 percent for the 5-year which is unchanged from mid-month and down 1 tenth from July.

This report is probably a wash for the September FOMC. The doves can argue that market events in China are hurting consumer confidence but the hawks can argue that the effect isn't that great.

No comments:

Post a Comment