Happy New Year? New Year, New Correction

“The stock market is a device for transferring money from the impatient to the patient.”

-Warren Buffet

First off, I would like to say Happy New Year, everyone! Unfortunately, the market has not been in a celebratory mood thus far. After a market correction of 12% in August of 2015, the stock market flirted with recovering back to positive territory in December of 2015 before deciding to pull back into correction territory once more at the start of this year. As I write this, the S&P 500 is down about 8% year-to-date – so what is the going on with the market?

If you turn on the news media, or go to your favorite investing pundit or politician, you are going to get many theories about the causes of this correction. I wanted to take some time to give you my thoughts and discuss the most popular reasons I see cited. I tried to be short and sweet this time around, but there is simply a lot to discuss- so grab a cup of coffee and get comfortable.

Devan’s Commentary

Why is the market correcting? In my view, it is correcting because that is what markets do. Like I wrote back in August – market corrections are normal, routine, and even healthy. You may be surprised to know that since 1928, stocks have been in a 10% drawdown (aka “correction”) 55% of the time. Here in Ohio, everyone expects there to be snow in January. How much? We do not know. It could be one inch of snow or eight inches, but we know that snow falling is just part of living in Ohio in January. Will the stock market go down further? It could, but it most likely will not stay that way for long.

It is easy to look at past corrections and bear markets and see the reasons why they happened but it is extremely difficult to diagnose a correction cause while the correction is taking place. Besides the fact that market corrections are just part of life as an investor, I think the volatility this year is being driven by a lot of confusion and fear.

Calming your market fears is an important skill for a successful investor, and is incredibly hard to do because it is an innate human response. As an investor, fear can become your absolute worst enemy. The best way to attack fear is through facts and logic. Let’s try to tackle the facts and logic behind this correction by analyzing and understanding some of the reasons we are hearing it is happening. The three most common reasons that I am seeing cited as causes of this correction are China, oil, and the threat of a US recession.

China

China’s economy is slowing down. The Chinese retail stock market crashed last year and continues to fall. It is hard to blame investors for feeling nervous when they hear that – bad things happen when big things happen to big countries right? That can certainly be correct for some investors – but how you are invested is going to dictate how a falling Chinese economy impacts your money.

Economists have been predicting that the Chinese economy would slow down for years. It is normal and expected for an economy to slow when it transitions from a “developing economy” to an established “developed economy”. China’s gross domestic product growth (GDP – the common measure of how an economy is growing) has fallen from being 10%+ to around 7% per year. To put that in comparison, in the United States we grow on average between 2-3% per year. Keep in mind that the U.S. is by far the wealthiest country on the planet and leads the world in business innovation. Economies move in cycles, and China’s slowdown is nothing that hasn’t been predicted. In fact, it has been fully expected to happen and economists are unsurprised.

Isn’t a Chinese slowdown bad for U.S. multinational corporations? For some, yes. For most, not really. If we examine the earnings of the S&P 500, around 8% of the overall revenue comes from the Asia-Pacific region of which 2% was reported from China. In simpler terms - for the average big American corporation for every $100 they earned, $2 came from Chinese customers. China runs a very large trade surplus with the United States. If you go into a Wal-Mart right now much of what is for sale comes from China. The reverse of that is not true; Chinese consumers are not buying a lot of American goods. China is much more reliant on our economy than we are on theirs. You could actually make the argument that a slowdown in China could be good for U.S. companies because Chinese companies would be forced to compete harder for our business.

If no one was surprised by a slowing Chinese economy, why has their stock market continued to crash? First, I’d like to call attention to a major difference between the U.S. stock exchange and the Chinese retail stock exchange. You may not realize this, but in the U.S. 90% of stock market trading volume is done by institutional investors, and less than 10% are retail investors. Institutional investors are the professionals who do it full time – large banks, mutual funds, hedge funds, ETFs, myself and my firm, etc. Retail investors are generally those who invest for themselves through a retail brokerage account. In China, it is nearly the opposite ratio. The market is nearly all individual investors, not sophisticated algorithms and professionals.

At the beginning of this year, the Chinese government introduced circuit breakers to their retail stock market. A circuit breaker automatically closes the stock market for the day if losses reach a certain level. I actually think circuit breakers are a good thing- but not when implemented in a moronic fashion. In the U.S. our circuit breakers kick in if we suddenly fall 20% in a single day (which has almost never happened) and it allows everyone to take a deep breath, go for a walk, and analyze what is going on in the world.

The Chinese government had the less than brilliant idea of setting their circuit breaker at 7%. Going back to my previous point about how normal market corrections are in the U.S., 7% is an absurd circuit breaker level. Following implementation, the Chinese circuit breakers caused a market close after only 15 minutes of trading – two days in a row. If right now you thought you may not have the option to sell your investments, how would you react? It would be pretty reasonable to panic post-close and probably try to load up on sell orders for the next day in case the market is only open for 15 minutes. Remember, this market exchange is made up of over 90% amateur investors making their own calls with no professional guidance. On top of the absurd new circuit breakers causing panic, the Chinese government has banned insider selling since the August crash- that ban expired last week. You read that right- not only did an absurdly low circuit breaker go into effect but any large shareholders who had wanted to sell in the past six months were finally able to do so that same week. The Chinese government is learning the hard way that you cannot simply “communist” your way out of natural market dynamics.

Oil

The next big reason for the market decline that I have seen cited is the crash of oil prices. Here is a chart with the price of oil for last few years for reference:

Past performance is no guarantee of future results.

As you can see, Oil fell from being $100+/barrel down to $30/barrel. Why has this had an impact on the stock market? Energy companies are really big and make up a large percentage of the major market indexes (such as the S&P 500). Am I worried? Nope.

The history of the price of oil is marred by crisis. In fact, I do not think that there has ever been a point in my life where we were not having some sort of an oil crisis. From the 1970’s-onward, we have been in a perpetual oil crisis. It is either too high or too low. Can you ever recall a point where you said “wow, the price of gas is just about right!” Probably not, even at $30/barrel I still do not enjoy filling up my vehicle.

If I were given the option to choose between an oil crisis where the price was too high or the price of oil was too low, I would choose a low-priced oil crisis all day every day. Why? Low oil is about as close you can get to a pure consumer tax-cut. Everyday Americans suddenly have hundreds of extra dollars in their pockets every month because of lower gasoline prices. That gets me excited because about 70% of market performance is directly correlated with consumer spending.

Of course, a low oil price is obviously not all good news. If oil stays at $30/barrel or goes lower for an extended period of time, there will be companies that go bankrupt and people are going to lose their jobs. This will be especially prevalent in areas where there was a large oil-boom like Texas and North Dakota. These bankruptcies are not going to be the Exxon-Mobil’s or Chevron’s of the world. It will be the smaller energy-related companies that you likely have never heard of. Many of these firms flocked to the oil boom regions and employed massive amounts of leverage and debt with the hopes that oil would always be expensive. It has the potential to be a very sad situation, but the overall net-positive effect on the economy and markets will be extensive.

Why did this happen? Supply and demand- specifically supply. When supply goes up without subsequent demand, prices will fall. That is exactly what has happened. If you recall, in the past few election cycles it was very popular for politicians to discuss how the U.S. needed to become energy independent. They wanted to free us from dependence on OPEC and Middle-Eastern Oil. Well they were successful and it has happened; we are largely energy independent in the U.S. and as a result there is a lot more oil available on the free market. Are you driving less or using less gasoline? Maybe a bit, but probably not substantially. Demand has stayed roughly the same, or perhaps even fallen slightly, but supply has risen- a low price of oil is the result.

If we could somehow pick our crises, this is one I would take all day every day. Let’s sit back and enjoy this one while it lasts.

Threat of a U.S. Recession

The threat of a U.S. recession is the third reason that I see cited as the cause of this market correction- and the most farfetched. I would like to be as clear as possible- the U.S. entering a recession is extremely unlikely, if not downright silly. In the world of macroeconomics, there are generally five reasons why a country goes into a recession: a financial crisis, a sector recession, an inventory recession, aggressive central bank tightening, or a black-swan event. Let’s talk about each of these for a moment:

Financial Crisis: A financial crisis is very unlikely to happen any time soon. Governments and central banks around the world have learned much from the 2007-2008 financial crisis, and a whole host of regulations and reforms have been put in place to prevent another from happening. World governments have also shown a willingness to intervene when necessary and provide stimulus and bail-outs to stabilize their economies and markets. We are unlikely to see a financial crisis again anytime soon.

Sector Recession: The two most recent cases of a sector crisis are the Housing Crisis of 2007 and the Technology Bubble of 1999-2000. The housing crisis was especially impactful because of the scope of the housing industry in the U.S. When a housing industry goes bust you not only impact the homebuilders but also the hundreds of thousands of construction workers, realtors, mortgage lenders, city governments (property taxes), and families who lose their homes and jobs. The current state of the housing market in the U.S. is improving and it is much more fundamentally sound.

During the Tech Bubble of 1999-2000, there was such overwhelming exuberance for technology companies that they all became incredibly overvalued. We simply do not have that type of exuberance or irrationality happening in any major sector of today’s markets. Therefore, I do not expect a major sector recession such as the Tech Bubble to reoccur anytime soon. And it is definitely not the cause of our current correction.

Inventory Recession: This just isn’t happening. Consumers haven’t stopped spending money; they are buying more.

Aggressive Central Bank Tightening: This one just makes me laugh. The Federal Reserve raising rates by 0.25% is about as non-aggressive as you can get.

A black-swan event: A black-swan event is something that comes way out of left field that no one sees coming. Think Pearl Harbor or 9/11. The problem with predicting black-swan events is that they are just that, unpredictable. However, we have not experienced a black-swan event (thankfully) that could have triggered this correction.

It doesn’t always feel like it, but the economy has drastically recovered from the lows of the Great Recession. Household wealth has rebounded past 2008 levels and is currently the highest we have ever seen. U.S. companies are seeing record profits and as a result we are seeing record-breaking job creation numbers. Unemployment is at 5.5% which means we are nearing full employment. The number of long-term unemployed and underemployed Americans has been declining steadily. We are seeing record levels of entrepreneurship, and some majorly mind-blowing innovation. I have talked about why there are many reasons to be optimistic, and a typical stock market correction does not change that. A recession in the U.S. is very unlikely to happen any time soon.

Markets in Turmoil?

Occasionally when the stock market pulls back, CNBC delays all of their programming, goes into full panic mode, and runs a special entitled “Markets in Turmoil.” Of course “Markets in Turmoil” made a return this past weekend. My friends at Sentiment Trader track every time “Markets in Turmoil” is aired and have charted it against the S&P 500 for us. Interestingly, every time they’ve run the special in the past five years the market has been at or near its bottom. Also, CNBC seems to think the term “turmoil” is applicable during a large span of routine S&P500 scenarios. Could it be that airing a program like “Markets in Turmoil” simply drives up their ratings and does not actually correlate with the state of the market? Please remember, a majority of the news we watch is a program owned by a company who is trying to beat out their competitor with more dramatic stories. In instances like this correction, the media is simply over dramatizing and adding to the fear and confusion of investors.

Past performance is no guarantee of future results.

Warren Buffet spoke true when he said "The markets are a system of transferring wealth from the impatient to the patient.” Market corrections are a part of investing (55% of the time remember?) and they are stressful and incredibly uncomfortable. Investing is gut-wrenching and hard work at times like this. The fear instinct inside all of us is yelling at us to do something, when the best thing you can do is do nothing. Rarely in life are the best things easy to get, it takes hard work and patience – fortunately the market has a way of rewarding the hard working and patient investors.

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