Tuesday, February 9, 2016

Separating Fact from Fiction…

From the Desk of Joe Rollins

There is just about no other way you can classify the month of January, other than a total debacle from an investment standpoint. The high volatility that was witnessed during January always tends to upset investors who are confused by the large movements in the market almost on a daily basis. Often times, I am confronted by the statement, “It is clear that Wall Street knows something that we do not know.”

When a client approaches me with the statement, “I cannot sleep at night due to my fear of the market”, I always ask them exactly what fear they are worried about – is it something that really should affect the market at all or are we just going through normal volatility created by traders’ desire to move the market in one direction or another for their own positive benefit? My job is to determine whether there is something fundamentally wrong with the economy and the market and act accordingly.

As a fund manager, I know that the easiest thing in the world to do is to get out of the market completely. Virtually within a second, we can sell the entire portfolio to cash on a moment’s notice. When we do so, it removes all of our risk and worries. No one would ever criticize you for moving to the sidelines until the volatility ends. However, as we have demonstrated in these posts for the last 30 years, market timing cannot be executed to the best benefit of investors. As Peter Lynch said, “I can't recall ever once having seen the name of a market timer on Forbes' annual list of the richest people in the world. If it were truly possible to predict corrections, you'd think somebody would have made billions by doing it.” Virtually, all of the wealthy people in the world are investors not speculators, and certainly not market timers.

I recently returned from Cuba and I will write a full blog on the subject in a couple weeks. It is quite sad to see what a great country Cuba could have been if not led by misperceived socialists who thought they knew how to run an economy better than capitalists. It is also amazes me that a complete supporter of the concept of socialism is currently running for President of the United States. It is even more surprising that the supporters tend to be young Americans, ranging from 18-30 years old. It almost makes me question what our colleges and schools are teaching younger Americans about economics.

If you look at Cuba, you see exactly what happens in a socialist economy. People in Cuba have absolutely no incentive to do anything other than take handouts from the government. There is virtually no productivity, and they cannot even provide for their own food. I was once approached by a university student who expressed the incredible, positive, economic benefits that socialism would bring to the U.S. However, he was totally stumped when I asked him to recite each and every country that has been successful and survived over time in this type of government.

It is interesting that the list of failures far exceeds its successes. We all know that Russia failed, Eastern Europe, Cuba, Venezuela, Argentina, and the list goes on. In any case, when I write the blog regarding Cuba, I will point out many of those economic events that occurred in Cuba which have destroyed the future of the country.

There is no question that the month of January 2016 was pretty much a “wipe out” from a financial standpoint. For the month of January, the Standard & Poor’s index of 500 stocks had a negative return of -5%. Interestingly, the one-year period on the S&P shows a negative return of -0.7%. However, the three-year return on this index still shows annual returns of 11.3%, the five-year 10.9% and the 10-year 6.5%. The NASDAQ composite clearly was the worst performer this month, with a net decline of -7.8% for the month of January. Despite that it still finished with a positive return of 0.7% for the one-year, 15.1% for the three-year, 12.6% for the five-year and 8.3% for the 10-year period. The Dow Jones industrial average had a negative return in January of -5.4% and a one-year negative return of -1.6%. However, the gains over the three-year period are 8.5%, five-year 9.5%, and 10-year 7% annualized gains.

As you would expect with all equities down significantly during January, the Barclays aggregate bond index should have shown positive returns. For the month of January, this index had a positive return of 1.4%, although a negative one-year return of -0.4%, a three-year annual return of 2%, a five-year annual return of 3.3% and a 10-year yield of 4.3%. As you would expect, when equities turn down, bonds should perform on the upside. However, during the mother January it was not as clear of a relationship between equities and bonds.

Virtually every classification of equities was negative in January. Large-cap, mid-cap, small-cap, international – everything was negative and interestingly, negative almost to the same percentage. It really did not make a difference whether you were in growth, growth and income, equity index, international or any other type of equities. If you were invested, you lost about the same amount of money during the month of January.

While it is clear that most bond funds performed fairly well and were positive, the high-yield bond funds were absolutely taken to the woodshed and beaten during January. High-yield bond funds lost between 1% and 3% fairly consistently throughout the classification. Investors thinking they were in the safety of bond funds found out they too could be subject to high volatility when traders decide to sell off the market.

Reflecting back on the month of January and the first week of trading in February, you would think from the outside looking in there must be some sort of logical explanation for such a large selloff. In some instances, the traders are forecasting the U.S. to almost certainly go into recession in 2016, dragged down by the recession around the world. Those assertions are so ridiculous that they do not warrant significant conversation; but I must do so in order to counter the argument.

The most pronounced argument is that the world must be in recession with such a decline in oil, and therefore when oil goes down, stocks go down, and vice-versa happens once the price of oil increases. I would like to relay that most of this theory is not based on fact, but total fiction. And finally the old argument that China will drag down the U.S. (since it is clearly slowing) is always pulled out in order to justify the traders selling broad indexes for no particular good reason. Later in this posting, I will attempt to address that issue as well.

One of the first subjects we need to address is the effect of oil on the equity markets. It is somewhat puzzling to me that, notwithstanding fundamentals of individual stocks, the markets have been trading basically on the price of oil. You will note that when the market goes down, the selloff is virtually the same percentage, regardless of the index you follow.

The traders basically sell the indexes, and therefore all stocks go down at the same percentage when there is a major selloff. I wish I could explain to investors that this has nothing to do with the economy or even anything to do with the individual stocks. It just means the traders are moving their position around to reflect whatever trading position they are trying to exploit that particular day.

There is this presumption that if the price of oil is decreasing, then of course the “demand” for oil must be decreasing and since the “demand” is falling we should be moving into recession. I guess the presumption follows that in 2008 the price of oil plunged and sure enough a recession followed, even though the economic facts of 2008 and the facts of 2016 bear no semblance to one another. Most importantly, let us analyze the demand issue. While consumption of oil in 2013 was 91.9 million barrels per day, consumption was 92.8 million barrels per day in 2014, and in 2015 consumption of oil was 94.5 million barrels per day. In a “demand” driven market, you can say consumption of oil was in fact up in each of those years. Total dollars were down of course because of the significant reduction in the price of oil, but claiming the country is falling into recession due to a lack of “demand” is not supportive of the facts. The facts reflect that demand is continuing to grow. And while not in a terribly robust fashion, the economy is continuing to move ahead.

The traders cannot seem to wrap their heads around the correlation between demand and supply. Supply is essentially flooding markets around the world with excess crude oil. With the U.S. creating huge oil supplies of their own and Saudi Arabia producing at all-time highs, and with the almost assured prospect of Iran putting excess oil in the market, supply is overwhelming demand at the current time.

No one quite understands exactly what Saudi Arabia is doing by reducing the price of oil while producing at full levels, but you would have to think it has more to do with the economic damage it does to Russia, Syria, and Iran more than benefiting themselves. However, the truth of the matter is that these actions, while not detrimental to the worldwide economy, are in fact an enormous benefit. Surprise, surprise. Since virtually everyone benefits from lower oil, to argue that the price is a detriment to equities just does not pass the smell test – not even close!

The other major argument regarding oil is that the entire banking industry will suffer huge losses due to loans to the oil industries. Over the last several months, all major U.S. banks’ stock prices have gone down dramatically. In some cases, bank stocks will move 5% on a given day. The overall loss in value to major banks has been close to 15% over the last 90 days. Once again, the argument that banks will fail due to loans they have made to energy companies is not based on any substantial facts. The most likely scenario predicted by Barron’s, along with other major forecasters, is that the price of oil should be down in the first half of 2016, followed by a rally to the mid-$50 price of oil by the end of 2016. A 100% gain.

By far, the largest exposure of any bank to oil has been Wells Fargo, and their entire energy portfolio is only 2% of its gross loans. Considering they have the largest exposure to energy, other banks clearly have even less. Also, missed in this supposed economic explanation is the fact that while all energy companies are suffering, there continues to be many strong energy companies that will buy up the smaller ones once prices recover. This is not the first time these energy companies have suffered through a bear market due to the price of oil.

As I have in prior postings, I will not bore you with the statistics regarding the misplaced fear of the Chinese slowdown. Basically, China reported that the GDP for the whole year of 2015 was 7.9%. If you do not believe those numbers and you assume that the real GDP is only half of that, 4.45% is still quite an impressive gain in the worldwide economy. There is absolutely no supporting documentation to back up any figures showing that China has fallen into recession. As pointed out over and over again, exports to China from the United States are less than 1% of our GDP. Other countries export to China much more heavily than we do. To argue that U.S. equities must fall into a slowdown in Chinese consumption borders on the virtual absurd.

Traders have been declaring for the last six or seven months that that the U.S. is clearly falling into recession, yet that argument was discounted when the most recent unemployment data for the month of January was announced. You must note that historically January is a bad employment month since you have significant layoffs in the retail industry after the holidays and a good deal of work that is not completed due to severe weather. However, the most recent unemployment report indicated that there were 151,000 new jobs created during the month of January, and the unemployment rate fell to 4.9%.

When I was in college, they taught us that 5% unemployment was “full employment”, which we have now reached for the first time since early 2008. Even more important than the unemployment percentage, the statistics of the employment report were extraordinarily bullish. Average hourly wages rose 0.5 during the month and total number of hours worked increase. Clearly this increase had a great deal to do with consumer spending, as restaurants, retailers and hotels all increased employment during January.

I read extensively on the subject of housing and the effect of housing on the U.S. economy. One of the true indicators of the economy is whether new houses are selling. If you look at the economic statistics supporting housing, you will see that those numbers continue to be extraordinarily strong. Based on the most recent reporting, residential spending has increased 8.09% over the last year, and the home price index across the country rose to 5.36%. There is just no way to characterize in any way other than once again, housing is moving up dramatically in the United States and the number of people working in housing is helping the economy grow even stronger.

You cannot drive anywhere in Metropolitan Atlanta without seeing construction cranes and commercial buildings announced daily. Again, the stock market traders’ assertion of a recession has no basis in fact. And even more ridiculous is the argument that the price of oil should lead to lower equity prices rather than higher. I am not even sure how they argue (with a straight face) that $1.50 for a gallon of gas is a negative for the U.S. economy, when only a few years ago we were paying an astounding $4 a gallon for gas.

All the above information regarding the economy really does not make you feel any better when stock prices go down every day. The reason I want to share this information is because I review it all very carefully to determine whether there is a fundamental problem that we need to address when investing in stocks. Based on the above information, it is fairly clear the economy continues to be strong, although not overwhelmingly so. Therefore, the three major components of stock investing- excellent earnings, low interest rates and a strong (and not a negative) economy - indicate higher prices are more likely to occur in the coming months.

I am often approached by investors who point out that the major brokerage firms present X, Y or Z about what you should do with your stocks. Occasionally, I am presented with articles sent by my clients that point out that J.P. Morgan, Wells Fargo, Goldman Sachs, UBS or some other major brokerage house has recommended you either be in or out of stocks, based upon certain criteria. I wish I could explain to investors that these brokerage houses are essentially your enemy when it comes to investing. They have an underlying vested interest in making you move stocks because it benefits them. If you buy or sell, they are paid a commission. There is a serious difference between investing and speculation.

What I really want to know from these major brokerage houses is not what they forecast, but rather what type of performance they have enjoyed over time. In the most recent edition of Barron’s magazine, they rated the mutual fund companies from best to worst. If, in fact, these major brokerage houses were better investors rather than speculators, they should appear in this ranking at the top of the list. If you would bother to look closely at the underlying ratings, you would see that J.P. Morgan had the highest rating among the group at number 19. UBS asset management was number 41. Wells Fargo fund management showed up at 46 and Goldman Sachs, a lowly 52. Interestingly, Morgan Stanley did not appear in the top 67 rankings. I can argue for hours that a fee-only arrangement is the best form of asset management for an investor, but frankly the statistics above speak to that point more clearly.

It is never fun going through this volatility and it gives me many sleepless nights wondering if I’m missing something concerning this current sell-off. But rest assured that we do watch this on a daily basis and are very concerned when equity prices are down, but we also understand that the biggest risk to our clients over the long-term is not being invested when the market turns good. At the current time, we think the risk/reward ratio supports the long-term cause of staying invested and waiting for the turn up in equities to occur.

As always, the foregoing includes my opinions, assumptions and forecasts. It is perfectly possible that I am wrong.

Best Regards,
Joe Rollins

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