Tuesday, February 13, 2018

"A 10% correction in the stock market due to the economy being too strong? Let me explain."

From the Desk of Joe Rollins

On the first weekend of February 2018, I fully intended to write this blog and explain how fabulous the month of January had been for the equity markets. Actually, the markets turned in a record performance in January. The Standard & Poor’s 500 index reached all-time highs for each of the first 6 trading days of 2018. You would have to go all the way back to 1964 to witness such a tremendous run and astounding highs for the beginning of a year.

Unfortunately, I was out of town during the first week of February, so I had to delay writing this blog for a week, but what a week it was. In the first 7 trading days of February, the S&P 500 actually fell by 10%. It was not the normal sell-off that you would expect when there are financial difficulties. Based upon the analysis of many market watchers, the sole reason for the huge sell-off was because the economy was financially too strong! I am sure this probably sounds illogical to you, because it certainly does to me; to have a sell-off of this magnitude just because the economy’s growth is actually too good is baffling.

In this blog, I fully intend to explain to you the difference between investing and speculation. I also intend to try to explain how the market can be down over 1,000 points on 2 of the last 7 days without any corresponding negative economic occurrences. In fact, this huge sell-off was accompanied by nothing but excellent financial news. As former Federal Reserve Chairman Alan Greenspan would say, “It’s a conundrum”.

While I plan to cover all of the aspects of this sell-off, as is my habit, I really need to explain how good January was in order to set the picture for the sell-off.

The S&P 500 index was up a sterling 5.7% for the month of January and up 26.4% for the one-year then ended. The NASDAQ Composite, the best performer of the major index, was up 7.4% for the month of January, and 33.4% for the one-year period ended January 31, 2018. The Dow Jones Industrial Average was up 5.9% for the month, and 34.8% for the year ended. Interestingly, the Barclay’s Aggregate Bond index was actually down 1.2% for the month of January and has risen only 1.9% for the one-year period ended January 31, 2018. As I have been writing in these blogs for many years, there is a high likelihood that bonds will continue to underperform given the strong economic growth and the increase in interest rates.

Ava enjoying the beach in St. Petersburg

January was quite an extraordinary month, but then all hell broke loose when the employment numbers for the month of December were announced by the government on February 2, 2018. This was also the day following the announcement of Apple’s quarterly income report. In this report, they announced that their earnings for the fourth quarter of 2017 were the highest quarterly earnings ever recorded in American finance. In addition, they announced ongoing strength in their operations and projected exceptionally high profits for 2018. It may seem very perplexing that the market would sell-off 10% over 7 trading days after both of these excellent economic terms were reported.

I would like to put into context something that is often misunderstood by the average investor. When I ask potential clients how many times the S&P 500 has fallen in the last 15 years, more times than not their answer is at least half. Much to their surprise, the S&P 500 has been up 14 of the 15 previous years. In fact, the S&P 500 has gained 10.1% per year over the last 50 years (1968 to 2017). And this is in spite of the fact that they endured 7 bear markets of a 20% or more decline. Just think about the economics of that statement. Even though the markets went down 7 times over the last 50 years, with a decline of 20% or greater, the market has still gained 10.1% over that time period. That strength is nothing short of incredible.

All of this is based upon an economy that has been subpar in prior years. If the year 2017 is not revised to a growth of at least 3%, which is highly unlikely, then we will have our 12th consecutive year of less than 3% growth in the U.S. economy. This includes the years 2006 to 2017. The current estimation of growth for 2017 is likely to be in the 2.3% to 2.6% range. What is even more remarkable about this fact is that the next longest streak is not 12 consecutive years, but only 4 years of less than 3% growth from 1930 to 1933. For those of you that do not remember those years, that was in the midst of the Great Depression.

In an attempt to try to understand why the markets would sell-off so abruptly in light of such great economic news, you have to play the “what if” game. I believe the traders came to the conclusion that the Federal Reserve would have to step in and substantially increase interest rates in the face of such strong economic growth and higher inflation, with higher interest rates becoming an alternative to stocks which in turn would drive down stock prices. Although there is absolutely no evidence of this, whatsoever, it was apparently enough for traders to bring the markets down. I will later explain how momentum traders work, but first I need to cover the economics of why the assumption that they acted on to bring the markets down borders on the absurd.

For the first time in my recollection, we are in the midst of a worldwide economic move up. China grew at a 6.9% GDP in 2017. Japan, which has suffered through 3-decades of near recession, registered its 7th straight quarter of GDP growth. If 2017 finishes the year up 2.6%, in the U.S., virtually every developed country in the world will be showing economic strength. So, the assumption that the Federal Reserve would be required to increase interest rates is based on the assumption that they could increase interest rates while the rest of the world would sit back and let them do so. Not likely!

As of Friday, February 9, 2018, the 10-year Treasury was yielding 2.85%, which had moved up significantly since the beginning of 2018. However, the German 10-year bond rate is only at 0.784% and the Japanese 10-year bond rate is at 0.066%. Does anyone with any economic training believe that the Federal Reserve could increase interest rates significantly while the rest of the world has significantly lower rates? As you know, money goes where it is treated best. If the U.S. has the highest interest rate in the world, money will flow to the U.S., strengthen the dollar, discourage exports and significantly impact the employment in the U.S. To think the Federal Reserve would make a move that would hurt the U.S. economy is not even plausible.

What do we know about our own U.S. economy? It appears quarterly earnings for 2017 are up 5.5% from 2016. But first we need to understand exactly what we are talking about because corporate earnings for 2018 are forecasted to jump a robust 22.5%. Yes, you are actually reading that number correctly. A 20% increase of corporate earnings in the U.S., but the stock market falls 10%? Of course, much of the expected corporate earnings in the U.S. are due to the significant reduction in income taxes for corporations. However, all the good news has yet to be told. Everywhere you read, corporate America is announcing bonuses for employees due to the tax cuts. The entire world has proposed building plants in the U.S. because of the tax cuts. There is unequivocal evidence that the GDP should be higher in 2018 than 2017 based upon the increase in corporate earnings alone.

There are also other economic indicators that cannot be ignored. The Federal Reserve Bank of Atlanta is now forecasting for the first quarter of 2018 to increase by 4%. This is not someone on T.V. making projections based on wild economic data; this is the actual Federal Reserve Bank of Atlanta. They anticipate strong economic growth in the first quarter of 2018 even though, historically, the first quarter of any year is the worst quarter of the year. There are a lot of reasons why, but the primary reason is the effect that weather has on construction in the U.S. This particular year, bad weather has been a significant negative factor to growth and, therefore, if we actually realize a 4% growth, it will be impressive given the negative economic evidence.

Let’s just say you agree that I have quoted strong economic information for 2018. So why do we still have a 10% sell-off? The first reason is that it has been over 1.5 years since we have even had a 3% correction in the market, let alone even 5%. We have become so used to the market grinding higher on a daily basis that we forget what a minor correction means. You have to have corrections in order to bring new players into the market and as I have quoted often in these pages, you can expect a 10% correction at any time in financial markets. They are not only expected but they are welcomed, as they allow for the process of “bottoming” and the market can move forward.

More than likely, the main reason we saw this significant sell-off over 7 trading days had more to do with true momentum traders and hedge funds than economic reality. It helps to actually understand the mentality of traders to understand why something like this would happen. If you are really interested in the subject, there is a fascinating book written by Michael Lewis titled “Flash Boys: A Wall Street Revolt”. You may know that Michael Lewis is the same author that wrote the best seller “The Big Short” relating to the decline in the real estate markets in 2007 and 2008. Even further ago, he wrote another book based upon economic events called “Liar’s Poker”. Therefore, I believe he is eminently qualified to analyze economic positions and write upon actual evidence rather than concepts.

In the book Flash Boys, he explains that these traders trade on momentum not fundamentals. If the trend is down, they trade down. If the momentum is up they trade up. They do not care what the fundamentals are. You often hear people explaining that the market had been controlled that day by program traders. This is what we mean when we talk about momentum investing vs. financial investing. During this 2-week period, it is almost assured that the momentum traders and the large hedge funds were in coordination in attempting to move the market. Each of these trading techniques requires that they borrow large sums of money from the local banks in order to magnify the movements by selling against sole momentum. Since they do not consider fundamentals, they live under the philosophy that a trend is a trend until the trend is broken.

I am sure some of you reading this will immediately say we should ban these traders because they clearly have a negative effect on your portfolio. I could not disagree more. The reason the market is efficient is because it has liquidity. If you want to sell your stock at any time, day or night, you can do so. You may not get the price you want, but at least you can get your money. There are many markets in the world where there is not a ready market to buy your security. The momentum traders create the liquidity that is critical for investing. You may not like what they do day-in and day-out, but you cannot disagree that they provide a benefit to the market and are therefore needed.

One of the things I noticed this week is that people assume that the sell-off in the market is a lot worse than it actually is. As of February 9, 2018, even though the S&P 500 index was down 7.16% for the month of February, it is actually only down by 1.85% year-to-date. Given the volatility of the market lately, a 2% decline could be either made up entirely or double just in one day of trading.

So, assume that you do not want the volatility of equity investing but rather you prefer the stability of the bond market. In this sell-off there were no prisoners. Everybody went down with the ship. As of that same date, the S&P 500 is now 1.85% and the U.S. Bond Index is down even further at 2%. Therefore, if you chose the conservative nature of bonds as opposed to equities, you would have lost even more. In addition, the international markets also fell by almost the same percentages as the U.S. market. So, the sell-off is worldwide and there are no safe havens, but I guess you could say that is exactly what the momentum seller and hedge funds wanted.

Wine Weekend in St. Petersburg, 2018

Dakota and Joe

Jennifer and Eddie

Danielle and Robby

At Rollins Financial, we promote investing, not speculation. We do not invest in gold, silver or Bitcoin. None of those are even really an asset class, not particularly rare and have no liquidity value. If you bought Bitcoin, just read the horrors of people trying to sell it but cannot create liquidity. We invest in the fundamentals of the stock market going forward and don’t look back at what happened last year or the year before.

I have studied financial markets for close to 40 years and there is absolutely only one slam dunk conclusion you can draw. Recessions bring negative stock market performance. Virtually nothing else will forecast a bad stock market unless there is a forecasted economic recession. There is no evidence whatsoever in any financial matters today that a recession is anywhere in sight.

In fact, quite the opposite is true. As mentioned above, corporate earnings are projected to grow in excess of 20% in 2018. In my personal opinion, that number will be even higher since we do not know the full economic effects of the new tax cuts. The entire world is rushing to build in the United States which will increase employment and it will make wages go up benefitting the average worker. As wages go up and corporate America uses their capital to build plants and equipment, the average worker will benefit from higher wages. In addition, regular GDP growth for 2018 is likely to be 3.5% which would be the highest over the last 12 years.

And the economic future continues to get rosier. This past Friday, the President signed into law an increase in federal spending of over $300 billion dollars for 2018. This increase in federal spending would be for higher military expenditures and infrastructure increases. If you compound the economic growth of this increase, the numbers are quite staggering. Based upon the velocity of money, a $300 billion increase in spending could actually generate a sevenfold increase in GDP of over $2 trillion. I know we are talking about numbers that are hard to even fathom, but to simplify it; a good economy has the potential to get better when federal money is added to the equation.

Let me express two concerns that clients have asked me to expand upon: First, many are concerned that China is buying up all of our U.S. debt and will therefore essentially “control” the U.S. as a large holder of our debt. Therefore, a massive sell-off of Chinese bond holdings would substantially wipe out the U.S. economy. Just so everyone understands, China needs us a lot more than we need China. Without the U.S. buying from China, the Chinese economy would be nothing. In addition, the Chinese have a need to stabilize their currency against the U.S. dollar and they do so by investing in U.S. bonds. It would be financial suicide for China to consider any major liquidation in U.S. treasuries since it would strengthen their own currency making their exports non-competitive. That concern should never affect your economic projections.

Second, while it is true that the large tax decreases will create federal deficits, is it just not possible that economic growth created by this economic stimulus would not increase federal revenues? There are many that are forecasting that if the tax decreases increase GDP by only 0.5% for the next three years, then these tax cuts will in fact pay for themselves. Just the repatriation of funds by U.S. corporations from international banks is already creating potential tax revenue to the U.S. Treasury by over $1 trillion over the next 10 years. The economic news just keeps getting better.

I am giving you a lot of economic numbers and financial circumstances to consider. As I often write in these reports, believe what you know and discount those that forecast negative economic evidence. The three major components that control the market are corporate earnings, interest rates and the economy. This month, going forward, all three are substantially stronger than they have been in years and all are likely to increase the market going forward. Therefore, my advice to investors is basically, do nothing. Yes, we evaluate this every day and may change on a dime if we see something new but at the current time, given the strong economic evidence going forward, no changes are warranted in your portfolios.

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

Best Regards,
Joe Rollins