Special Market Commentary: Is Correction Our Direction?

SPECIAL MARKET COMMENTARY

August 24, 2015

Is Correction Our Direction?

Not even a week ago I started to write an article for our clients that I was going to title, “Is Flat The New Up?”  I was basing this article on the fact that as of last Tuesday (August 19th) the S&P 500 stock market index was up slightly over 1% for 2015.  A puny return when compared to the returns of previous markets for the same time frame.  The 500 hit its highest mark on May 21, 2015 when it peaked at +3.4%.   My original thought was, “Is this what it’s going to be like for the rest of the year?”  So is flat the new up?  We have been sharing with clients since last fall of our belief that the U.S. stock market might be considered fully valued.  That means that on a price to earnings valuation some believe it would be perhaps more difficult for stocks to grow at the same pace as the prior three years.  After all we are six and a half years into this bull market which is the third longest in stock market history.  But when considering the reasonable growth rate of the U.S. economy why wouldn’t stocks be able to continue to grow modestly in 2015?  So our statement to clients has been that we believed that the 500 in 2015 potentially could grow at a pace between 6% to 8%.  We also stated that most of this year’s growth potential would occur in the second half of 2015, not the first.   The reason?  Because our last two winters (2013/2014) have been so severe that business that would typically consummate in the first quarter would be pushed into the second quarter GDP numbers and then continue to improve and stabilize through the end of the year.  But just as I was about to wrap up our thoughts on “Is Flat The New Up?” stock markets around the globe fell at the end of last week in rather dramatic fashion in terms of the amount and speed of the decline.  Hence the retitling of our paper to “Is Correction Our Direction?”

A stock market correction is defined as a drop of 10% of more from any prior high.  A bear market is defined as a drop of -20% from any prior high.  As of the close of the market Friday, August 21st, the Dow Jones Industrial Average (only 30 stocks) was officially in correction territory (-10%).  The S&P 500 Index finished down -7.5% from its May high or -2.5% short of meeting the correction definition.  To detail last Friday’s S&P’s action the 500 lost -3.2%, but registered a -5.8% loss for the week.  Friday’s drop alone was the worst one-day decline since 2011, four years ago.  The NADAQ finished -9.8% off of it’s July high (not May) registering a one week loss of -6.8%

As previously stated, last weeks stock decline was not isolated to just the U.S.A.! Markets in Beijing, Frankfurt, Tokyo and London also had their worst declines since 2011.  So let’s jump into Mr. Peabody’s Wayback Machine and revisit 2011 to discover if there are any parallels to then and what happened last week.

Article Headline:  “Stock Market Crash of 2011?” August 11, 2011 by Michael Snyder. 

How far does a market go down before we call it a crash?  On August 8, 2011, now referred to as “Black Monday” U.S. credit rating firm Standard & Poors lowered the vaunted AAA rating of sovereign U.S. bonds to AA+.  Three days later the stock market was down 2000 points.  Yesterday’s (August 10, 2011) announcement by Federal Reserve indicated that the central bank would keep interest rates near zero until mid 2013.  The Dow Jones leaped by 400 points on the Fed news, but all of those gains were wiped out today.  Gold reached unprecedented levels $1,800 as fears of a European Sovereign debt crisis and crumbling U.S. economy dominates the market place.  With each passing day this looks more like 2008.”

This article from 2011 summarizes how fear feeds like an infectious contagion the can spread quickly.  If you don’t recall, the S&P 500 Index finished 2011 basically flat, up less the two percent and bonds at best were fortunate to stay positive that year.  However the following years of 2012, 2013, and 2014 were all good for U.S. stock investors.

So where do we go from here?  Some market pundits believe we will hit a short-term bottom very soon.  But the fundamental questions should be, “will the U.S. economy continue to expand and will U.S companies have the ability to make money?  It’s that simple!!

So what are the major factors that may have contributed to last weeks surprise decline?  Here are a few “pro’s and con’s.”

  1. CHINA (Con): as the worlds number two economy, represents 15% of the world’s GDP, but only 2.3% of the America’s GDP.  However this time China sneezed and the rest of the world caught a cold.  A little over two weeks ago China devalued their currency, the Yuan, by 2% and the U.S. stocks declined on the news.  China’s devaluation makes their exports less expensive, therefore more competitive, which should help China’s economy.  But Beijing’s struggles this summer have spooked investors into viewing China as a threat to, rather than a rescuer of, global growth.  During the financial crisis of 2008 and early 2009, China with a significant stimulus plan, acted as a shock absorber.  Now it’s China that providing the shocks.
  1. FEDERAL RESERVE (Pro/Con): Janet Yellen and her team of Fed bank presidents have been teasing us by stating that hey would raise rates.  First it was thought to happen in June, if not then maybe September, or perhaps December, or possibly not until 2016.  So does “when” really matter?  Evidently it does.   The markets seems to pause or back down with every hint of an increase.  Here is what we believe.   The Federal Reserve clearly understands that if they move too soon, by too much or too often they could throw our economy into a recession.  Therefore we firmly believe that when they do raise rates it will only be one quarter of one percent.  We also believe that it will be a very gradual process.  In fact we are estimating that the Fed funds rate in 1 year will not be higher than 2.5%.  But can stocks do well in a period of rising rates?  History tells us yes.  In fact this gradual approach over time should make it easier for stocks to grow since interest rates may not rise enough to compete for stock dollars.
  1. OIL (Pro): Everyone knows that gas prices have come down dramatically in the past year.  Oil productions is high and the good ‘ol U.S.A. through technology and fracking is knocking on the door to being a net exporter of oil.  Since the price of oil is so low you would think that Saudi Arabia (the world’s largest producer) would slow up production since the oil gut globally coupled with decreased demand could move prices higher.

So for now oil production is maintaining current levels.  This of course if good for the U.S. economy because cheap gas prices keeps more money in our pockets that may (most of the time) find its way back into our economy.

  1. DOLLAR (Con): The U.S. dollar is king once more.  But as the dollar has soared in value it is creating a headwind for multi-national U.S. companies who export good and services overseas.  Because of the dollars gain our products shipped overseas are more expensive hence less competitive.  This will most likely continue for sometime.

In conclusion the market has reached the “correction” level.   The next test will be whether or not the markets will stop falling, stabilize and once again attempt a new high.  Or will the market remain volatile and possibly find the beginning of a new bear market.  We can’t at the present time buy into the bear market scenario.   Unemployment is low, wage growth is rising, inflation is low and likely to remain low, earnings are pretty sold and once we digest China’s problems we should remain the world’s best market for growth!

* The Standard & Poor’s 500 (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general.
* The DJ Global ex US is an unmanaged group of non-U.S. securities designed to reflect the performance of the global equity securities that have readily available prices. 
* The 10-year Treasury Note represents debt owed by the United States Treasury to the public. Since the U.S. Government is seen as a risk-free borrower, investors use the 10-year Treasury Note as a benchmark for the long-term bond market.
* Gold represents the London afternoon gold price fix as reported by the London Bullion Market Association.
* The DJ Commodity Index is designed to be a highly liquid and diversified benchmark for the commodity futures market. The Index is composed of futures contracts on 19 physical commodities and was launched on July 14, 1998.
* The DJ Equity All REIT TR Index measures the total return performance of the equity subcategory of the Real Estate Investment Trust (REIT) industry as calculated by Dow Jones.
* Yahoo! Finance is the source for any reference to the performance of an index between two specific periods.
* Opinions expressed are subject to change without notice and are not intended as investment advice or to predict future performance.
* Past performance does not guarantee future results.
* You cannot invest directly in an index.
* Consult your financial professional before making any investment decision.
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