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The 3rd quarter of 2015 was not a good quarter for the equity markets. The S&P 500 was down 6.44% in the quarter; the Russell 1000 was down 6.83%; the Russell 1000 Value was down 8.39%; the Russell 1000 Growth was down 5.29%; the Russell 2000 was down 11.92%; the Russell 2000 Value was down 10.73%; the Russell 2000 growth was down 13.06% and the MSCI ACWI ex US was down 12.17%. All of these indices have bounced back month to date as of October 19.
So what caused this volatility? One reason was that China devalued its currency and data showed that its growth is slowing. The assumption that China’s remarkable economic growth can continue uninterrupted under capable guidance from its political leaders was proven wrong. The mishandling of its stock market and the slight devaluation of its currency have shaken confidence in its pace of growth. Exports in China are growing at their slowest pace since the 2009 recession while inventories are high. There is a fear that a slowing Asia will export deflation to the West.
Another reason was the belief that low interest rates had driven stock markets up, and that cheap rates would keep share prices high. The Federal Reserve was expected to raise interest rates in September because the U.S. economy was growing enough to warrant an increase. When the Fed decided not to raise rates it triggered a sharp sell-off in world stock markets. The good news of cheap money was swamped by the bad news of the reason for the decision. The reason was the indication of a global slowdown in growth coupled with employment data in the U.S. that showed payrolls grew by less than 150,000 jobs for two consecutive months. This was the first time this has happened since 2012. Employment in the U.S. is still growing, but the rate of growth is slowing. Money left the stock market on this news and went into bonds, taking the yield on the 10-year Treasury below 2%.
Another reason was a concern about earnings growth in U.S. companies. Can corporate America keep churning out rising profits? The strong dollar has affected earnings of companies who sell products or services globally. For the third quarter in a row Wall Street is braced for an outright year-on-year decline in S&P 500 earnings. The consensus calls for a 4.3% decline compared to a 0.4% rise when the quarter began. This comes as the forecast for the first quarter was a decline of 2.8% and later turned out to be an increase of 2% and a 3.0% decline projected for the second quarter resulted in a 1.3% rise in earnings. This is a result of the tired game of earnings management of talking down prospects to lower the bar and beat earnings. Growth is now almost static, and margins are falling in addition to top line revenues falling in many industries.
Still Too Much Debt
Our friends at Hoisington Investment Management Company point out that future business activity will reflect two economic realities: “1) the over-indebted state of the U.S. economy and the world; and 2) the inability of the Federal Reserve to initiate policies to promote growth in this environment.
“U.S. government debt stands at 103% of GDP. If private debt is included, the ratio climbs to about 370% of GDP. Scholarly studies indicate that real per capita GDP growth should slow by about one-quarter to one-third from the long-run trend when the total debt-to-GDP ratio rises into the range between 250% and 275%. Since surpassing this level in the late 1990s, real per capita GDP has grown just 1% per annum, much less than the 1.9% pace from 1790 to 1999. The current expansion began in 2009, and since then real per capita GDP growth has been 1.3%, less than half the 2.7% average growth in all expansions from 1790 to 1999. Public and private debt relative to GDP for the entire global economy stands at 265%, up from 219% at the peak of the prior credit cycle. Additionally, the global rate of growth is decelerating significantly while debt levels are continuing to rise, indicating an increasing debt drag on the global economy.
“The second economic reality is the failure of the Federal Reserve to produce economic progress despite years of wide-ranging efforts. The Fed’s zero interest rate policy (ZIRP) and quantitative easing (QE) have been ineffectual, if not a net negative, for the economy’s growth path.
“The current zero interest rate policy has rendered mass distortions in the allocation of capital and mispricing of risk assets. Such repressed interest rates have contributed to more excess capacity that, in turn, has reduced inflation. The ZIRP policy allows low quality borrowers access to debt markets, creating untenable balance sheet exposure when economic activity slows. This condition can last for a long time.”
Martin Wolf is Chief Economics Commentator at the Financial Times, London. I find his comments worth paying attention to. He wrote in the Financial Times on October 9, 2015 in a commentary entitled “Reason for low rates is real, monetary and financial.” He sums up the commentary as follows:
“So what does this view imply for the future of world interest rates? Here are five implications.
“First, people feel that savings have to be valuable. On average, they are. But at the margin, they are not. And the price of anything is decided at the margin. In this case, it is zero.
“Second, the bursting of the credit bubble in the high-income economies led to another huge credit bubble, this time in China.
“Third, after the end of the China bubble, the global savings glut is likely to grow in coming years. China has a national savings rate not far short of 50% of gross domestic product. But its investment rate (which is almost as high) seems sure to fall.
“Fourth, the debt overhangs created by the western and subsequent Chinese credit booms have been large enough to constrain spending for a long time.
“Finally, for strong global growth, we would seem to need another credit boom somewhere. But where might that happen? The obvious candidate for another such boom would be the U.S. If so, weak global demand is likely to keep U.S. interest rates very low.”
The Current Market
The stock market has bounced back from the decline in August and September. At this writing the S&P 500 stands at 2032.41, just slightly below the high of 2058.90 at the beginning of the year. The trailing P/E Ratio of the S&P 500 before the August crash was 21.7X, and the forward looking was 16.7X. As of October 19, 2015 the trailing P/E Ratio was 21.53X and the forward was 17.1X. The 25-year forward average is 15.8X. Using this gauge the stock market is fully valued. Many believe that because interest rates are so low the stock market can maintain such a high valuation. The fear is that if interest rates go up the stock market will readjust its valuation by falling in price. In addition, the revenues of many companies are falling while earnings are still growing. Others are seeing falling earnings as well. Some companies are increasing their stock buyback programs in order to stabilize their stock prices. One reason is that they do not feel that they have a better way to spread their cash flow like building new plants because the economy is not growing fast enough. These are all signs of a top in the market.
That said, the market can still go higher and a crash like 2008 is not foreseen. However, the stock market can have another correction like August and September. As already mentioned, interest rates can stay low for a long time. Whether the Fed will raise rates this year is anyone’s guess. If it does it will probably be 0.25% and then it will wait to raise rates again. Keep in mind that the Fed only controls the Fed Funds rate, not long term rates. With market rates around the world in developed markets lower than rates in the U.S., our bonds look very attractive even at 2.07% for the 10-year Treasury. We expect to see money from around the world continue to be invested in our Treasury market which should keep rates low.
We are not recommending any changes to the current asset allocation for our clients at this time. We will recommend changes if we think they are warranted.
Chairman & CEO
Director of Consulting
Released: December 02nd, 2015 04:00 PM