Fear Not, Market Will Rebound

First published on Talkmarkets.com on 02/15/2016

Last year our real GDP grew 2.4 percent primarily driven by personal consumption and fixed investments by both residential and non-residential fixed investments. However, markets in 2015 ended up flat; that also means corporations have added one-year worth of retained earnings in their balance sheets without any market price gains. As end of the last week, markets further declined by this year by 9 percent. You can also say markets are approximately 11 percent cheaper than beginning of the last year.

There are number if unknown fears and concerns spooked the investors lately. In our opinion many of these fears are caused by the faulty reasoning and improper processing of the market data.

Biggest of all the fears is drop in oil prices: When prices go up against the fundamentals they fall as rapidly as they grow. It was evident in the year 2000 market crash due to overpriced internet stocks and in 2008 crash after overpriced housing sector. That is what exactly happened in the oil industry. There was abundant supply of oil from shale producers in the US, happens to be US is the biggest oil consumer in the world. We have warned about oil price bubbles in the last two annual reports here at Covestor. Other oil producers at OPEC never realized how much glut of oil in the market or re-entry of Iran into the oil market. At one-point barrel of oil went up to $140 encouraged more and more drilling. There is no room to store the excess oil produced in the US; all those oil tankers are full and floating in the gulf. Due to this over (abundant) supply, prices plunged and opened the door to export oil from US for the first time after Arab oil embargo.
Naturally Oil firms started cutting drilling and slowing the capital expenditure; sure it has some impact on the economy since energy sector weighs 6.6% of S&P 500. What about rest of the sectors? Every sector in S&P is benefiting either directly or indirectly due to lower oil prices. Chemical companies, fertilizer firms, agricultural sector and biggest of all, the transportation firms such as airline industries, consumer discretionary and staples sectors. Energy sectors loss is everyone’s benefit. Last year alone US consumers benefited approximately $129 billion on fuel savings that is $960 per household. If you add industrial and transportation sector savings the benefits are enormous. It is the biggest economic stimulus both domestically and also abroad like India and China.
Fear of market multiples: As of last week S&P 500 Price to earnings ratio is at approximately 20.5 that means 4.86% in earning yield. When compared to 10 year treasuries yield of 1.75%, stock market looks reasonably priced. Many pundits measure market averages with cyclically adjusted ten-year average earnings. The biggest flaw in this comparison is outlier corporate earnings in the great recession year 2008. If the year 2008 earnings excluded and extend it to one more year in the past, then the average goes down to very reasonable multiples (No offense Dr. Shiller). There is no way we can say market expansion stops at PE multiples of 20, the average PE ratio in the internet bubble days were at 30 range. We don’t see the irrational prices in the market or we have not noticed over enthusiasm by novice investors yet.

Fed’s increase in interest rates: Market wild swings started right after Fed raised interest rates from zero to 0.25% after prolonged period of zero interest rates. Our economy is in excellent condition to handle normalization of the interest rates. Normalization of the interest rates are not a bad omen. Due to lower interest rate environment banks could not take risk of lending money to the borrowers and is also not encouraging savers to add more to their savings accounts.
Other end Fed cannot take unilateral decision of raising interest rates too far and over heat dollar value since rest of the developed countries in the Europe and Japan kept their interest rates below zero. Now Fed has to watch not only the domestic inflation but also interest rates at our trading partners and value of the dollar.

Slowing Chinese Economy: Chinese economy slowed a bit this year but still growing at healthy pace of 6.8% rate. Chinese equity market is isolated, not open for all foreign investors. It is different beast all together. Irrational trading, Euphoria took over their markets. Shanghai index returned 61% in Renminbi terms and single digit return last year even with the correction. China is celebrating Y2K moment for the past couple of months. Though China’s equity market is a closed market but had some impact on the global markets. The Ripple effect is we are having tremors while earth is shaking in China.

Finally, Recession fears:
Even though 2016 market started with losses, we believe this year US GDP even advance little over two percent and do not see recession on the horizon. Unlike the last two years’ unusual warm weather will help first quarter GDP to grow better than the past. Savings from energy is evident in the consumer discretionary spending such as automobile sales. Airline industry is benefiting dearly from lower energy prices and also uptick in the consumer spending. We have recommended Southwest Airlines couple of years back in our annual letter.
In our view there are number of signs indicate harbinger of the recession such as flattening yield curve both at US and in other western countries. Employers prepare downsizing the workforce.

Unemployment is so low now a days creating a wage inflation which is a positive sign of healthy growth. Average weekly hours in the manufacturing sector are improving, seasonally adjusted unemployment insurance claims are in declining, building permits for new homes are slightly improved, and globally in all major economies Yield curve is steep. These are all good indicators of future economy.
So far wild swings in the markets caused so much volatility; it was not a great market for the faint hearts. People respond more for losses than pleasure of the gains. Irrespective of the early market losses this year we see calm after the storm. In our view probably it is good time to keeping your feet wet in the market and keep a long term perspective according to your individual needs.

Finally, our Lakeland Wealth Management’s Long term value covestor portfolio returned gross of 1.3% last year or 0.7% net return compared to 1.38% return of S&P 500 (including dividends). Last year was not so satisfying except we did not lose money. For a long term value investor December 31st is another day for the tax purpose. We think in the year 2016 markets will bounce back and roll forward.