Market observer Zach Karabell argues that we should stop fearing a bear market and just be selective.
FROM BARRON'S | FEBRUARY 4, 2016
In case you have been otherwise engaged, it will not come as news that this has been a month marked by market turmoil. As far too many commentators and analysts have emphasized, the first two weeks of the year marked the worst start for U.S. equity markets ever. The Standard & Poor’s 500 was down 8% in the first 10 days of trading. Global markets, starting with China, were even weaker, and the energy and commodities markets continued their 2015 swoon, with oil plunging below $30 a barrel to lows not seen in more than a decade.
What that rather dismal start means for equities, however, is another story entirely. The mantra for investors is: don’t panic at the first sign of volatility, and rarely has that been more apt than this past month. The other mantra should be to ignore the naysayers of doom as much as possible. It is always possible that this is the start of the Big One, and it is always incumbent on all of us to assess whether now is that time. That said, now is not that time.
Rather, it is precisely the moment to ease off the fence many of us have been perched on these past months while waiting for some clarity. The year ahead remains as unknown as ever, but a substantial pullback in stocks and lessening volatility in bonds offer a slew of opportunities.
Reading the signs
There’s no dearth of those making the bear case, and it’s the same case that’s been made repeatedly the past few years: too much easy money from central banks did little to boost the real economy, and instead created asset bubbles that now are deflating. Stocks are exhibit A for this argument, which continues in the vein that earnings are slowing, prices for equities and bonds are frothy, the energy complex is collapsing, and dangerous volatility is returning now that the Federal Reserve no longer is dampening it.
There is one equivocally accurate aspect of the bearish stance: energy and commodity prices are collapsing along with global demand. Oil may soon “find a bottom,” either around $30 or in the $20s, especially if Saudi Arabia and OPEC shift gears and agree to curb output to prevent further price erosion. But most experts (including those who did not see these price falls a year ago) agree that these sharp resets in commodity prices and global supply (too much) and demand (too little) have in the past lasted many years, rather than months, and there is little reason to suppose that this time is different.
Outside the oil and commodity complex—along with some waves negatively affecting industrial companies whose contracts have been cancelled—the bear story lacks heft. Or rather that story has been in play for some time, and while a global rout cannot be dismissed as a possibility, it lacks several key fundamental ingredients.
First among these is global economic weakness that extends much beyond the oil, commodity, and related industrial industries. Although it is likely that Brazil, South Africa, Russia, and other smaller countries could see significant dips into recession, such signs are not evident elsewhere. Yes, the International Monetary Fund (IMF) recently lowered its estimate of global growth from 3.6% to 3.4% in 2016 to adjust for that weakness, but that rate still represents expansion, not contraction, and much of that will be felt outside Europe and Japan, and hence in the developing world.
There is global weakness, in short, but it is insufficient to fuel a financial market meltdown. The high-yield and emerging market fixed income stress that was evident at the end of 2015 has stabilized in spite of the equity volatility of late, even though the fundamentals of those sectors barely have budged. That is a good indication (albeit short term) that this weakness is not yet causing general contagion.
The second ingredient is that although China may be rocky and transitioning, it clearly is not imploding. The fear at the beginning of the year was that structural liabilities and hidden debts in China, along with capital flight and plunging stock markets, presaged the long-feared “hard landing” of the Chinese economic miracle. While the government-reported 6.9% GDP growth was met with some skepticism in mid-January, Apple’s iPhone sales reported on January 26 are not amenable to the same political pressures. Even though Apple CEO Tim Cook noted some roiling in the Hong Kong market, Apple still managed to generate $18 billion in revenue in China, up more than 50% from the year prior. Wall Street analysts judged Apple’s quarter a mixed one based on expectations, but that says more about Wall Street’s expectations than either Apple’s performance or China’s economy.
The final point is the valuation of stocks and interest rates. A 15x multiple on the S&P 500 based on earnings of $120 for 2016 makes the index neither all that cheap nor all that pricey. There is the usual heated debate about what the proper multiple should be. That debate never has been settled, and it will not be now. But the idea that there is a perfect multiple that tells us when to buy and when to sell is an illusion.
Only in rare cases, such as the extreme multiples of the Nasdaq in 1999, can we say stocks are either genuinely too cheap or expensive. Investors always are weighing where and how to invest, and the cost of each asset always is assessed relative to other assets. So multiples on stocks must be judged in relation to interest rates, to inflation, to the growth rate, and to what returns theoretically are available elsewhere. Prices do not exist in a vacuum.
It is fairly impossible to conclude what the right price of equities should be, just as it is a parlor game with no resolution to game out what interest rates would be without central bank intervention. What is clear is that rates are low globally where banks are modestly tightening (the United States and the United Kingdom) and where banks have a loose monetary policy (the European Union and Japan). Although there has been an upsurge in volatility in stocks, that situation has not been evident in the credit markets, which would be a more troubling sign of systemic weakness.
Stocks have sold off significantly, and indeed the majority of names are down more than the 10%-15% that the indices were in mid-January. That is a normal correction, which was made much more dramatic because it took place at the beginning of the year, and hence was perceived as a harbinger. That too is a mistake. Over the past 35 years, January has been an ambiguous gauge at best. Sixty percent of the time when January ended down, stocks ended down for the year, and 40% of the time they ended up. Hardly a strong signal, but one that generates much noise.
What to do
What remains unknown, of course, is what is unknown. Few knew in 2008 that the housing bubble was attached to a much greater and far more dangerous derivatives and bundled security bubble. There is no sign today that debt problems in China are magnified by either of those issues, nor does it appear that the leverage in the energy and commodity space has been magnified and securitized to anywhere near the degree that housing was in 2006-2008. That doesn’t mean that we are in the clear—only that it does not seem likely we are in circumstances resembling 2008.
We may, of course, be in for a prolonged period in which neither stocks nor bonds move much overall, but instead oscillate significantly month to month. That was certainly the case for much of the 1970s. The goal in such times is to identify sound fundamentals and pick good price points that volatility inevitably provides. We have been through a period of downward resetting, and unless you believe that we are on the verge of a major decline, this is when you look to buy—carefully and deliberately.
It’s not about trading and timing. Rather, it is about the calculus of collapse versus chugging along. Whenever the collapse narrative reaches a crescendo, and markets roil in response, fundamentals disappear, and the long-term is forgotten. That is the time for investors to invest, and those times are as precious as the long months of low volatility that characterized much of 2014 and the early months of 2015. This has been a challenging period, but unless there is fundamental fuel to feed the market frenzy, we will look back at these months of reset as the perfect opportunity to position for the future, and not the time to seek shelter from the storms.