January 2016 was one for the record books. A steep dive, half offset by a one-day reversal on the last trading day of the month, gave many investors Maalox moments.
The month reminded investors that markets do decline. The last day reminded them that markets do go up. Beyond this obvious point, what are the lessons to be learned?
The first lesson is that stock market declines and financial losses are two different things. If you need funds soon, you should not have them invested in something as volatile as stocks. Conversely, if you do not need the funds soon, the fluctuations in price are simply things to watch. If the price changes are driven by a change in the fundamentals of an investment, that is one thing. If the price change reflects widespread panic or mania, that is another. So far, there has been more of the latter than the former.
The second lesson is that China cannot sink the US economy. Our total exports to all countries total less than 13 percent of GDP. In China, the figure is over twice that. In the real world, employment and the economy are doing well. Stock market commentators inveigh about how stock market declines presage economic downturns, forgetting that this does not happen two out of three times following a stock market decline. The American consumer, who makes up 70 percent of the economy, is optimistic, has the ability to spend, and the ability to borrow.
The American economy will get a further boost this spring from the latest authorization by congress to increase spending on infrastructure by over $50 billion per year in 2016-2022. As unemployment declines, wages will increase, making consumer spending gains all the more dramatic.
The price of oil has declined. It has declined before. It will decline again. Forgotten is that the creation of oil requires millions of years of geologic formations. The world uses 94 million barrels of oil per day. At some point, supply and demand will come again back into balance. Given the cutbacks on spending to maintain oil and gas fields, much less drill for new sources, supply will begin to contract. The result will be higher oil and gas prices.
Due to the restrictions placed on immigration after 9/11, population growth in this country has slowed significantly in the past decade. With it has come a reduction in economic growth. But a reduction is not the same thing as a contraction. While immigration reform would help to kick start this trend to get economic growth back to its long-term rate, it is a political problem awaiting a political solution. Too many people are making too much money not solving the problem, while those of us who would benefit from a solution are injured.
The stock market itself has changed. About one of every three dollars invested now goes into some sort of index investment. Index investing strives to match the performance of the associated yardstick. It makes no distinction between what is undervalued, overvalued, or is a house of cards. Historically, index investing’s appeal grows when markets are going up, and collapses when the markets head south.
Because the purchase or sale of an index investment triggers the proportionate purchase or sale of all the associated stocks in that index, it leads to price gyrations that most find unfathomable. Since the average investor has no idea what may be in the index, he or she has no conviction to stay the course when prices become unstable. Thus, indexes fuel market rises, and contribute to market declines. If the price of an investment is going up, the average person could care less what is behind it. When the price declines, their ignorance of the investment’s nature contributes to their panic to sell.
So when does the volatility end? It ends when most or all of the nervous investors are washed out of the market. Remember that markets are weakest at the top, because at the top there is no one left to sell to. This is why markets decline. Conversely, markets are strongest at the bottom, because at the bottom there is no one left to buy from. This lack of supply relative to demand causes markets to rise again. We are closer to the bottom than the top.
In terms of a sign of a bottom, look to the price of oil. While oil has been a poor long- term indicator of market direction, over the recent past the direction of the two has moved in lockstep. Expect this to continue until the market recovers and finds its own footing. Once people realize that the economy is doing better than the oil sector, the correlation between the two will diverge.
The Greek Chorus that connects the stock market’s decline with the economy aside, economic activity is doing well. It is not at the ascendant rate of last year, but it is not declining either.
The key to economic growth is the expansion of the job market. So long as employers are willing to hire, the economy should continue to expand. Their hiring is related to two factors. First is the rise in infrastructure spending, which is government-mandated for the next several years. The second is the growing sense that the job market is tightening, and that the better employees will be taken if they are not hired now.
Inflation is one of those issues that are not discussed until it becomes more prominent. It is on the way to becoming prominent now.
While the cost of energy has continued to decline in 2016, its descent has not been as rapid, in terms of percentage, as 2015. Thus, wage pressures are beginning to be felt in certain industries, especially those which are experiencing significant retirements. Service inflation is far greater than goods inflation, which is kept in check for the time being by import competition. Expect the topic of inflation to become more pronounced as the year goes on.
Interest rates continue to be low, with foreign investment inflows offsetting the Federal Reserve’s efforts to raise rates.
People have speculated that, with financial markets in turmoil, there will be no more interest rate increases in the near future. The Federal Reserve is telegraphing that increases are still in the cards. Time will tell who is right.
The Stock Market
Stocks, after experiencing a selling panic in January, seem to be trying to find a bottom. That will occur when the price of oil stabilizes. While oil forecasts are plentiful and diverse, it would seem that the cutbacks in capital and exploration budgets will lead to an increase in oil prices to the $50-60 range by year end. ‘
Such an increase would be salutary for stock prices. In time, the markets will forget the correlation with oil, and focus on how consumer spending and corporate profits are helped by falling oil prices. Since oil is still somewhat imported, a decline in energy is a net benefit to the US economy.
Warren M. Barnett, CFA January 30, 2016