Living Through the First Correction In Ten Years

Posted:
Tuesday, November 27, 2018

On a typical day, about one half of one percent of all shares of stock in this country changes hands. Depending on whether there are more sellers than buyers or more buyers than sellers, the result projects the value of the other 99.5 percent of stocks that did not trade that day.

For the past seven weeks, we have witnessed more sellers than buyers, overall. The market’s decline, which has wiped out most of the gains of 2018, has occurred in an environment of positive economic data, low inflation, and meddling economic growth, which is about average for an economy of our size. Some people believe the stock market’s decline is a harbinger of an economic recession, although the relationship between market declines and economic direction is no better than a coin toss. Half the time, markets predict economic declines and half the time they do not. Sometimes you just have more sellers than buyers.

Is there anything that stands out about this correction? A couple of things. First is the accelerating demise of hedge funds. There were, at the peak, 10,000 hedge funds in this country. People tried to capture inefficient returns until there were none left. Since economic opportunity is finite, but the amount of money chasing signs of growth is almost infinite, it would stand to reason that returns would be driven down to zero.

Some hedge funds are closing their doors. Since this decline has begun, at least eight hedge funds of $1 billion or more in assets have announced they are liquidating. The culprit is the success of the concept. Hedge funds, who use increasingly esoteric strategies to try to earn excess returns, are less able to beat the market when they are the market. Hedge fund strategies range from momentum to smart beta. None of the strategies work when there is no one on the other side of the trade. As investors bailed out of hedge funds, the redemptions triggered significant selling, which caused hedge funds to underperform even more.

The golden age of hedge fund investing was generally up to 2006. While many hedge fund operators presented themselves to the world as investment wunderkinds, in reality, much of the return was the result of competing with the exchanges who were still using humans to execute trades. Given the computing power obtained by the hedge funds, competing against human floor traders was like shooting fish in a barrel. It was as lop-sided as the outbreak of World War II when the German mechanized infantry went up against the Polish Calvary, which then still used horses.

After the great real estate bust of 2007-2008, hedge funds as a group began to underperform their corresponding indexes. Once everyone, including the exchanges, had computers, the advantage of the speed of execution diminished. Added to that was the fact that as funds grew in size, there became fewer investment opportunities in a size that would supposedly allow for liquidity. In this case “liquidity” refers to the ability to get out of a position without moving the market.

One popular strategy of hedge funds was to use momentum, which is the rate of change in the price of a stock relative to an average, to find investment “winners”. If a stock was going up more than the overall market, hedge funds crowed in, making the stock go up more, and vice versa.

Hedge funds, for the most part, invest for the short-term. They generated billions in commissions, which made them popular with brokers. However, as time went on, investors grew disgruntled with returns at best no better than the market, for a far higher fee.

This fall, some investors began to exercise their right to cash in their hedge fund investments. As the number of redemptions rose, the momentum stocks went into reverse, as the funds sold them to raise cash. As few were buying compared to the number selling, prices began to buckle.

Caught up in all of this are the owners of index funds. Most people who buy index funds believe they are getting diversification, and that such diversification reduces risk. The problem is that, at its peak, almost a quarter of all index funds for the Standard & Poor’s 500 Index invested in five stocks: Facebook, Apple, Amazon, Netflix, and Google.

As the liquidating hedge funds sold these stocks, indices took a hit. If five stocks made up 25 percent of the fund’s value, then 495 stocks account for the 75 percent balance. While such diversification has reduced risk compared to some hedge funds which have been wiped out, it has not this year generated positive returns, which some investors have come to expect.

From a historical perspective, the correction is long overdue. Markets go both ways, which creates an opportunity for those who have courage and convictions when others do not. Markets also go up over time, in tandem with the economy overall. The challenge is to determine how companies are doing and invest in them. Hedge funds, with their algorithms, were trying to find opportunities that may exist only for a second. Investors have a time horizon far longer than that.

When will the correction end? That is hard to say. Hedge fund selling should be abating by year-end. Whether owners of mutual funds and ETFs will sell next is anyone’s guess. The bottom will only be seen in retrospect when it happens. Thankfully, this is occurring during a time of economic prosperity, rather than a financial meltdown like 2008. When markets are this nervous, people tend to focus on the risk to the downside. When markets are at peaks, people look at the potential for further upside. Sort of the opposite should be done.

The Economy

Economic activity is continuing to look good. Employment gains are solid, and retail sales are doing well for the holiday season. Certain sectors like farming and energy, both of which have sustained collateral damage from the administration’s policies of a trade war and encouraging higher international oil production respectively, have seen some weakness. Hopefully neither is a permanent state of affairs.

Next year, however, is expected to be a year of slower economic growth than 2018. The lack of a tax cut, lower export demand, and a lack of follow through by businesses to invest in capital goods with their tax savings, will all conspire to lower earnings growth to 8-10 percent, or about half the rate of 2018. 

Inflation

Inflation’s latest damper has come in the form of lower oil prices. The 30 percent decline from the peak earlier this year has led to lower inflation rates, potentially even to the point of impacting the cost of living adjustments for 2020.

Other commodities have also fallen, including lumber and grains. Steel and aluminum, in contrast, are still up 18 percent since the tariffs on imports were imposed. Steel, in particular, is needed for the infrastructure program that is slated to be announced early next year. 

Interest Rates

Interest rates are still expected to rise again in 2018 but may get a reprieve in 2019. The Federal Reserve has noted that the rest of the world has not done as well as the U.S. in maintaining economic growth. This may be laying the groundwork for a hiatus from further increases until the rest of the world catches up to the U.S. regarding economic growth.

The Stock Market

While not in a panic, investors feel like 2018 was taken away from them. How this sentiment plays out with additional selling from here is anyone’s guess.

At some point, the market will find a bottom and will advance from there. As stated before, a not-yet-named sector will lead the way. It could be airlines, infrastructure, or any number of other groups.

 

Warren M. Barnett, CFA
November 27, 2018

Warren Barnett, Founder & President, CFA - Barnett & Company

Warren Barnett

Warren Barnett is the founder and President, and Portfolio Manager for Barnett & Company. He was associated with the investment banking firm of Kidder, Peabody & Company and the investment counseling firm of Davidge & Company in Washington before returning to Chattanooga to accept a position in the trust department of a local bank. Perceiving the local need for the type of firms with which he was associated in Washington, he established Barnett & Company in 1983. He obtained the Chartered Financial Analyst professional designation from the Institute of Chartered Financial Analysts, Charlottesville, Virginia in 1986. Mr. Barnett graduated from The McCallie School in Chattanooga. He received his Bachelor of Science degree in Accounting from the University of Tennessee at Knoxville and his Master of Business Administration degree in Finance from the Owen School of Management at Vanderbilt University.

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Barnett & Company is a fee-only registered investment advisory firm registered with the Securities & Exchange Commission working with the investment and financial planning needs of individuals and organizations. For a brochure on the company and its available services, please call Mary Chastain at 423-756-0125 ext. 1006.