On August 17, the S&P 500 closed at 2,102.44, within striking distance of its all-time high, achieved in May of this year. Six trading days later it closed at 1,867.61, more than 12% off that high, which constituted the first market correction in approximately four years. Market corrections, which are often defined simply as downward moves of at least 10%, are regular events, occurring about once a year on average since 1900. While it’s not unprecedented to go much longer without a correction, the stretch from 2011 to this August was the third longest since World War II. The longest was from 1990-1997, and the second longest was from 2003-2007. So perhaps people have become less accustomed to the feel of such a downturn. For that reason, we felt it was important to address what we view as the causes of this correction, assess whether it has run its course, and, most importantly, determine whether it has altered BTR’s positive long-term view on stocks.
If one is looking for the reasons why a correction happened now, or at all, there are plenty of culprits. First, after more than six years of this bull market, stock valuations can no longer be called cheap. We do not believe they are unreasonably expensive, but one has to admit that by historical standards, we are at or perhaps a little beyond what is considered “fair value.” Second, a large portion of the returns generated during the more recent years of this bull market have come from increases in valuation. We have often pointed out that stocks ultimately move in accordance with three factors: earnings growth, dividend growth, and changes in price/earnings ratios. The first factor dominated in 2009-2011, when the market rose 39% while earnings almost doubled. Since the beginning of 2012, however, the market is up 54% while earnings are only expected to be up 24%. The situation is reflective of the fact that although the U.S. economy is growing at a respectable rate, particularly relative to other developed nations, it has never achieved true “expansion” mode after the financial crisis of 2007-2008.
Third, political turmoil in Europe resurfaced loudly in the summer of 2015. Specifically, the latest round of negotiations regarding Greek debt seems to have triggered the initial move down in late June and early July. Although the market rallied quickly and strongly after that, it wasn’t able to achieve a new high. While the departure of Greece from the eurozone would certainly be disruptive and potentially lead to further departures, depending on how well the country succeeds on its own, we discount its importance because of its small size, and because Mario Draghi, the head of the European Central Bank, has made it clear that liquidity within Europe will not dry up on his watch.
Then There Was China
But the major issue that led to the correction is, of course, slowing growth in China. Just last quarter we wrote that a strong U.S. dollar is on balance a positive factor for our economy, primarily due to the fact that we are a net importer. After watching its currency strengthen against the dollar from mid-2005 through late 2013, and against the euro through early 2015, then having its exports drop 8.3% year-over-year this past July, the more export-oriented Chinese government apparently decided that trend had gone on long enough. Therefore, on August 10 it devalued its currency, the renminbi. This action came as a shock to global markets, and suggested that the Chinese economy was growing even more slowly than consensus belief. Since then, economic news out of China seems to have become the most important determinant of our own stock market’s behavior. Unfortunately, the news hasn’t been good. The Chinese government had set a target growth rate of 7% for its economy, and while there has long been skepticism about the accuracy of reported figures, for years it was clear that China was growing fast, in any case. Now the evidence is pointing to a meaningful slowdown, as China goes through the growing pains of a rapidly developing economy. Having invested for years in infrastructure, government policy is changing to promote a more consumer spending-driven economy. While statistics on car, gasoline, and iPhone sales indicate a measure of success in this regard, it doesn’t seem to be enough so far to maintain high-single digit overall GDP growth.
There is even some concern that China’s growth will be weak enough to trigger a global recession. While we don’t place a high probability on that outcome, we do recognize that global growth is weak. In fact, it could be that U.S. growth in the 2.5% range will be among the best in the world. However, the U.S. economy does not exist in a vacuum, and we recognize that if no one else in the world is growing, our own economic growth will also be at risk. So what is America’s direct exposure to China? Fortunately, not that high. With exports constituting only 13.5% of our economy and exports to China only 7.4% of those, total exposure is approximately 1% of GDP. Also, we import more than four times as much from China as we export to it, so on balance we do benefit from a weakening renminbi.
Before we condemn China’s economy to recession, however, let’s consider a few points. First, the Chinese economy is no more monolithic than our own. There are sectors that are struggling and those that are doing just fine, thank you. While most people may think of China first and foremost as the world’s manufacturing hub, its economy seems to be progressing faster than we may have realized from an agrarian economy, through the manufacturing stage, and into a services-based economy like our own. BCA Research notes that since 2012 the industrial side of the economy has slowed from more than 10% growth down to 6%, and as a result has shrunk from more than 47% of GDP to less than 42%. Offsetting that decline is a services sector that is now nearly half of the economy, growing at 8% and possibly accelerating. This transformation is consistent with recent anecdotal evidence from some of our portfolio companies that sales to China remain strong. By our reckoning, U.S. export exposure to China is twice as concentrated in consumer-oriented areas (food, airplanes, cars, and electronic equipment) as industrial.
Don’t Forget the Fed
While it does not appear to have been a proximate cause of this correction, there is one final factor that seems to occupy the thoughts of stock market participants: When is the Fed going to raise interest rates? Fed Chairwoman Yellen has made it clear the Board wants to begin “liftoff” this year, but after the poor GDP report in the first quarter, the idea of raising rates in June was dropped and most people began to expect it in September. Perhaps the market’s correction was also a factor, but certainly concerns about global growth caused enough consternation that the Fed chose to pass in September, as well. Now the question is whether rates will rise at all this year. Should they? The Fed is clearly in a difficult spot. On the one hand, U.S. growth is solid. After the somewhat disappointing advanced release estimate of 2.3% for second quarter GDP growth, this number has been adjusted upward to 3.9%, which was outside the range of market participants’ guesses. While no one expects this rate to be sustained, it seems clear that the U.S. economy is in reasonable shape.
This good news is offset, however, by the struggles in China as well as Japan and, perhaps most importantly Europe, which is now staring at a refugee crisis that threatens its already strained resources. As a result, the Fed is the only major central bank in the world that is even considering a rate increase. What is not clear is whether the Board members actually see evidence of imminent inflation, or whether their intended rate increase is merely a symbolic act to get interest rates above zero, if only to have the opportunity to lower them again if necessary. We assume they do not want to toy with the idea of negative interest rates, unlike Europe. We also assume that the Fed would raise interest rates more than a token amount only if it saw a genuine need; in other words, if economic growth were strong enough and unemployment falling fast enough that wage inflation was picking up. Preliminary estimates for August show an increase of 2.2% in average hourly earnings over last year. That’s not enough to fear generalized inflation at the moment, but if it goes much higher, the Fed could find itself behind the curve.
To the question of whether the correction is over or not, our best guess is that it has a way to go yet. As we see it, this correction was short-circuited by talk of easing monetary policy, as other market downdrafts have been in the past. Last October, the intraday low got extremely close to a negative 10% move and it looked for all the world like we were going lower. Then, St. Louis Fed President Bullard suggested the tapering of bond purchases (Quantitative Easing) could be put on hold. Known now as the “Bullard Put,” his comments gave investors the confidence to buy back stocks, and within a couple of weeks the market was at a new high. This time around, New York Fed President Dudley commented that a September rate increase seemed “less compelling.”
We view Dudley’s comments, along with the surprisingly good GDP number released the following day, as having interrupted what was going to be a more severe correction, something on the order of 15-20%, similar to what we experienced in August of 2011. Unlike last October, however, we have not gone straight to a new high. We regained about half of what was lost and the market has been unsettled ever since. From a technical standpoint, this correction, while not much worse in overall percentage terms than last October, nonetheless did more damage to more stocks. A lot of stock prices have dropped through their moving averages, and many have not been able to make much headway since, even if the market has recovered somewhat. In other words, this is a market led by just a few stocks. That could mean the overall market will go lower before it is over.
Looking Beyond Next Month
We don’t want to spend too much time focused on how long this correction will last because we view it as just that: a correction. Whatever the size, it is a perfectly normal event that could have been triggered at any time, for any reason. More importantly, we view it as an opportunity for BTR and other investors to buy stocks we like at better prices. Given what we know and what we are forced to infer, we feel strongly that U.S. equities remain the most appropriate and attractive asset class for our clients.
The main reason for this conviction is that the upwardly-revised second quarter GDP reinforces that U.S. growth is solid, giving a firm foundation to the earnings of domestic companies. From 2011 through last year, annual S&P 500 earnings growth has averaged nearly 8%. Expectations are currently for a little less than 6% growth in 2015. We would view ongoing 6% earnings growth as very positive, as it would provide, along with dividends, a solid high-single-digit return, if valuations do not change. That said, 6% may not be an easy target to achieve, as it implies some leverage to underlying economic growth at a time when inflation is low and profit margins are high, but thankfully companies continue to increase productivity and we are beginning to see an increase in stock buybacks.
Given the turmoil in some foreign countries, and the stagnation in others, we choose not to have much direct foreign-equity exposure right now. Even if domestic earnings growth doesn’t achieve the 6% level, as long as economic growth remains steady or even improves slightly, we can expect the dollar to stay strong or even strengthen further. That would make both U.S. debt and equity investments attractive to foreign investors, whose capital flows could drive valuations higher. In short, improvement abroad will be good for everyone, including U.S. companies and stocks. At the same time, continued trouble abroad should make U.S. investment securities of all kinds attractive as a relative safe haven.