The third-quarter of 2015 was ugly for global equity investors. The Standard & Poor’s 500 Index fell 6.4% in the quarter, while international markets experienced even deeper declines. The German DAX dropped 11% in the quarter while various Chinese bourses sank over 20%. The cause of widespread equity carnage can be succinctly described as a change in risk appetite globally. A slowing economy in China, uncertainty at the Federal Reserve, and geopolitical problems in both Europe and South America colluded to force investors to reconsider their risk tolerance, regardless of valuation levels.
Many factors played into the third-quarter decline and renewed risk aversion. The most obvious was a potential bursting of the Chinese stock market bubble. From its June high, the Shenzhen Composite Index has fallen 45% in just three months. Once termed the ‘growth engine of the world economy’, China’s economy has been struggling for some time as it manages a shift from export-oriented growth to internally-driven consumer growth. While the slowdown was well known, its domestic equities surged for much of 2015. Since financial markets are forward looking, many investors had hoped that Chinese stocks were simply forecasting an improvement in economic conditions or forthcoming stimulus. Despite high valuations, poor balance sheets, and sometimes questionable business models, Chinese companies were perceived to potentially transcend the slowdown and weather the economic transition.
Speculation is nothing new in China. Anyone who has visited the Middle Kingdom can attest to the strong entrepreneurial culture and capitalist instinct despite the country’s communist foundation. Yet, while the Chinese government has been cognizant to avoid any bubble in real estate, they treated the stock market more gently and tempted fate. Margin limits were too loose for too long, and account requirements were minimal. Stories of newly minted day-trading Chinese millionaires were common and plausible given the 156% rise in the Shanghai Composite from 2014 to mid-2015. The Shenzhen Composite was up 124% year-to-date at the peak in mid June.
Once the Chinese stock market collapsed, the Chinese government acted to support domestic companies by buying up shares with its vast foreign reserves. It also banned new IPOs, prohibited short-selling, and halted trading on hundreds of issues to help maintain indexes’ price levels and limit headline risk. Adam Smith would have some serious problems with the direct involvement to artificially prop up the faltering market. Regardless, the end result is likely a backlog of investors just waiting to get their money out of high-risk companies and legitimate concern over the safety of investments in China-listed securities.
The similarities to the US dot-com bubble from 15 years ago cannot be overlooked. A significant portion of the Chinese stock exchanges consists of companies that are overvalued, unprofitable, and expensive. Many trade on opportunity, rather than earnings. Questionable ownership structures, asset valuations and liquidity concerns are common. Based on price-to-earnings ratios (P/E), over 42% of the Shanghai Composite Index trade for more than 75 times earnings. Nearly 38% trade at over 100 times earnings or do not have a P/E due to absent profits. Those are large segments of the index which, to put it kindly, have high expectations.
The effect of the slowing Chinese economy on the US at this point appears manageable, but a spreading crisis is within the realm of possibilities. Unfortunately, uncertainty is something investors do not like and often reveals itself as a disdain for risk assets and poor sentiment. This is most evident in the VIX Index, which measures volatility in the US equity market. The VIX spiked to over 40 in August 2015, one month after the China stock market crash. For most of the year, it had traded at a subdued low level and within a narrow range. Yet as China unwound, risk aversion and volatility spiked.
Biotechnology and some specialty pharma stocks, which had been among the best performing equities for several years, have suffered the most from a renewed aversion to risk. Due to high margins, new biologic products, and rampant mergers and acquisitions, the groups enjoyed a stellar run. It also led to high valuations and a profit-taking frenzy once cracks emerged. Apart from a large-cap industry bellwether, we have avoided much of the biotech sector due to its speculative characteristics and high valuations.
The unwinding of the commodity boom has been underway since 2011. Just a few years ago the fear of deflation was a much discussed reason for quantitative easing and for keeping interest rates low. Talking heads and Fed governors professed the dangers of deflation and why it should be avoided. Thus, measures were enacted and do indeed seem to have supported the economy and stock markets. However, deflation appears more tangible today. From their peaks in 2011, copper is down 49% and cotton has dropped 71%; corn is off 53% since 2012; natural gas is down 59% from its 2014 high; and finally oil is down 57% since 2014. Shale drilling is likely the biggest loser in the commodity club. Supported by new extractable discoveries, high prices and the insatiable appetite for its high-yield debt by investors, the shale industry boomed but has cooled considerably.
In light of the renewed risk aversion and decline in global equity prices, the Federal Reserve delayed its plans for interest rate increases at its September meeting. This perpetuates not only the low rate environment, but also the uncertainly regarding the benchmark rate take off. Expectations are now focused on a December rate increase, but even that could easily change. We believe the forthcoming interest rate increases are merely an attempt to rearm the Fed’s toolkit rather than the traditional manipulation to slow a potentially overheating economy.
On a more positive note, the consumer is benefiting from strong tailwinds. Low energy prices and falling commodities act as an informal form of consumer stimulus. The job market is also recovering, though at a slower pace than many would like. New positions and placement are both up, as too is wage growth. The housing market is also doing well, another key area for the consumer. So despite the difficult quarter, we remain focused on the underlying strength of companies and the economy. Investor sentiment can be fickle, and long-term investors are usually rewarded for buying when it’s low. While risk aversion may impact stock prices in the short-term, long-term performance is driven by economic fundamentals and corporate profits.
Best regards,
Robert Stimpson, CFA, CMT
Portfolio Manager
Oak Associates, ltd.
The investments mentioned or listed in this article may or may not represent an investment currently recommended or owned by Oak Associates for itself, its associated persons or on behalf of clients in the firm’s strategies as of the date shown above. The investments mentioned do not necessarily represent all the investments purchased, sold or recommended to advisory clients during the previous twelve month period. Portfolios in other Oak Associates strategies may hold the same or different investments than those listed or mentioned. This is generally due to varying investment strategies, client imposed restrictions, mandates, substitutions, liquidity requirements and/or legacy holdings, among other things. The particular investments mentioned were not selected for inclusion in this report on the basis of performance. A reader should not assume that investment(s) identified have been or will be profitable in the future.
