It has been a dreadful start to the year for stocks, with the S&P 500 Index down more than 10% as we write this. As is usually the case, this correction is being driven by concerns about a slowing economy. The emerging markets and the commodity sectors are the primary culprits this time, and the fear is that the weakness in those areas will spill over into the broader US economy. The long commodity boom, which includes oil, drove a large buildup in property, plant and equipment in those sectors, mainly in the emerging markets. Now that global economic growth has slowed, there is a supply-demand imbalance that is driving commodity prices sharply lower and creating questions about whether the corporate debt that funded the expansion can be serviced. It is a classic boom-bust scenario - growth as far as the eyes can see leads to over-investment, but eventually demand falters, and the supply glut leads to a painful adjustment period, with prices and unit demand drying up. In 2001 commodity producers made up 30% of the fixed asset base (property plant and equipment) worldwide. Today they represent 45%.
Even though commodities are a relatively small portion of the US stock market, domestic stocks have been punished because of the possibility that the weakness in this area and in the emerging markets will drag the US economy into recession. Based on some of the economic data, such as wages and unemployment claims, we don’t believe that is the most likely scenario, but it would be foolish for us to completely dismiss the possibility.
One of the noteworthy elements of the recent selloff is the carnage among the high-fliers, those companies with strong revenue growth and high valuations. These high-expectations stocks, which we largely avoid, have endured one of their worst relative (to the market) two-month periods in history.
Also of note is the poor performance of the bank stocks. Worries about a slowing economy and some bad loans made to the energy sector have contributed to the selloff, but the main driver has been revisions to interest rate expectations. The profitability of banks has been suppressed by low interest rates. The Fed raised rates late last year, creating hope that a new tightening cycle (higher rates) was underway. But in light of the softening global economy and nervous markets, the market is forecasting that the Fed will not raise rates again anytime soon. This has crushed the bank stocks to what we believe are ridiculous levels. Many banks are now trading at less than 10 times earnings. This alone is compelling, but when one considers that bank profitability is being suppressed, meaning earnings are much lower than they could, and presumably will, be, it makes the stocks look even more attractive. Recall that the value of a company is the sum of all its discounted future earnings.
Further enhancing the case for the banks is the fact that, unlike in 2008, a wave of bankruptcies or dilution from forced capital raises is extremely unlikely given the health of the companies’ balance sheets. Reserves and capital levels are higher, and lending has been much more disciplined. So with a disaster scenario for the banks seemingly off the table, an analysis of the stocks comes down to assessing the future earnings power. Even if interest rates stay low for many years, the bank stocks look to be attractively priced. Perhaps earnings growth would be limited, but at 10x earnings this is baked into the stocks. If recession fears abate and interest rate increases re-emerge as a possibility, the earnings power of the banks would be revised upward, and the stocks would likely rally.
Interestingly, we already have at least one ingredient for a higher rate scenario: accelerating wage growth. Going back a few quarters, the bank stocks traded closely with this statistic, as faster wage growth made the Fed more likely to raise rates, since they view wage inflation as a catalyst for higher prices throughout the economy. But even though wage growth has continued to accelerate recently, the link with bank shares has been broken, due to broader concerns about what slowing economic growth means for interest rates. Currently the Fed is fighting an internal battle as it weighs the inflation-inducing effects of higher wages against the general health of the economy and markets. Right now the latter is imparting more influence. We don’t know when interest rates will rise, but as long-term investors we aren’t as concerned about the timing as we are about the companies’ future earnings and what we are paying for them.
Getting back to the broader market, general investor sentiment is becoming encouraging, in that negativity has been increasing. In general, the more pessimism there is among market participants, the better it is for future stocks returns. This week the Investors Intelligence survey, which gauges the sentiment of advisors, showed the bull/bear ratio at its lowest level since March 2009, which was the market bottom in the financial crisis. This is a very positive sign, but it is only one sign. Other sentiment measures are not at such extremes, though the volatility index (VIX), sometimes referred to as the fear index, has been rising and currently sits at a level it has reached only a handful of times since 2009. Each time stocks were near a bottom. Equity mutual fund and ETF flows have been quite negative, which is good from a contrarian standpoint.
The future is unknowable, even if some market pundits would like you to believe otherwise. It is entirely possible that the recent slump in stocks is signaling a coming global crisis, with China and other emerging markets infecting the US economy. We believe it is more likely that we trudge through this scare, as we have the others over the past seven years. In any case, we believe those that are buying today will look smarter in the long run than those that are trying to time the market.
Best regards,
Mark Oelschlager, CFA
Co-Chief Investment Officer and Portfolio Manager
Oak Associates, ltd.
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