“The busy man is never wise, and the wise man is never busy.” – Lin Yutang
The purpose of this quarterly commentary is to communicate with you about our thoughts on the markets, provide some snap-shots of market metrics, and provide an overview of topical issues; however, it will also be married with some aspects of our recently initiated monthly commentary, in order to provide you with a succinct update of our views on the market, without the need for two separate communications. We hope you enjoy this information, and that it allows you to better understand what we see going on in the market place.
Market Commentary: A Stumble off the Block
The time has come once again to close the page on another year, and with the way the markets performed in 2015, many participants have likely already said ‘good riddance’. Most markets failed to break even last year, and, unfortunately, 2016 has not offered respite from the woes of 2015; at least so far. The S&P 500 has now fallen 7% since its peak in May of 2015, and strangely enough, the average stock in the index has actually done much worse, falling 24% from the same period. This can be explained by a newly-coined acronym, known as ‘FANG’, or, Facebook, Amazon, Netflix, Google (now Alphabet). All of these companies performed very well over the course of 2015, and due to their size and weighting in the index, helped mask the true underlying performance of most stocks. For example, Amazon gained 100% over the year, and has a very large weighting within the index. Netflix also gained 100% over the year. Chart 1 below, obtained from Bloomberg, breaks down the relative performance of the S&P 1500, looking at individual sectors based on size. All data displays the average percentage drop in stock price for that sector since their respective 52-week highs. Chart 2 shows the same data, but broken up based on industry.
These charts serve to further display the current dichotomy in the market, between the performance of the ‘average’ stock, and the performance of the actual indices, which has been masked by a handful of large momentum stocks. As noted in previous commentaries, despite the relative outperformance of stocks such as Facebook, Amazon or Netflix, we believe that they trade at lofty valuations which make it difficult for value-based investors to get involved. As can be seen in Chart 1, the risk-off environment which took place following the August correction of 2015 has been very detrimental to all stocks, however, small cap and mid cap stocks have been hit harder than their larger peers. Unsurprisingly to most, Chart 2 shows that the Energy industry has been hit the hardest over the last 12 months, thanks largely to the rapid decline of oil prices. Materials have fallen the second strongest, due to slowing global economic growth, while, somewhat surprisingly, Consumer Discretionary stocks have come off from their highs to the third largest degree. Overall, stocks have fallen an average of ~24% from their 52-week highs, despite most major indices remaining relatively flat over the same time period. This phenomenon is what’s is known as an ‘internal correction’, and can hopefully lead to the opposite scenario of what we saw in 2015; a scenario where the average stock outperforms the actual performance of the index, as the large momentum stocks soften in price and the overall stock universe regains lost ground.
The most logical question, then, seems to be ‘why have markets sold off to begin the year?’ The answer, unfortunately, is all but too familiar, in more ways than one – China. In August of last year, North American markets experienced one of the most volatile and precipitous corrections in recent memory, and as we detailed in a special commentary, the reason for this correction was a sell-off in Chinese equities due to a reversal of massive speculation and over-valuation in their stock market. The country’s central government stepped in to stem the bleeding, which actually resulted in exacerbating the situation, as market participants worried that their strong response may be indicative of non-divulged weakness in the country’s underlying economy. The People’s Bank of China (PBOC), however, were eventually able to calm the markets through a few key initiatives, most of which were centered on disabling investors’ ability to sell massive amounts of stocks in a short period of time. One of the instituted changes was known as the ‘Circuit Breaker Mechanism’, which was designed to close Chinese stock markets if they were to fall greater than 7% in a single session. The mechanism was designed to eliminate days of free-falling stock prices in China, and its first day of implementation was the first day of trading in 2016. This was the reason that Chinese markets closed multiple days in a row following 7% declines; on the 7th of January, the markets were open for only 29 minutes before the 7% decline figure was triggered and markets were closed for the day. The Circuit Breaker Mechanism had spooked investors, causing them to ditch stock as soon as possible, in fear of not being able to do so in the near future and a continued decline of stock prices. The program was a colossal failure, and was deactivated after only four days of implementation. Chart 3 below shows the continued decline and volatility of the Chinese Shanghai stock index, which began last summer.
Another reason for the crashing stock prices in China was due to the PBOC’s decision to weaken their currency. The central bank controls the value of the Chinese yuan by setting a narrow band of which the currency will be allowed to fluctuate between. By lowering the band, international investors feared that, once again, this may be a signal of deeper issues within the world’s second largest economy. The PBOC reversed this decision and increased the allowable trading band once again in order to repair the impact of this decision. Lastly, as a result of the crash in August of 2015, the Chinese government had instituted a rule which disallowed institutional investors from selling over 1% of their holdings over a period of 24 hours. This rule was set to expire on January 8th, and caused many investors to liquidate in fear of a possible wave of selling activity upon expiry of this rule. In order to combat this effect, the PBOC gave another kick down the road to the proverbial can, extending the rule for another six months. All of these developments served to create the volatility in the Chinese stock market which has resulted in the worst 4-day start to the year for the S&P 500 since 1928, the worst week for the European Stoxx 600 since August of 2011 – during the European Debt Crisis – and a 4.4% decline for the Canadian TSX. The financial markets have become increasingly globalized over the years, and as such, contagion in a period such as this should be expected. China is the world’s second largest economy, and anything that may affect their economic strength, or signal of further weakness in the area, will justifiably hurt the sentiment of international investors, especially in regard to internationally-focused equities. As a reminder, ~33% of the S&P 500’s revenues are sourced from international markets. For interest, Chart 4 below shows a detailed breakdown of where these international revenues are sourced from.
Despite the weakness of global stock markets to begin the year, we would also like to stress that all hope is not lost, and, more importantly, this is not the beginning of a 2008-esque crash. Opportunity remains in the market, and a well-balanced and properly prepared portfolio should hopefully benefit from recent market weakness in the form of buying opportunities moving forward.
Three key reasons why the current market environment is not the precursor to a market crash are: credit spreads, which measure the spread between the average cost for companies to borrow relative to the risk-free (treasury) rate, are not excessively widening. In periods of turmoil, you will see a quickly diverging trend in credit spreads, as banks become less willing to lend cheaply to corporations. Valuations – although not exactly cheap – are also not excessively high. The S&P 500 currently trades at a P/E multiple of 20.4, which is above the long-term historical average of ~15.5x, but also far below any level that would suggest an immediate crash. Lastly, investor sentiment is fairly weak everywhere, which is usually not indicative of market tops. A large amount of investors are bearish and attempting to be the wizards who call the next market bubble. Crashes typically occur in the wake of exuberance, not shrewdness.
As we have stated many times before, most of the areas of strength and pockets of optimism are based within the United States; the US is the largest economy in the world, holds the most trusted capital markets, and is currently one of only two countries in the world which are raising interest rates (the other is Brazil, who is raising interest rates in order to combat inflation). We believe that these trends will result in continued capital inflows into the US, further support to the American Capital Markets, and – unfortunately for us Canadians – the continued relative strength of the USD. For this reason, we maintain the belief that the most prudent decision at the moment, in regard to investment decisions, is to gain as much exposure as possible to both the US market and US dollars. The recent strength of the Greenback may result in some to believe that it is too late to hop on the train, but, for the reasons discussed above, we do not believe that this trend of strength will be reversing any time soon. Chart 5 below details the global interest rate environment.
The key to the continued strength of the US economy and capital markets remains to be the consumer economy, and with a strong USD dampening manufacturing, industrial and export data, the importance of the all-mighty consumer has been put on further display. This development is highlighted by the divergence of the Non-Manufacturing (consumer) PMI, which recently read 55.3, and the Manufacturing PMI, which was quoted at 48.2 in December. Any figure below 50 indicates contraction, however, luckily, 70% of the US economy is consumer-based, while only 30% is industrial-based. At this juncture, the potential fear is that weak industrial data and performance serves to pull down consumer data, and therefore, the non-manufacturing PMI is one of the most important data points in the world right now. On the other hand, it is also possible that the strong consumer economy ‘pulls up’ the manufacturing sector, which it was able to do in 1998, 2005, and 2012. All three instances saw rallying stock prices in the subsequent years. Chart 6 below shows the continued divergence of the non-manufacturing and manufacturing PMI gauges.
Our faith in the US economy has been bolstered by strong employment data as of late; December non-farm pay rolls, which are used as a proxy as employment additions, showed an increase of 292,000, as well as an upward revision to the November figure of 50,000. The unemployment rate also remained steady at 5%, even while 466,000 workers re-joined the work force. This positive employment data also coincided with a 2.5% increase in average wages, which is hoped to be the beginning of a trend. All of this data combines to a strong picture for consumer discretionary, consumer staples and housing stocks in the US, and these are all areas of the US market which we are currently seeking increased exposure to. This strong employment data will also likely serve as justification for another interest rate hike in either March or April; as such, we are wary of exposure to extremely rate-sensitive sectors.
Unfortunately, we do not see very much strength in most contemporary Canadian stocks, unless they serve a purpose of portfolio insurance (precious metals), represent attractive value, have strong US exposure, or display a market which is non-dependent on economic growth. We expect that the weakness of oil and the strength of the USD will continue to hamper the performance of Canadian equities, and we will plan accordingly to insulate client portfolios from these developments. In addition, we continue to believe that precious metal exposure is important in the current market environment, and the volatility to begin 2016 has, in our minds, proven this importance, as precious metal stocks outperformed the index and gained ground while the large remainder of stocks suffered. We wish you all the best in 2016, and cannot wait to see what this year brings.
MacNicol & Associates Asset Management Inc.