Follow-ups and New Thoughts:
So little happened this summer that every time I sat down to write about the concern of the moment, it quickly faded and the market made new highs. I do think the current environment merits some commentary, however:
1) The current stock market high close, 4532[i], was recorded on September 2nd. From there to the October 4th close of 4286 was a decline of 5.4%. For the S&P 500, the current decline is the largest so far this year[ii]. Declines of more than 3% but less than 5% occurred in the 4th week of January, the last two weeks of February, the second week of May, the third week of July, and of course more recently. Dips of slightly less than 3% occurred in March (3rd week) and June (3rd week). Short declines are frequent. They only become a concern when the market cannot rally from the bottom to new highs. One should never react to an initial decline; only get concerned when there is no meaningful buying of the dip and the market rolls over and falls below the previous low. We are below the 50-day moving average, but we also did that in March and June, and in September and October of 2020. I don’t expect that significant selling would begin unless we crossed the 200-day moving average, which is around 4200. We didn’t even touch that level intraday yesterday, October 4th. I believe history is still on the side of “buy the dip”.
2) One of the other indicators I like to monitor is the high yield bond index, especially the CCC-AAA yield spread[iii]. Though the spread has widened lately, it is still lower (6.59%) than it was on August 23rd (6.63%). Bonds do not see danger coming. (This spread exploded between February 21st and February 28th, 2020).
3) Switching gears to emerging markets: Sure, emerging markets are oversold. Unfortunately, that has been the case for most of the last 13 years. The simple fact is that emerging markets don’t perform well (in dollar terms) while the dollar is rising. The currency hedged EM ETF (ticker: HEEM) has trounced the EM benchmark since its 2014 launch. The current period of dollar strength suggests that while EM (especially China) might have an oversold bounce in the near term, there will be no major rally unless and until currency stops being such a headwind.
4) China’s private sector crackdown this year might seem bizarre, or at least counter-productive given the growth that their major companies (Tencent, Alibaba, etc.) have brought to China over the past 10 years. A casual observance of the current U.S. Senate hearings on Facebook should start to make Chinese actions a little clearer. The United States has basically said that its government either cannot or will not support its people against a company with harmful technology. China is saying it absolutely will. I am dubious about the wisdom or eventual success of telling people what they are allowed to know or do and how they should live, indeed “pro-social” (as China deems its actions) is obviously in the eye of the beholder. That said, I am sure that the Chinese Communist Party looked at the role of Facebook, Google, Twitter, and other American companies in the spread of lethal misinformation leading to all kinds of social dysfunction and told themselves, “whatever mistakes we might make, we are not letting that happen here.”
5) India’s 3-year return exceeds that of the U.S. George Friedman of Geopolitical Insight[iv] points out that there have been 30-40 year cycles in which an emerging market country comes to dominate low cost production for the world until its rapid growth drives its costs to where it could no longer fulfill that role. At that point, it needs to change its economic model toward domestic consumption, which is generally a difficult process. The U.S. from 1890 to 1930, Japan from 1950 to 1990, and China from 1990 to last year embody this. Is it India’s time to step in?
6) Switching to inflation: The 10-year Treasury yield bottomed at 1.17% on August 2nd. Its current surge to 1.53% is not enough to derail the stock market, but it is enough to prompt a modest shift from growth to value. This happens because value stocks are more a play on current earnings and assets whereas growth stocks derive most of their value from future cash flow. The proximate cause of the upturn in rates was an uptick in oil prices and the belief that the Federal Reserve will begin to taper its bond purchases by the end of this year.
7) Inflation is both a measure and a mindset. The market only has a problem when inflation becomes a mindset. In other words, when people change their behavior on the belief that they need to keep up with rising inflation. Surveys done by the NY Fed and the University of Michigan suggest this is happening. Supply chain disruptions happen all the time, so they have to persist for quite a while before people stop dismissing them as being temporary. We appear to be at that point. Wages are rising too, as employees want a bigger slice of the pie and companies know they can pass this cost on to their customers.
8) The final part of the inflation story is commodity prices. Goldman Sachs suggests that the case for cyclical stocks – materials, chemicals, energy, etc. – is becoming a structural[v] because of chronic under-investment in productive capacity. Long bear markets in commodities cause the companies in these sectors to scrap capacity and delay upgrades and repairs. As demand returns, companies are temporarily unable to meet it, driving prices way up. As capacity returns, investors anticipate the next down cycle and they bail out. Most investors avoid these situations because the window to make money is often very short (months, not years)[vi]. Increasingly, investment houses are calling for this cycle to be protracted because the ability to ramp up capacity is being held back for a variety of reasons. Carefully, I believe that investors should build commodity exposure.
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[i] As measured by the S&P 500
[ii] The NASDAQ has had declines of 11.5% and 7% in February and May, respectively. Its current decline is 7.8%.
[iii] The CCC-AAA spread is a measure of the extra yield bond buyers demand for the risk of holding CCC-rated debt, which has a not insignificant risk of defaulting.
[iv] As shared with John Mauldin in his Over My Shoulder report, October 2, 2021
[v] Cyclical means a year or so, structural means 3-5 years or longer.
[vi] This is so much harder than growth stock investing, what has become “buy a platform company and take a long nap as it inexorably rises”.