Increased volatility and lower market prices have led commentators to wonder if this is a correction, the start of a major bear market, or just a bear (cub) market. However, with U.S. equity markets down in excess of 15% over a very short timeframe, discussing the names that characterize this period is only helpful for financial news “entertainers”. Investors care less about what this decline is called and more about how much they suffered during this uncertain and volatile time.
We have been positioned conservatively, holding substantial cash, through the second half of 2015 and the beginning of 2016. We also continue to see market characteristics that argue for a conservative posture. During volatile markets, we need to advise people on the merits of patience and long-term focus. This promotes an investment strategy that should produce more purchasing power in the future when the funds are actually needed. Seeing assets decline over the short term is not easy, yet it should be viewed as a potential opportunity to invest at attractive prices. This is easy to say (and do) when you have material cash in your portfolio looking for those opportunities. And that is the position we sit at this time.
What is causing this move in the markets?
It may be best to start with an analogy. When a car is driving on rough pavement, the shock absorbers act as a cushion and ensure that the wheels maintain traction. If a pothole is encountered so large as to render the shock absorbers ineffective, the conclusion is not to removed them from the car.
That appears to be the conclusion of the world’s governments when it comes to the banking system. The 2008 financial pothole was severe and tested the limits of the banking system. The financial wheels were coming off the road producing an out-of-control situation. We made it through, with the Federal Reserve’s help. (You may read more about our thoughts on that time frame in our piece Monsters and Shadows).
Many analysts drew the conclusion that the shock absorbers in place failed completely. There was little acknowledgement that the severity of the situation was so large that to produce an absorption mechanism to counter it was nearly impossible. Instead, governments in many developed countries (the U.S. included) rewrote the banking mechanisms in hope of making sure the banking system survives the next great pothole. A commendable idea that may have created unintended consequences.
It is important to note that the recent market turmoil has not weakened the stance of most global banks (especially the U.S. banks). Banks’ capital structures are strong and the distrust between financial institutions that evolved in 2008 has not been witnessed. Even the European banks are better capitalized now versus the period immediately prior to the Great Financial Crisis. However, this has led to the brunt of the volatility being felt, and absorbed, by the investing public with most commodities down over 50%, world equities down more than 15%, and high yielding debt instruments declining 12%.
Market commentators from the Financial Times produced an article that describes many on the causes of this turbulence. (Many suspects behind murderous markets). Their conclusion (which we partially agree with) is that the blame is widespread. The causes include: (i) the China market bubble and their currency manipulation, (ii) tepid global growth, and (iii) disappointing corporate earnings. The one cause neglected, we believe, is that all of these factors have been exhibited in past cycles and may not have been met with the same swift market reactions. Why now?
We argue that the root of all of these is a common attribute. Many of the economic shock absorbers of the past are not present now. The efforts to bullet-proof the banking system has led to the removal of many shock absorbers that were present in the past, leaving the financial markets vulnerable. New banking regulations around the globe (Dodd-Frank in the US, Basel III and Solvency II in Europe) have led to a dramatic change in the ways markets react to news. Gone are the days that sophisticated market makers and banks would act as stabilizers, adding liquidity when opportunities presented themselves. An example would be the European insurance industry, a $10T investment portfolio. Under the new rules, the insurance complex is less likely to move into riskier assets as prices fall as their current holdings’ risk measures would prevent them from doing so.
With many of the large financial institutions removed from the markets during times of turmoil, liquidity dissolves at the time of most need leading to sellers forced to accept dramatically lower prices in order to meet their commitments. We see this as an unintended consequence of the legislators’ acts to make the banking system less fragile. In many ways, the requirement of the financial markets acting as the absorber of shocks has led to more severe asset movements.
“Only in the darkness can you see the stars.” – MLK
The conservativism that we have built into our investment portfolios over the past year has resulted in a high level of cash. It has made us as much a spectator as a participant. This was a mindful decision so that when the time comes, we will have the cash available to invest. The swift moves of the global equity markets and the aftershocks they have created may now be opening up opportunities. Our methods of analysis are indicating that the level of fear in the financial markets may be exaggerated compared to the real fundamentals.
A few examples:
- One of the largest bank in Germany, Deutsche Bank, has seen material weakness on fears that it will not be able to make payments on its debts even though the capital coverage looks strong and has the backing of the German central bank.
- A large amount of oil recently traded in a local market at -$2.50 per barrel (below $0) suggesting panic at a time that U.S. and Canadian producers are starting to lower production.
- The percentage of investment grade bonds trading at distressed levels is at a level comparable to 2008 even though the distress appears largely within the energy industry.
Although we stated in our 2016 outlook that we worried about the growth in corporate debt, we feel that the equity prices are starting to reflect that concern. As mentioned earlier, the banking system is in good shape and may allow the economy a smooth transition to whatever is in front of us. Economic activity, outside of the energy sector, continues to move forward. The $800B per year dividend caused by lower oil, the high savings rate of U.S. households, and the high number of workers comfortable enough to quit their jobs in front of better opportunities suggests that not all is negative. Poor investments over the past decade have been extreme in some industries and, like the technology bubble of the early 2000’s, the economy should be capable of absorbing their soft conditions and at prices that may now reflect the worst case scenarios.
So where do we stand?
Patience and caution have rewarded us to this point. We see opportunities where fear has overstepped what we believe are the fundamentals. This is resulting in us looking to move, albeit slowly, back into the market. There are no promises that we maintain this course of action and we reserve the right to change our minds if we believe it to be in the best interests of our clients. So we, in the words of Theodore Roosevelt, are speaking softly and carrying a big (cash) stick.
Suggested Reading on the changing role of banks.
The Auour Advisory Team