The stock markets are off to a rough start as we start the fourth quarter of 2018. So far, the major U.S. and Canadian markets have declined in the high single digits, while markets overseas are down double digits. In this article, we start by highlighting some of the reasons being cited for this pullback, then discuss how investors should be thinking about these risks and conclude by describing what this all means for investors.
The major themes contributing to the decline in the markets are:
The U.S. Federal Reserve continues to raise interest rates as it moves to normalize its policy. The latest remarks from Fed Chairman Jerome Powell, emphasized that additional interest rates hikes are required to keep inflation in check. This caused the U.S. 10 year yield to spike to 3.2%.
U.S. relations with China continue to look increasingly fragile. Conflict over the ownership of the South China Sea is spilling over into political and trade tensions. It is important to remember that China holds over $1 trillion in U.S. treasury bills and they will most likely be continuing to decrease this position, possibly adding upward pressure on rates.
The U.S. stock market has significantly outperformed other international markets due to the earnings boost from the tax cut which has largely been used for share buybacks. This may now be coming to an end.
Increased tensions around the U.S. mid-terms where a potential change in control of the House could bring changes to the very pro-corporation policies of the past two years.
In typical fashion, after a market pullback, the media bombards us with countless reasons for why the market has pulled back. There are no shortages of “experts” willing to voice an opinion, after the fact, utilizing their 20/20 hindsight to their benefit. However, what the savvy reader will realize from the above list is that in fact, none of these items actually represent a major change from what we have been seeing over the past year. In fact none of these events come as a surprise. Consider the following examples:
With the unemployment rate at a 50 year low and limited excess capacity left in the economy, it was a sure bet that inflation would start to accelerate. The Federal Reserve’s primary defense against inflation is to raise short-term interest rates. Was it not fair to assume then that the future trajectory of interest rates should have been easy to predict?
The U.S. stock market benefitted enormously from the tax cuts which allowed companies to experience a significant boost to their earnings this year, offsetting the initial decline in their valuation multiples. However, was it not unrealistic to assume that this unprecedented level of earnings growth would eventually diminish, removing this short term factor supporting higher stock prices?
[What you should notice from the above two points is that knowing the exact level of interest rates at some future date or the exact earnings growth is a fools game and therefore largely irrelevant. What matters is recognizing the trends and understanding the direction these variables are heading and adjusting your portfolio accordingly to align with these shifts.]
If all these risks were easily forecast ahead of time why did the markets behave in such a violent and negative manner? The answer to this question is that a market trend will generally continue until a triggering event occurs that brings a sobering sense of reality back into focus. Nobody wants a good party to end. Importantly as we have said many times before, the single most important variable when investing is the level of interest rates, and more importantly, the trend that they are going in.
As interest rates rise, there is a change to profitability: the cost of money (price to borrow) going higher means a lot of investments do not happen because the returns are no longer adequate to compensate for the risks. It also costs more to service existing debt, consumers have less money in their pockets to spend as their mortgages increase, and ultimately it all feeds into less purchasing power, and lower profits. But profits are only half the story as interest rates rise all financial assets decline to ensure that they are now yielding more to keep pace with the rise in interest rates. Whether it’s the earnings yield or dividend yield of a stock or the bond yield in the case of fixed income, prices go down to move yields up. When there is a lot of debt, and the price of the debt goes up, investors that are leveraged having purchased their shares with debt are often forced to sell what they can in order to be able to pay down that debt. This leads to forced selling in the market. In other words, stocks are often not sold because there is something wrong with the company, but often because the holder of those shares needs the money for something else. That is what creates a good investment opportunity for those that do not need to sell, but are in fact in a position to buy.
Cash has two value enhancing properties. The first of which is the most obvious, that is, the interest received on this cash balance. Contrary to what many believe, in our opinion, this is not the most important property of cash. The most important benefit of holding cash for an investor is its second property: the risk-free optionality that it provides to take advantage of opportunities in the most critical of times. That is, the ability to put this cash to work without having to sell an existing asset in the midst of the panic (when prices are depressed) is a big competitive advantage for an investor. Cash allows the immediate and cost-less flexibility to be a buyer when others are forced to sell. This is when bargains are plenty and the value of cash is at its highest.
So, are bargains now readily available and is now the right time to deploy this cash? The simple answer is, unfortunately, not quite yet. The reality is, despite this sharp pullback, valuations are still not cheap enough for the most part and downturns in prices almost always overshoot. The stock price decline for most companies is still less than 10% or so. The November mid-term elections in the U.S. could bring some surprises that may be worth waiting for in order to position the portfolios accordingly. Therefore, we still remain cautious on valuations and as such will continue to tread lightly. We are much more focused on what could go wrong as opposed to what could go right at this juncture. After all, our goal at Summerhill is to foremost preserve capital above all else and this continues to call for the holding of an elevated cash position.
The Summerhill Team