“Never forget that the stock market is just a market for stocks.”
– Herman Miller, an old accountant I knew when I was a kid
The bloodletting on Wall Street may have paused, but no one is taking any chances. We’re not technically in a bear market yet – the S&P500 would have to break its resistance around 1863 before that happens. But the world is braced for it. Morgan Stanley has told its investors to hold on at least into the third quarter – exactly what Barataria said a few weeks ago.
Why all the negative sentiment? After all, China’s loss can only be our gain if you believe what you hear in politics. Then again, investors aren’t that gullible. It’s one big financial world and what goes ‘round comes ‘round. While there are some good reasons to take a six month or so pause, most of the reasons for this downturn are indeed lousy. It’s time to run through, and over, these arguments.
The big fear is that a huge meltdown in China will spread around the world. We’ve already discussed how capital is fleeing the dragon, but none of this has much to do with either the Chinese economy or the world economy. It was never a particularly real thing all around, which is to say that their stock market was even more tenuously related to the real economy than ours. It could collapse tomorrow and hardly anyone would notice.
The real problem is China’s banking system – which was never properly connected to international banking in the first place. That’s their problem. The potential for melt-down is as limited as the potential for melt-up in the first place.
Given that we don’t depend on exports to China and the only real problem is that the US Dollar will increase in value there isn’t a lot of downside for us as money flees for a safe harbor. Investors may be nervous at the appearance of risk, but that’s very different from actual risk.
Speaking of risk, away from misleading headlines the collapse of oil stocks is what really has the market spooked. The problem was first noticed here a bit over a year ago – oil wells drilled 3-4 years ago were financed primarily with junk bonds and now they are all worthless. The possibility of a financial “contagion” that rips through the banking system has everyone nervous for what appears to be good reasons. Citigroup recently added $250M to the reserves to cover their share of this debt.
Yes, $250M to Citigroup is a drop in the bucket. It’s pretty obvious that this is well covered.
The other concern is that corporate profits are indeed down. Where two years ago they were at an all time peak no matter how you measured it, they are returning to normal levels. A decline in earnings is a good reason for the stock market to take a pause, after all, since it’s really all about the Price to Earnings Ratio (PE) in the end – lower E means higher P which means sell, right?
Then again, the recent wave of hiring and the decent rise in worker’s wages seen in 2015 tell us a little about what’s going on. We can also turn back to our old friend capacity utilization, which we last visited a year and a half ago, to see what’s happening. Where we were at a nearly full-up 79% then we’re down to 76% now. Is that a recession in the works?
No, it’s a reflection of the investment that’s been put into businesses over the last few years. Capacity has been growing at a real (inflation adjusted) rate of 3% a year since 2013, a streak not seen since this Depression started in 2000. Businesses are re-investing in both equipment and people, which is to say that the downturn in profits comes from a positively bullish, not bearish belief.
It’s entirely possible that this may pause in 2016, given the downturn in the stock market, but that seems unlikely. 2015 was also a record year for venture capital, topping $72B for the first time since 2000 – despite a bit of a pause at the end of the year. That investment is not going to pare back for the purposes of looking good but will more likely charge ahead this year.
If anything, the stock market rout is hitting larger cap companies in the S&P500, which is down almost 7% for the year. The total market is down only 5.8%, meaning small companies are holding their own. Given that the market for venture capital just beneath that is hot we can see that this is less about a full retreat than it is a turnover in who is driving the economy.
Like the job market, it’s going be all about smaller cap companies when sentiment finally turns.
So why is the market down? China’s problems are nothing but good for us. Oil patch defaults will be large but are already priced in. Profits are down, but only because there has been a solid investment in future growth.
The stock market is down right now because the stock market needs to be down. The fundamental economy is doing fine – never great, but fine. If anything, Wall Street’s loss will be Main Street’s gain as the benchmark 10yr treasury finally starts breaking resistance and yields below 2.00%.