The stock market has gotten off to a lousy start in the new year, continuing the trend from 2015. As of this writing we have already experienced a 10% drop that typically defines a correction and only time will tell if we head lower into bear market territory (a decline of 20% or more). The most common reasons cited include a slowdown in China, a collapse in oil and commodity prices and an increase in interest rates by the Fed leading to concerns that we may be heading into a global recession. Let me address these concerns individually as well as attempt to assuage fears that anyone may be experiencing.
As much as China is a headline story right now, its slowdown is not new news. China’s economy has been slowing from its unsustainably high growth rate for several years and current forecasts project growth in the 6% range for the next few years. Oh what we would give for a 6% growth rate. When China devalued its currency last year in an effort to make its products and services more affordable the markets sold off, and China’s efforts to stabilize their markets since then have backfired. Investors do not like negative surprises nor do they like uncertainty.
China is the world’s second largest economy so what happens over there matters on a global scale. The concern is if a slowdown in China will de-rail our economic expansion back home. U.S. exports to China represent less than 1% of our GDP (gross domestic product) and our total net exports amount to only 3% of GDP. Compare that to consumer spending which comprises 70% of our GDP. What the U.S. consumer does matters a lot more than China and the U.S. consumer is in very good shape. Personal income is growing at over 4% and auto sales, housing sales (two of the largest contributors to GDP) and new credit formation are all very strong. These are not signs pointing to a recession.
With oil prices falling under $30 last week, the entire energy industry is in panic mode. Cheap oil, however, is not due to a global slowdown but to an over-supply situation, which is a result of the successful development of fracking technologies. Production is exceeding consumption by over 1 million barrels per day and Iran is about to bring 500,000 barrels per day onto the market - a result of the lifting of economic sanctions. Some companies are now renting oil tankers to store excess capacity. As expected, the rig count plummeted, and once production comes down the imbalance will eventually correct itself. However, no one knows when that will happen and it may take years, not months. Concurrent with oil prices, other commodities are also falling. This hurts the materials sector and countries like Brazil that are export dependent, but not necessarily the global economy, as the rest of the world consumes those cheap commodities.
As bad as cheap oil is for the energy industry, it acts similar to a tax cut for everyone else. People are saving money at the pump and those savings will either find their way into more spending, more savings or debt reduction - all positive outcomes. Earnings for the S&P 500 were flat in 2015 but it was completely due to the drop in earnings in the energy and materials sectors. Excluding those two sectors, the rest of the S&P 500’s earnings grew at a healthy pace.
We addressed interest rates in our recent quarterly market commentary but suffice it to say, the Federal Reserve believes the U.S. economy is strong enough to withstand a series of gradual rate increases over the next several years. The Fed’s dual mandate is to maximize employment while minimizing inflation. With a 5% unemployment rate and inflation under 2%, they could possibly argue that they are meeting their mandate.
What to do now?
Admittedly, the stock market can feel like a roller coaster at times. It does go down on occasion and this is one of those occasions. The market experienced a low volatility run from August 2011 to August 2015 without as much as a 10% correction, which could have been a reversion to the mean from an extremely oversold condition in 2008 and 2009. In the long-run stock values are a function of earnings. Earnings were flat in 2015 (again due to energy and materials) and the consensus forecast is for earnings growth in excess of 10% in 2016. If that forecast proves accurate, current market conditions may represent a unique buying opportunity.
We believe the myriad of economic, political, social and other influences that impact markets are unpredictable and incorporate this belief into our investment strategy. Additionally, stocks, by their very nature, are volatile (as evidenced by the current decline). It is imperative that every investor knows what blend of stocks (for growth) and bonds/cash (for safety, income and liquidity) is most appropriate for his or her unique situation. Your portfolio should represent the blend that offers you a reasonable probability for success but without unneeded risk, no more and no less.
The only way you can determine that optimal blend is through an objective, analytical process in which you reduce your goals to writing, identify the resources available to fund those goals and then evaluate expected results from various asset allocations until you arrive at the answer. This risk-return evaluation is one of the planning services Wealthview offers our clients. If you are unsure of your appropriate blend of stocks, bonds and cash, we stand ready to help you find out. Once resolved, you can then turn your attention away from the daily gyrations of the stock market and focus on those things that are more important.