Is This The Bear Awakening?

By Mark Bern, CFA

• ·        The Dow falls 832 points in one day!
• ·        Plausible reasons why the market dropped.
• ·        Positives still outweigh the negatives.
• ·        Stick with quality and look for good buying opportunities.

Short answer: Probably not.

I know it feels horrible when we read the headlines like: “Market Falls 832 Points!!!”  But let’s try to put that into perspective.  Yes, it is a big point drop and more of a percentage drop, at 3.15%, in one day than we have had for some time.  But it comes after the market has had a very strong run off of an intra-day low of 23,360 on February 9^th to a recent high of 29,951, or 15.37%.  The Dow Jones Industrial Average Index (^DJI) had posted a respectable year-to-date gain of 8.5% before this latest down draft and remain about 3.56% ahead for the year, even after the recent dive on Wednesday.

The last time the market took such a large point beating?  August 10^th, 2011, when the market dropped by 519.83 points.  But the percentage loss was 4.62%.  The market is much higher now so it requires a much larger point drop to record as large a percentage dip.  The largest one-day percentage loss on record happened on October 19^th, 1987.  I remember it well.  The DJI fell by 508 points, or 22.61% in a single day.  That felt horrific to most investors.  But turned out to be a great buying opportunity as the market rebounded by over 10% on October 21^st of that same year and two years later (in August of 1989) the index had fully recovered, providing those brave enough to jump in when things seemed at their worst with a 42.8% gain (not including dividends). 

This may be a good time to review some of the largest one-day gains and losses in history (from wsj.com).  After looking at those tables things are not as bad as the headlines may infer…yet. 

Why Did the Market Drop?

Several reasons have been proffered by the financial media and gurus on the Internet.  Over the weekend we read about a spike in long-term interest rates being the culprit of the initial dip in stocks last week.  Now the list of problems has been expanded to include:

• ·        Trade war with China,
• ·        The economy is too strong so the Fed will keep raising rates,
• ·        Mortgage rates are rising which could cause weakness in the housing market,
• ·        Tariffs are adding too much cost to U.S. products which will cause a rise in inflation as businesses pass on the costs to consumers,   
• ·        Debt levels are too high, especially on commercial real estate,
• ·        Emerging markets  have too much USD (US dollar) denominated debt and the stronger dollar makes it harder to service the debt thereby weakening those economies,
• ·        Inflation is coming!

Let’s take a look at each one very briefly.

The impact on U.S. consumers, as I have explained in an earlier blog, should be relatively muted and not likely to cause a significant drag on the economy.

The Fed plans to continue raising rates at small increments (0.25%).  This has not changed.  It is not news.  It was supposedly built into the market prices before the dip.  Interest rates are still about half the normal level from a historical perspective and should continue to support higher asset prices.

The same applies to mortgage rates.  An increase of another 0.25% in the average mortgage will not be the cause of a real estate collapse.  It may create a drag on demand which could actually be healthy as home prices have risen faster than wages.  Slower growth in home prices would give wage growth a chance to catch up.

Tariffs should not be a big drag on the economy; small, yes.  But since the trade war began the Chinese Yuan has depreciated against the USD by about 8%.  That makes most things imported from China with a 10% tariff cost almost the same as before all the tariffs.  If tariffs rise to 25% on many Chinese import in January the impact could be felt a little more here but much more in China.  The Yuan is likely to fall more between now and then (and probably additionally after) which would reduce the impact, though.

Commercial real estate could pose a small problem but not enough to cause a collapse in the banking sector.  The situation appears worse in Europe as does the healthy of the financial system.  US banks are in much better financial condition that prior to the great recession.

Emerging markets are having problems and things could continue to worsen for those that have too much exposure to USD-denominated debt.  However, most emerging market countries have far smaller USD debt proportionally now that when the taper tantrum roiled the markets.  I expect the problem will be much less wide spread than before and the impact to US companies to be contained.

Inflation?  The same factors that have kept a lid on inflation still exist.  Demographics will not improve appreciably for a few more years in the U.S. and may never improve in some developed nations like Japan and parts of Europe.  That will continue to create a drag on the demand side.  Wages continue to be competitive on a global scale allowing large multinational corporations to seek the lowest input costs wherever those inputs exists.  Highly paid employees are retiring in droves and being replaced by lower paid, younger employees.  Productivity improvement also remain illusive as skilled employees leave the workforce.  I could go on, but you should get the picture.

Inflation will come, but the threat is not imminent in my opinion.

The Positive Side of the Economic Equation

The U.S. economy is humming along, growing at a brisk pace but not so fast as to create inflationary pressures.  Again, that is my opinion and when considering opinions one should always take such with a grain of salt.  No one is infallible, not even me.

U.S. multinational corporations continue to repatriate hundreds of billions in cash from overseas.  It will not be an overnight event but a process as companies weight the best ways to put those nest eggs to work.  But acquisitions, equipment and facility upgrades, increased dividends and share buy backs will probably continue to be the primary allocations.  All are good for the economy and will support continued growth.

The unemployment rate is the lowest since 1969.  That will eventually put upward pressure on wages.  That process has already begun but I expect wage increases to remain relatively muted for the next few years.  By that I mean that wages will rise faster than inflation but not so fast as to cause inflation.  If wages rise by 1% more than inflation each year it should not cause a significant enough rise in demand for goods and services to cause inflationary pressure.  Also, the workforce participation rate is still well below its peak meaning that there are still employable people sitting on the sidelines who could be induced back into the workforce if wages increase much more.  There is still a little wiggle room before inflationary pressure should become a problem.

Even though the Fed is tightening monetary policy, the federal government has loosened fiscal policy and the tightening is advancing at a very measured pace.  Unless the Fed speeds up its efforts or makes a mistake by tightening too much too soon I do not foresee monetary policy pushing the US economy into recession.  It could happen but, again, it does not appear imminent.

Costly regulations are being rolled back which will reduce costs for businesses.  The tax cut legislation has higher profits flowing to the bottom lines of companies large and small.  The impact is not a one-time event as some analysts would have us believe, but it will continue to add to the health and profitability of corporate America for years to come.  All that additional cash flow will be allocated just like the repatriated cash adding more flexibility to business capital structures.  These are also good for the economy.

Stick with Quality

As stock prices fall we should be looking for opportunities among the quality companies that we may have overlooked because those stocks looked too expensive.  As prices come down and profits continue higher, bargains may appear.  Stay tuned as we begin the process of culling through the debris to identify the diamonds among the heaps of coal.