2015: The Road to Nowhere
2015 had many twists and turns, but from a financial market perspective, it was effectively a road to nowhere when looking across a variety of asset classes. In U.S. equity markets, large company stocks (large cap) barely moved as just a few sectors and stocks were big winners. In the broad market, many stocks performed far worse than the large cap averages and gave investors the false impression that the market was generally flat. On the contrary, a broader measure of the market which consists of 1700 equally weighted stocks was down roughly 7% on the year, and helps to highlight how skewed the major indices were, due to just a few large companies that had good years.
Outside of the U.S., global markets were all over the map. Japan had a solid year, but many other parts of the world did not fare so well. The worst region within equities was found in the emerging market world, where the broad indices were down double digits and select regions were mired in severe commodity related bear markets. Commodity futures continued their descent in 2015 and registered losses of approximately thirty percent. Fixed income investments were no easier to gauge—while intermediate government bonds and municipals had a solid year, riskier fixed income instruments closed out the year with solid losses due to exposure to energy companies and a sagging economic backdrop.
2016: New Year, Same Old Story
While the calendar has changed, the investing landscape is mostly a continuation of what we witnessed in the second half of 2015. Our last quarterly piece was titled “A Time for Caution,” because the bull market was aging and becoming overvalued as it had finally met technical conditions that were turning negative.
As we start the New Year, not much has really changed from a big picture perspective. We continue to deal with a global business cycle that is slowing, valuations that are high, and a technical environment that continues to break down. In short, it looks like the transition from bull to bear market is taking hold within the equity markets. Given this, we believe we should continue to focus on risk management, which is why we are currently managing our portfolios defensively. This defense has consisted of shifting the holdings within our portfolios to own less risky assets and more fixed income (bonds). We have concentrated the equities that we own into more defensive holdings that are less exposed to cyclical areas of the market.
Corrective Activity or a Cyclical Bear Market?
2015 may have gone out like a lamb for the major averages, but 2016 has come in like a lion. The sudden and violent drop at the start of 2016 puts us in corrective territory and we have already made a substantial downside adjustment in response to the volatility.
The crucial question here is whether or not the current adjustment is a correction within the ongoing bull market, or the start of a cyclical bear market in stocks? We believe the market has been displaying textbook bearish tendencies based on the changes in the market that have been developing for the past few quarters, including some that helped warn us that the market’s internal condition was compromised prior to the latest drop in the headline indices. Along with deteriorating technical conditions, we are also concerned that an expensive U.S. market is now clashing with a methodical slowdown in the global economic backdrop, a slowing earnings environment, and an important change in monetary policy from the U.S. Federal Reserve.
As we align the evidence today, it would appear that the transition from a bull to bear market has begun to pick up steam, and that the major averages have finally entered the gravitational pull of a normal and healthy cyclical bear market cycle.
How Long and How Deep?
Given that we believe a down trend is in motion, how long and protracted might it be? While there is never a way to gauge the depth and severity of a cyclical trend with precision, we think history can be a useful guide. One method analysts have used to gauge the severity of a bear market is to compare prior bear market periods to those that were associated with recessions, and those that had no connection to a downturn in the economy. While numbers differ by market and exact time frame analyzed, the U.S. studies we have examined would conclude that cyclical bear markets are typically longer and deeper if a recession is involved. According to data by S&P IQ, the average bear market in the S&P 500 since 1929 is about 35%, with a duration of about 21 months. If history is any guide, our best guess is that this bear market should be contained to somewhere between 20 and 30%, and if we escape it without a recession, then we will likely land on the lighter side of that range.
Recession or No Recession?
The global economic environment is extremely weak. The combination of a volatile commodity market and the persistent weakness in China has produced fragile economic links within the emerging market universe, for a number of quarters. In stark contrast to the emerging world, the developed regions have been enjoying a low but stable growth profile. In general, the developed world has benefitted from low inflation and interest rates, and from central banks that have been in overdrive to make up for the scarcity in world aggregate demand that has been a hallmark of the post Great Recession period. Unfortunately, the world is highly globalized, and when a large portion of the globe is having a severe problem, it is hard for any single economy to remain unaffected. It would seem that the problems in the emerging market world are finally beginning to disrupt the goldilocks environment the developed world had become accustomed to over the past few years.
Last quarter, our forecast was for a U.S. economy to continue slowing, primarily due to the weakness abroad that was beginning to infiltrate our shores. While recession was not our base case, we did note that risks were rising as we began to see a variety of regional economic surveys slowing, and manufacturing numbers were feeling the pull of weak world growth and a strong dollar environment.
As we start 2016, we believe that 2015 fourth quarter growth will come in very close to recessionary levels, though we still believe the economy will likely skirt negative numbers (even if by an anemic margin). It would also appear that the first quarter is setting up to be quite weak as well. While we are not calling a recession just yet, we think it is fair to say that growth is low enough to continue to cause problems for earnings and the stock market. So far, our non- recessionary call has kept us in the short and shallow bear market camp. However, recent data is not encouraging, and our view could change over time. If it does, it could alter our long term view and the amount of de-risking we ultimately employ during this cycle.
Wealth Generating Opportunity
When markets turn down and the media whips up into a negative frenzy, it is easy to lose the larger context. But if we remove ourselves from the day to day craziness and undertake a more clinical evaluation of a cyclical bear market, there are actually many silver linings for those looking to build wealth over time.
The first silver lining is that cyclical bear markets help clear out some of the excess that has been built during the prior cyclical bull phase. In essence, a bear market is nature’s way of removing the weakest hands from the market so that a healthy balance between fear and greed can coexist. Bull markets are nice as they run and build wealth, but if they don’t have occasional pullbacks, they turn into bubbles which can be devastating when they eventually pop (see the current drop in oil, the prior drop in gold, the drop in the NASDAQ in 2000, etc.). So let’s just accept that cyclical bear markets are a natural part of the investment cycle, and are occasionally necessary to cleanse excess, and recalibrate market sentiment and valuation.
Beyond restoring a natural balance to markets, the tail end of a bear market is what ultimately gives investors the best possible chance to build wealth. As valuations drop and prices get marked down, investors ultimately get a chance to pick up assets with robust long term appreciation profiles and greater margins of safety. The run off the 2009 and 2011 bottoms were both healthy moves, and have put stocks in a place where some froth needed to come out of the system to allow for adequate long run gain potential.
When viewed through this prism, a cyclical bear market is like a sale on quality assets—and who doesn’t want to go shopping when things worth buying are on sale? The last few years have brought about an aged condition, which didn’t give us much enthusiasm to overweight risk assets. But a cyclical bear market should help reset valuation profiles and finally give us an opportunity to increase exposure to these assets at very cheap prices.
So in the end, cyclical bear markets can be something to get excited about for those willing to reflect on the mission of building long term wealth.
When markets move quickly and confusion reigns, it’s easy to make mistakes. We use a systematic approach in managing our portfolios and the evidence we follow has helped us identify this period as a rocky one, while giving us the flexibility to alter allocations and become defensive in front of the latest volatility. We’ll continue to monitor market conditions and respect this bear market while it runs, but we’ll also keep an eye out for evidence that turns in a more positive direction.
Warren Buffet has long talked of being fearful when others are greedy and greedy when they are fearful. We won’t rush back into this market, but we will keep an eye out for that point of maximum fear, where we can attempt to put Buffet’s principals into action and get a chance to build long term wealth with a greater margin of safety.