Markets Were on a Roller Coaster During the First Quarter — Opening the Period with a Pounding Only To Rebound Dramatically. Clearly, in the Short Run, Logic Wasn’t the Dominant Factor at Work.


As a portfolio manager, I’m continually confronted by the healthy discipline of market forces — and by the market’s inevitable bouts of fear and optimism. While company earnings tend to drive stock prices toward fair value over the long term, anything can happen in the short term.

This is what Benjamin Graham meant when he characterized the market as a rational “weighing machine” that considers the facts over the long term, but also as a fickle “voting machine” that’s influenced by fads and fleeting popularity in the short term. Such short-term psychological mood swings were exactly what we saw during the first quarter of 2016.

At the heart of the current situation is that the U.S. economy has plodded along at a tortoise-like pace since the end of the Global Financial Crisis (GFC) in 2009. But the stock market has mostly run at a hare’s pace, with a pause to rest in the last year. Because central banks around the world haven’t been satisfied with the global economy’s tortoise-like pace, ever since the GFC they have pursued unprecedented monetary policies — including massive bond purchases, low interest rates, zero interest rates and now even negative interest rates!

Investors have been left to battle their emotions, waffling in their views as to whether the glass is half empty or half full. But for the economy as a whole, the level in the glass really hasn’t changed much. What does change, however, is the tenor of the financial headlines, which can meaningfully influence investor psychology. I believe this is what accounted for the market reversal that began mid-quarter.


As we consider economies around the world, the big concerns recently have been the slowdown in China and the decline in commodity prices.

For years, economists have worried that China’s development has been grossly unbalanced — even as the country’s economy has grown to be the second-largest in the world. Household consumption has been very low, with a correspondingly high household savings rate.

Both the Chinese government and Chinese corporations have used these savings to undertake massive investments. As a result, government and corporate debt levels in China have been increasing at an alarming pace as the country has overbuilt its infrastructure and manufacturing capacity. This overbuilding — until recently — created an almost insatiable demand for commodities of all types and helped drive oil, cement and iron-ore prices higher.

China also kept the value of its currency pegged to the U.S. dollar. This allowed China to give its manufacturing exporters a competitive edge, especially in markets that are dependent on consumption in the U.S. and other developed countries. The willingness of Chinese companies to deliver goods at thin (or even negative) profit margins threatened businesses and workers around the globe.

Now, with economic growth slowing, China’s government is finding it necessary to work on developing a more balanced economy — one that will rely more on Chinese consumption and less on exports to the rest of the world.

As the economy shifts, the decline in production of goods exported from China gives economists a new worry — that the flattening use of commodities in Chinese manufacturing will trigger turmoil in countries and industries that are dependent on Chinese consumption of petroleum and metals. But while it’s true that commodity-oriented countries and industries have already experienced painful adjustments, and will probably continue to feel the effects of lower prices, I don’t anticipate an economic implosion that would have major world-wide ramifications.

I think China and other emerging markets are simply going through the normal phases of economic development that many other countries, including the United States, experienced in the past. Along with these phases, there may be further adjustments in the Chinese yuan now that it will be pegged to a basket of currencies, rather than just to the U.S. dollar. But I don’t expect to see a global crisis as the yuan and other emerging-market currencies reach new equilibriums.

Declining prices for commodities — particularly oil — also have some beneficial impacts. Consumers are receiving what is, in effect, a tax cut. And who doesn’t like a tax cut? Especially one paid for by those whom many view as oligopolistic polluters. So despite the often apocalyptic headlines, the real story of weak energy prices is much more positive when we consider that the winners vastly outnumber the losers.

Moreover, for many commodities, world-wide demand hasn’t actually fallen. Weak prices have had more to do with better extraction methods and slowing growth in consumption, rather than outright declines in consumption. Although I don’t foresee a sharp rebound in commodity prices, I do expect prices to stabilize somewhat as producers adjust their capacity utilization to the new demand trends and the availability of alternative energy sources.

In addition to the constructive overall effects of lower commodity prices, there were many other favorable economic conditions in the United States that continued during the first quarter. These conditions included the spread of information-age businesses and high-tech industries, still positive gross domestic product (GDP) growth, falling unemployment, modest wage increases, and the progress consumers have made in repairing their balance sheets since the GFC.


As I’ve already discussed, the economic story hasn’t changed much in the last several years. And stock markets throughout most developed countries have generally performed remarkably well during this period. The past year was an exception, however. The vast majority of indices across countries, sectors and industries were down for the 12 months ended March 31, 2016.

Similarly, the first quarter of 2016 started with powerful declines across most stock-market indices. But later in the quarter, stocks staged encouraging rebounds as commodity prices firmed, the U.S. Federal Reserve (Fed) backed off its rhetoric regarding future interest-rate increases, and investors regained their optimism.

The large-cap S&P 500® Index rose 1.35% for the quarter. And the Russell 2000® Index of small caps fell only -1.52%, after having been down almost -16%. As for international stocks, the MSCI World Ex-U.S.A. Index declined -1.95% for the quarter — which was much improved from an interim loss of over -12%.

Meanwhile, high-quality bonds moved up nicely. The intermediate-term Barclays Capital U.S. Aggregate Bond Index returned 3.03%. Similarly, the long-term Barclays U.S. 20+ Year Treasury Bond Index gained 8.49% for the quarter.

For stocks, an important concern is the possibility that the declines in the past year and early in the first quarter indicate the type of vulnerability we may see going forward. This concern is heightened because the low-single-digit annual GDP growth over the last several years hasn’t remotely kept pace with stocks, many of which have had annual returns approaching or exceeding double digits. Market observers frequently attribute the high stock prices we have seen to the unorthodox experiments in monetary policy by central banks around the world.

The classic role of central banks is to ensure that adequate liquidity exists in times of panic so the panic doesn’t feed on itself. The first round of quantitative easing (QE1) during the height of the GFC was a prime example of this classic role.

Subsequent easings by the U.S. Fed and other central banks have essentially been experiments in trying to stimulate economies that haven’t been in a state of panic. But the lackluster growth rates of economies around the world suggest that the intended improvement hasn’t been achieved.

Moreover, not only can monetary experimentation be unsuccessful, but its effects can also be extremely unpredictable. For example, the Bank of Japan (BOJ) recently introduced a policy of negative interest rates in which commercial banks have to pay (rather than receive) interest on reserves held at the central bank. This was intended to stimulate Japanese exports by weakening the value of the Japanese yen. However, since the BOJ’s negative interest rate policy began, the yen has actually strengthened.

So here we are with very modest global economic growth, seemingly excessive gains in stocks over the past several years, potentially flawed monetary policies around the world, and mediocre readings on the sentiment indicators I follow. Although this may sound like a prescription for flat — or possibly even falling — stock prices going forward, I continue to be the “nervous bull” that I’ve been for quite a few years. In hindsight, I should have been a “raging bull” for most of that time. But, while I don’t feel comfortable abandoning my caution now given the challenges described above, I have taken note of a number of favorable conditions.

These favorable conditions include the following: 1) The availability of some stocks at fairly reasonable valuations, even within the context of high valuations overall. 2) The improvement in sentiment indicators relative to the bearish readings several months ago. 3) The recent tightening of credit spreads between high-quality and lower-quality bonds of the same maturity. 4) The prevalence of stock yields that exceed 30-year Treasury bond yields. This fourth condition is particularly noteworthy because when you buy a stock, the dividend can rise. But when you buy a Treasury bond, the yield is fixed until maturity.

As for current monetary policies and extremely low or negative short-term interest rates, there’s a debate as to whether they’re beneficial or harmful. But the fact is that no one knows for sure what the effects will be.

Throughout recorded history, interest rates have almost never been as low as they are today. And in a world of electronic transactions, central banks have never had the type of power that they currently wield. As a result, we may have entered a new era in which stocks trade in a range of higher valuations for metrics such as price-to-earnings and price-to-cash flow ratios.

From my position as a nervous bull, what would change my opinion positively or negatively? On the positive side, I think improvements in industrial production within the U.S. and — even more importantly — outside the U.S. would make me more optimistic.

By the same token, on the negative side, if we see declines in industrial production or if investors continue to focus more on central banks than on company fundamentals, I’d become increasingly pessimistic.


As discussed, especially in the short term (which may last for several years), investment returns can be influenced by factors that are more psychological than logical. This means that investors who chase the performance of stocks that have done well in the past may be ignoring valuations and may be missing opportunities in areas of the markets where company fundamentals are strong and valuations are more reasonable.

At Wasatch Advisors, we believe one of the best examples of negative psychology creating attractive valuations is the recent situation in emerging markets — where, in stark contrast to developed markets, stock returns have generally been uninspiring over the past five years. We think this has largely been due to fears regarding the economic slowdown in China, negative sentiment surrounding the commodities rout that tainted the entire emerging-market category, and currency movements — namely, strength in the U.S. dollar and weakness in emerging-market currencies.

Our outlook is that these conditions won’t persist. We believe well-chosen emerging-market companies will stand on their own merits and will decouple from the problems in China and the commodities complex. Therefore, we believe the stock prices of these companies have the potential to rise. Moreover, many of the companies in our emerging-market portfolios pay significant dividends. And for U.S. dollar-based investors, we think there’s strong potential for appreciation from currency adjustments.

We’ve recently published a white paper “Is Now the Time for Emerging Markets?” that describes the reasons for our outlook. You can access the white paper on our website at

With sincere thanks for your continued investment and for your trust,

Sam Stewart


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Someone who is “bullish” or “a bull” is optimistic with regard to the stock market’s prospects.

Someone who is “bearish” or “a bear” is pessimistic with regard to the stock market’s prospects.

The financial crisis of 2007-09, also known as the Global Financial Crisis (GFC) and 2008 financial crisis, is considered by many economists to have been the worst financial crisis since the Great Depression of the 1930s.

Gross domestic product (GDP) is a basic measure of a country’s economic performance, and is the market value of all final goods and services made within the borders of a country in a year.

A credit spread is the difference in yield between two bonds of similar maturity but different credit quality. For example, if the 10-year Treasury note is trading at a yield of 6% and a 10-year corporate bond is trading at a yield of 8%, the corporate bond is said to offer a spread over the Treasury of two percentage points.

The price-to-cash flow ratio is a measure of investors’ expectations of a firm’s future financial health. Because this measure deals with cash flow, the effects of depreciation and other non-cash factors are removed. Similar to the price-to-earnings ratio, this measure provides an indication of relative value.

The price-to-earnings (P/E) ratio, also known as the P/E multiple, is the price of a stock divided by its earnings per share.

Quantitative easing is a government monetary policy used to increase the money supply by buying government securities or other securities from the market. Quantitative easing increases the money supply by flooding financial institutions with capital in an effort to promote increased lending and liquidity. QE1 is the nickname for the first round of quantitative easing.

Valuation is the process of determining the current worth of an asset or company.

The S&P 500 Index includes 500 of the United States’ largest stocks from a broad variety of industries. The Index is unmanaged, but is a commonly used measure of common stock total-return performance.

The MSCI World Ex-U.S.A. Index captures large and mid cap representation across 22 of 23 Developed Market countries — excluding the United States. With 1,004 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.

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The Russell 2000 Index is an unmanaged total-return index of the smallest 2,000 companies in the Russell 3000 Index, as ranked by total market capitalization. The Russell 2000 is widely used in the industry to measure the performance of small-company stocks. Russell Investment Group is the source and owner of the trademarks, service marks and copyrights related to the Russell indices. Russell® is a trademark of Russell Investment Group.

The Barclays Capital U.S. Aggregate Bond Index covers the U.S. investment grade fixed rate bond market, including government and corporate securities, agency mortgage pass-through securities, and asset-backed securities.

The Barclays U.S. 20+ Year Treasury Bond Index measures the performance of U.S. Treasury securities that have remaining maturities of 20 or more years.

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