Commentary | January 21, 2016 |
The dramatic recent declines that originated from China’s Shanghai Stock Exchange have spread to all global developed-country stock markets. This raises an important question: is this just another brief correction, or is the weakening global economy catalyzing a sustained cyclical decline?
From 1945 to 2000, the U.S. stock market experienced cyclical declines at very regular intervals, with significant market bottoms occurring in the second year of every presidential term except 1986. (That one extended rising cycle ended in the infamous Crash of 1987.)
The massive interventions by the Fed have apparently caused the rising phases of recent stock market cycles to sustain for longer terms. However, growing evidence of a significant decline in many important global economies may now be causing a change in investor sentiment.
Revenues and profits of the S&P 500 have been weakening, and analysts continue to reduce their forecasts. Stock market internals, as well as the sustained nature of the downtrend in transportation stocks and small-caps (the Russell 2000 is down over 22% from its high of last June), imply that the U.S. stock market is finally focusing more on fundamentals and less on the potential of the Fed to “rescue” the stock market once again.
If so, what we are seeing could well be the early phase of a substantial cyclical decline, as some commentators are forecasting.
Global economic trends are not reassuring. Inflation remains low in the U.S. and Europe, and is trending lower. China is clearly entering recession, and some economies of Europe are also in recession, as well as deflation.
Those emerging markets that are dependent on commodity exports have been hit hard, both as to equities and debt. This has resulted in a broad, indiscriminant decline in emerging markets that has spread to countries that are not commodity dependent, such as Poland, South Africa and Israel. Developed countries such as Australia and Canada that are commodity dependent have also suffered, and the decline in oil prices is causing major pain in Saudi Arabia, Russia, Venezuela, Nigeria and Iran.
Although Germany remains the largest and strongest economy on continental Europe, the DAX Index of German stocks has fallen over 12% in the past six weeks, and is down 20% from its high of April 2015. A striking sign of how the financial sector is faring in Europe is the ADR for Deutschebank – which is down almost 66% in U.S. dollars from its high of January 2014, including a fall of over 33% just since last August.
The FTSE Index of UK stocks is down 16% from its high of last April, including a similar sharp down-leg in recent weeks. Japan’s Nikkei Index is down 15% from its high of last June. Hong Kong’s Hang Seng Index (which is less subject to manipulation than the Shanghai stock exchange, thus a better metric of confidence in China’s prospects) is down 30% from its high of last April.
Overall, a broad, dollar-denominated basket of non-U.S. stocks is down about 19% since its high of last May – about the same time of the high of S&P 500.
FedEx stock – a barometer of confidence in U.S. economic outlook – is down almost 30% from its high of last June. Similarly, the stock of UPS has fallen over 20% from its high of January 2015.
The stock of Caterpillar – the world’s largest manufacturer of heavy vehicles, including mining equipment, farm equipment and heavy trucks, thus an indicator of confidence in global growth – is down roughly 45% from its high of June 2014.
The Baltic Freight Index, reflecting global shipping rates, is at a 30-year low, reflecting very weak demand for tankers and freighters – again a tangible sign of the growing decline in global output.
Our portfolios at Sierra have been allocated very conservatively for many months. Should the decline in global equities accelerate, high-grade U.S. and European bonds will likely benefit from a typical flight of safety, and we are positioned to benefit if that occurs.
Municipal bonds have performed very well so far this year, and constitute very substantial allocations in each of our diversified portfolios.