One of my favorite books, for many reasons, is The Fourth Turning, by William Strauss and Neil Howe. It begins with the line, “America feels like it’s unraveling.” The book was written in 1997, but its message is relevant yet today. News channels and campaigning politicians make sure that instability in the economy and the markets is in front of us on a daily or even hourly basis.
The markets have certainly been unraveling to start the new year. The S&P 500 ended January down 5.0 percent, including dividends for the month, and lost 0.7 percent for the year then ended. Small, mid-cap, and international stocks fared somewhat worse still. The slide has continued into February as I write. While the declines may be moderate by some measures, the volatility has been significant, causing a lot of tension for investors. Most pundits are blaming the slide in oil prices and China’s economic decline as the reasons for this. These are certainly factors that matter, but we believe that there is more to the story than this. To find causation, we may have to look a bit deeper.
Dr. Alan Blinder of Princeton wrote for the Wall Street Journal in January that the effect of China’s slowdown on our own economy is probably overblown. Exports to China made up less than one percent of our GDP in 2015. Even if China’s purchases of our goods and services were to drop by 10 percent, which he finds implausibly large, the effect would be a hit to our GDP of a mere 0.1 percent. There could be ripple effect because we have other trade partners that rely upon exports to China, and a slow-down there could adversely those countries, which could in turn hurt us. But even if the rate of decline is doubled, it is still not of huge concern when taken in proper perspective. The morning news still reports the Chinese stock market results, and it still seems to have an effect on European markets as well as our own. Blinder calls this “slightly nutty.”
The other major morning headline relates to falling oil prices and their effect on our economy. Once again, Blinder: “Ask yourself: When the price of something you buy goes down, does that make you better off or worse off?” We import more oil than we export, so the drop in price is a far bigger problem for Saudi Arabia and Venezuela than it is for us. Granted, those poor souls who work in Texas and North Dakota may be feeling the pinch as drilling firms cut back, but the impact on the overall growth rate of our economy is still quite small. The fact that large energy stocks have been hit far more than the overall stock market seems to point toward opportunity looming on the horizon, not the doomsday story painted by so many. We will watch this closely. Meanwhile, in an apparent appeal to the fear on Main Street, one big provider of exchange-traded funds has just announced a new ETF that invests in all of the S&P 500 except for energy. Viewed from our fiduciary perspective, that timing seems odd, but understandable given the current level of fear of all things oil.
We have often remarked here that GDP growth is paramount to our future. Most reasonable minds know that a recession is coming someday. But are the current concerns overblown? It truly appears that the U.S. economy is surprisingly stable, albeit at a quite low level of growth. What might cause us to be stable in this environment? We believe that it has to do with our evolution from manufacturing and farming to services. Services are intrinsically less cyclical than non-service sectors. Manufacturing workers now account for only 10 percent of GDP. Some see a problem with this. We do not. Reminder, there are essentially four factors that add up to GDP: consumption, net exports, investment, and government spending. The evolving service sector supports stability in consumption, which is good for the economy. There are certainly other factors, such as a collapse of global markets that could start of an avalanche of panic here at home that would virtually guarantee a recession. A watchful eye toward sentiment seems appropriate right now. If you are looking for a good leading indicator, it usually can be found in household debt. When household debt gets too big, people slow consumption, which drags down the economy. For now, there is no boom in household debt like we have known before.
So, if these are not the reasons for current market instability, what are? Chief among the reasons is likely to be slowing of earnings growth. For quite some time, we have said that one should not expect the next decade or two to look like the last three. We are coming off three-plus decades of declining interest rates, which were very high in 1981. This, and other factors, contributed to an unexpected rise in after-tax corporate profits from six percent of GDP to 10 percent from 1981 to 2015. At this writing, 63 percent of the S&P 500 companies have reported earnings for Q4 2015. The blended earnings decline so far is −3.8 percent. If the index reports a decline for the quarter, it will mark the first time since Q1 to Q3 2009 that we have had three consecutive quarters of decline. Furthermore, the number of companies that are reporting negative guidance for Q1 2016 outnumber those reporting expected increases by about four to one. All of this is to suggest that we investors should probably not rely too heavily on long-run averages for stock and bond returns over the next few years.
If one were to look for a strategy that could be reasonably expected to make money, it would probably not be passive investment in a traditional buy-hold-and-rebalance strategy. Many have no choice but to do that with their employer-sponsored retirement plans, but individually managed accounts are a different story. Our friend, Ed Easterling at Crestmont Research often uses a boating analogy for the market and speaks of a time for rowing and a time for sailing. The time for sailing along in a rising market appears to be over, at least for now. It is time for rowing. That equates to trading portions of the market that are likely to do better than others and having risk controls in place that keep small losses from getting big.
Scott Neal is president of D. Scott Neal, Inc. a fee-only financial planning and investment advisory firm. Contact him via email email@example.com or by calling 1.800.344.9098.