All in favor of canceling 2016 and starting over, say aye. Chinese stocks have dropped 18%, the S&P 500 is down 8%, North Korea tested a nuclear weapon, and we’ve lost Alan Rickman, David Bowie and Glen Frey – all since the big ball dropped in Times Square. All in all, not a great start to the year.
The loss of cultural talent notwithstanding, exaggerated market volatility is not a new occurrence. What we’ve experienced over the past fortnight is reminiscent of the selloff of last August and September, similarly provoked by events in China. We stated at that time, and continue to believe, that rising price volatility tells us more about the internal state of the market than it does about the genuine implications of international developments.
Simply put, as we near the seventh anniversary of this aging bull market, earnings and valuations are not as supportive as they once were. Corporate earnings growth has waned and will probably post a decline of about 6% for the full 2015 calendar year. The S&P 500 is valued at 18 times trailing operating earnings, which, although certainly not the bubble territory of the late 1990s, is nevertheless above the historical average of 15 times earnings. That combination of lethargic earnings and elevated valuations doesn’t necessarily spell the end of the bull market, but it does make the market far more susceptible to external shocks – and far more likely to overreact to them. That was the story of last August and September, and it’s been the story of the past few weeks.
To borrow an analogy from materials science, imagine a pile formed by dropping one grain of sand at a time. At some point, dropping one additional grain of sand will result in the entire pile shifting. We can blame that last grain for the collapse, although it was indistinguishable from every grain that preceded it. In reality, the critical state of the pile itself is to blame for the shift. The financial press has blamed China (or the Fed, or energy, or …) for the selloff of the past two weeks, but developments in these areas are not materially different from what we’ve seen before. Instead, the lack of support from earnings and valuations places the market in a critical state in which a response to external developments is magnified.
We examined the Chinese situation in depth in the Q4 2015 issue of InvestorView, in a commentary titled “Red Scare: Does a Chinese Slowdown Threaten the Global Economy?” To answer the question posed by the article title: no. There is no question that the Chinese economy is slowing down, but we believe that this is an inevitable evolution of a maturing economy and that the Chinese are far more interested in the sustainability of economic activity than the pace. In other words, we see this as a natural part of the maturation process, albeit a rare occurrence, as most emerging economies never quite manage to emerge. An aging population implies that China needs to emerge, as it needs to create the social safety net that an older population requires – and that the Communist Party wants in order to maintain civil accord. It is certainly a process that poses threats to market sentiment, but we believe the threat to true market values is limited.
Let us address two issues that have garnered a great deal of media coverage over the past few weeks, some of it egregiously misinformed. First, the specific threat of a Chinese slowdown to U.S. exports. Exports accounted for roughly 8% of gross domestic product (GDP) in 2015 – a meaningful number, but one that pales in comparison to the 68% of GDP that is a product of personal consumption. Our largest export markets are Canada (19% of total U.S. exports) and Mexico (16%), with China a distant third at 7%. That exposure to Chinese demand is not immaterial, but nor is it enough to derail the U.S. economy. The health of the consumer is far more important for economic growth.
We’ve also read a great deal about the so-called January effect, in which market performance in the first month of the year is believed to predict what the rest of the year holds. We are fundamental investors and don’t place much credence in technical analysis, but in this case the analysis doesn’t support the existence of the January effect. Since the creation of the S&P 500 in 1928, there have been 32 Januaries in which the market posted a negative return. In 15 of those cases, the index went on to end the year in positive territory, and in 17 cases, it lost ground for the full year. That set of observations is within one data point of a 50/50 outcome. In other words, January market performance has historically had no predictive value for the balance of the year.
What does have predictive value is earnings, and the recent picture is admittedly not encouraging. We’ve already referred to the likely decline in corporate profits for the full 2015 calendar year, and we are just beginning to get evidence of that as the reporting season gets underway. Energy companies are responsible for much of the drag on overall corporate profitability, but the pain is spread more widely than just one sector. In the third quarter of last year, consumer staples, materials and utilities also posted year-over-year declines, and consensus estimates expect a similar outcome for the fourth quarter. This is important because earnings are the fuel that drives the market higher. We are reminded of the old adage that in the short run the market is a voting machine (and voters have been unhappy for the past few weeks), whereas in the long run the market is a weighing machine. Earnings are what the market weighs.
It is not uncommon for corporate profit growth to decelerate as an economic cycle matures. Cost cutting – a dynamic source of earnings growth coming out of the recession – has run its course, and it is difficult for companies to grow revenues in an environment of modest economic activity and little pricing power. That’s the bad news.
The good news is that these market characteristics don’t necessarily apply to every company within the market. The benefits of active management are made manifest in periods of price volatility, as disciplined and patient investors can identify those companies that continue to create economic value in spite of the economic environment, and then allow price volatility to create the opportunity to acquire them at an appropriate discount to their intrinsic value.1
So perhaps it is a happy new year after all, at least for those investors who can weather the storm of price volatility and remain focused on the durability of value. We wish you all the best for the 50 remaining weeks of the year, while hoping that they’re not as volatile as the first two.
1 Intrinsic value: BBH’s estimate of the present value of the cash that a business can generate and distribute to shareholders over its remaining life.
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