It’s All About the “Short” Term.
“In investing, what is comfortable is rarely profitable.”
While bulls await Santa and his rally, bears focus on yesterday, today and one or two days forward. Historically, last week was the peak for tax loss selling, but this current market is consumed by Fed uncertainty, energy and raw material prices, deteriorating technicals, and the widening of the junk bond yield spread. October gains have been largely retraced and volatility continues to climb. Shorts dominate and permabears have tilted the weight of commentary to the pessimistic side. China has been pushed to the background as the inevitable Fed 25 basis point rise starts the gradual process of rate normalization. According to the bears, the policy shift will mark the beginning of the slide of the economy into recession. Let’s look at the major short-term concerns from a longer term perspective.
Fed Policy Initiative
The most telegraphed 25 basis point increase in history is priced into stocks. But on a day-to-day basis traders take sides. The anxiety level has increased as discussion focuses on currencies, particularly the US dollar, commodity prices and global growth. A quarter of a point move will not affect the economy in any meaningful way, but as we all have to learn, “fear can far exceed reality.” The increased volatility (VIX) is the barometer of this fear. High junk bond yields have led some to draw comparisons with subprime loans, in our opinion it is more of a head fake similar to the Puerto Rican bankruptcy and the ensuing contagion. One only has to look at the carnage to see it is almost entirely limited to energy-related high yield bonds.
Further complicating the situation is Third Avenue Management’s ceasing and barring redemptions in its junk bond fund, Focus Credit Fund ($789 million). This is interpreted wrongly by many as in indicator of overall conditions in the junk bond market. However, subsequent to the barring of withdrawals a list was circulated of bonds offered for sale by a single seller believed to be the Focus Fund. Most hedge funds passed on the list citing the illiquidity of the unrated deeply distressed bonds and private equity investments. The fact that Third Avenue does not have the cash to meet redemptions is Focus Credit Fund specific and not reflective of the situation for the High Yield Market. The ripple affect should be minimal as Third Avenue is not Lehman Brothers or even Bear Stearns, where there were multiple layers of leverage linked to the financial system.
The good news is by Wednesday afternoon the speculation on the move will become reality. Unfortunately, despite numerous statements to the contrary by the Fed, bears focused on the potential of too much too soon, after Wednesday they will shift the rhetoric to the timing of the next rate increase and its dire consequences. We have long believed that the best strategy with regard to Fed action is listening to the Fed. In our opinion, it would take a reversal of the 25 basis point increase to question the Fed’s credibility. Short-term volatility will increase around this week’s rate rise, but there should be little or no long-term reaction.
The problems of oversupply and rapidly declining oil prices will not be solved short-term. In fact, until a surprise increase last week, US oil inventories rose seven straight weeks. A continuation of the oil surplus should push equilibrium further into the future, but the laws of supply and demand still work. Demand has been stimulated by lower prices, oil demand is up about one million barrels a day, benefitting consumers and reflected in the increase in consumer spending but at the expense of slower corporate earnings. The recent decision to continue all-out production by OPEC led to the sharp decline in the price of crude over the past week. The budget problems of many Middle East oil producers, along with Russia and Venezuela, preclude any supply reduction. Contrary to any economic theory, when dependent on oil revenues to fund government spending, these countries pump at full capacity despite losses. In addition, other oil producing countries with reserves set aside are rapidly depleting these funds.
Lower overall commodity prices benefit consumers at the expense of corporate earnings. Consumer spending is hampered by higher rent and healthcare costs, but this is more than offset by lower energy prices and rising wages. Oil price equilibrium is farther out than expected only a month ago, adding confidence to consumers and translating into spending. Unfortunately, commodity producers bear the brunt of this transition. Additionally the strong dollar has lowered revenues and earnings to multinational corporations. Traditional retail, particularly department stores, is losing out to online retailing. Withexcess capacity and low margins, corporations lack pricing power. Rising unit labor costs as employmenttightens and rising interest rates will benefit consumers more than the average corporation.
Potential for Recession
Under the present circumstances there is no reason for a business cycle downturn. Remember, all recessions result in bear markets, although all bear markets do not lead to recessions. Those forecasting recession, the numbers have been increasing lately, believe that with only 2%-2.5% real growth, any loss of economic momentum will result in negative real growth. Not true. Even slow growing economic recoveries do not end until excesses create imbalances. Most often these excesses begin with rapidly rising inflation. An exception was the Financial Crisis of 2008-2009 was attributable to excesses and imbalances in Wall Street and the banking system. Today, our financial system is healthy and corporate and consumer debt are currently at very manageable levels. If there are any excesses it is federal spending.
Unicorns – Not the Mythical Variety
Unicorn is the term for a one billion dollar plus tech start up. Google, Amazon, Microsoft, Intel and Cisco never approached that valuation until after going public. An article appearing in the January 22, 2015 Fortune Magazine listed 80 Unicorn companies. In a recent update (August 25, 2015), the number grew to 138 Unicorns. This is in sharp contrast to only one, Facebook in late-2013. According to Fortune, “Smartphone, cheap sensors, and cloud computing have enabled a raft of new Internet-connected services that are infiltrating the most tech-adverse industries.” The characterization of these disruptors sounds eerily similar to the rhetoric of the 1997-1999 dot.com bull market.
Changes to previously accepted ground rules were made by the Unicorns to facilitate additional capital. Foremost is an insurance policy for late-stage investors. The risk to these investors is lessened by guaranteeing a specific return on investment if the next round of funding, an IPO, or a sale comes in lower than their round. Approximately 30% of the Unicorns have such an agreement for IPO’s, with lowerround employee shares diluted to satisfy out of the money investors. To protect employees from a down round, companies on average stay private longer (7.7 years) compared to 2011 (5.8 years). However, the extended time period increases the risk of a lower valuation from a market downturn and opens the possibility for potential competition. Mutual funds are rethinking and restructuring their strategy for these high valuation private investments. Lower valuations resulting from greater focus on earnings, as opposed to revenues, may be the beginning of a reclassification of the highly vulnerable Unicorn market. The threat of shrinking funds from private investors make Unicorns a leading indicator of potential problems for technology in general.
The US economy remains the engine, albeit not hitting on all cylinders, of the global economy. The current problem with the market is valuation as corporations work through a strong dollar, tighter margins, and inventory liquidation. Expect volatility into 2016 as corporations shift to satisfy increased consumer demand in an environment of uncertainty. The transition to a more consumer-oriented economy is in its early stages. After the Fed raises rates, stocks should perform better throughout the rate normalization process. Longer term we believe that moderate economic growth, accompanied by slow rising real interest rates and low inflation, will result in increased earnings and multiple expansion with continued upside for select Large- Cap Consumer Discretionary and Technology companies.
Merry Christmas and Happy New Year. We will see you in early 2016.