Seven out of the first ten trading days of 2015 showed losses for the S&P 500, with the market down about 4.5 percent from December’s high. Along with many analysts, we expected greater volatility in 2015, but the market’s performance year-to-date has done nothing that would make us revise our bullish thesis for the year.
During an uptrend, we can discuss “healthy” pullbacks with cool rationality -- when they’re actually happening, that gets more difficult. Part of the way we orient ourselves during a pullback is by reflecting on the psychological forces that are at work in the market. This serves two purposes: first, it gives us a sense of the events that will need to unfold for market participants’ fears to be eased and for the correction to run its course; and second, it lets us analyze those fears critically to see if any of them have substance. Both of these purposes allow a rational investor to execute his or her own strategy with more conviction and effectiveness.
What Fears Are Currently Driving Market Action?
We see two major fears driving current market psychology and the resultant volatility.
First fear: disorder in global currency and commodity markets.
Last Thursday, the Swiss National Bank (SNB) removed the ceiling that had limited the appreciation of the Swiss Franc against the Euro. This decision by the SNB happened a week ahead of today’s meeting of the European Central Bank, after which a large and bullish sovereign-bond buying program was announced. Although trading settled down after the SNB action, the Euro initially fell some 20 percent against the Franc. Switzerland is a small economy and the Swiss Franc is not a global reserve currency -- but the speed and size of the move were disconcerting.
Another uncertainty creating turmoil in global currency markets is the upcoming Greek election, which may see an anti-Euro, anti-austerity coalition come to power in that country -- a coalition which could conceivably take Greece out of the Euro, with highly unpredictable effects.
Additionally, many global commodity markets show continued weakness. Uncertainty surrounds the price of oil, with bearish analysts now calling for a bottom in the $20s (a view that’s too bearish, in our opinion).
What will calm these fears? First, the much-anticipated ECB meeting is now behind us, and we now have a clear sense of the scope and structure of ECB action. Markets may take some time to fully digest this morning’s ECB press conference. Second, getting the Greek election behind us. And third, seeing a bottom put in to global commodity markets, particularly oil. This may not occur for some time -- possibly several months.
Is there substance to these fears? We do not believe so. We do not view the decision of the SNB as a bearish vote on Europe, but more an indication of perennial Swiss independence. We also believe that if the announced ECB QE program proves inadequate, further measures will be announced later in the year. We do not believe that the Greek elections will result in that country leaving the Euro; there is ultimately too much political capital invested in the Euro project to allow it to founder. As we discuss further below, we don’t view global commodity price weakness as a function of weak demand as one of robust supply.
This leads us into the next market fear…
Second fear: Deflation is lurking around the corner.
Deflation -- a condition in which negative inflation discourages spending by making money increase in value over time, and puts an economy into a spiral of contraction -- is the great fear. Market participants seem to see signs of it everywhere. Some of the fears include: “Rates are falling -- bonds are predicting a recession! Commodity prices are falling because demand is falling! Inflation is weakening everywhere!”
Eurozone Inflation Trends -- A Sign of Imminent Recession? We Think Not
Source: European Central Bank
What will calm this fear? Markets will overcome this fear gradually as they see incremental good economic data about employment, wage growth, inflation, capital expenditures, and consumer and business sentiment. We have already begun to see those data -- and we believe more are coming. However, this will be a gradual process, and it may take some time for the “wall of worry” to get climbed. One thing that may be cathartic is a default event of some country (think Venezuela) or some commodity producers. Getting such an event under our belts could help markets find firmer footing.
Is there substance to this fear? We do not believe so. We believe that various macro forces -- including central bank policies (buying many of the world’s government bonds), government fiscal policies, and “safe haven” money flows -- are working to keep global government bond rates subdued. Also, we definitely do not view commodity prices as indicative of an oncoming recession. China’s explosive growth over the past fifteen years resulted in an enormous buildup of global commodity production capacity -- and now that China (1) is producing more commodities domestically, and (2) is shifting to a consumer-led growth model, global production capacity is in excess. Similarly for oil -- we are witnessing the effects of the U.S. shale revolution, the disarray of OPEC in the face of these upstart producers, and the playing-out of U.S. and European sanctions against Russia -- not the prediction of a recession by the price of oil.
Inflation is reasonably healthy in the U.S. -- and we do not believe that markets have absorbed fully the good news that falling oil prices really represent. As we have pointed out in our past several letters, historical data show very clearly that cheaper oil will ultimately be a boon for most countries, most companies, and most consumers -- so disinflation that’s a consequence of falling oil prices is not at all alarming. We can be sure many central bankers will take this “disinflation” as an opportunity to keep rates low and stimulative for longer -- which is also bullish for stocks.
When Will the Correction Be Over?
Our bullish thesis is intact; we don’t believe there is any substance to the fears that are behind the current volatility. When will we think we’ve turned the corner and an uptrend is beginning to re-emerge?
In the medium term:
- Psychology will improve as positive economic data points continue to be announced and as global commodity markets -- especially oil -- show signs of bottoming, and
- Psychology will also improve as the benefits of cheaper oil filter through to the global economy and become more apparent.
In the short-term:
- Psychology will improve now that the ECB’s QE program has been announced, the details of the deal are becoming clear, and Greek elections occur; and
- Psychology will improve when and if a cathartic financial event of some kind occurs -- the default of a country dependent on its resource exports, or the bankruptcy of one or more over-leveraged energy companies.
While we wait for these events to alter market psychology in a more constructive direction, we are happy to see the correction unfold. It is indeed natural, normal, and healthy -- and affords investors buying opportunities in a market that is, on balance, fairly valued.
Investment implications: Markets remain unsettled by rapid and unexpected moves in global currencies and commodities. However, we do not believe that the concerns voiced as justification for bearish sentiment are valid. We believe some fears will dissipate gradually as good data continue to emerge for the U.S. and several other economies. Other fears may dissipate more rapidly after cathartic events. We continue to watch closely, taking declines as opportunities to buy attractive stocks and markets.
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