Download “China is a sleeping giant. Let her sleep for when she wakes she will

QUA R TE RLY RE V I E W OF T H E C A PITA L MA R KE TS | OC TOB ER 2015
“China is a sleeping giant. Let her sleep for
when she wakes she will move the world”
— Napoleon Bonaparte
Geopolitical events continued to dominate much
of the news during the third quarter. The tragedy in
the Middle East notwithstanding, much of the more
important coverage emanated from China.
After over five years of GDP growth between 8-10%,
more recently inflation fears resulted in China initiating policies that were intended to create a “soft
landing” and reduce GDP growth to 7% levels. At the
same time, China has been attempting to lessen its
dependency on construction and exported manufactured goods in favor of a more balanced economy
favoring services and consumerism.
China is the world’s second largest economy representing 13% of global GDP. It is also a voracious
consumer of commodities. Thus, when news began
to trickle out that perhaps China had overachieved
in the desire to slow economic growth, ripple effects
were felt across the globe and, in particular, to an
already depressed commodities market.
A second negative surprise came in mid-August
when, following a weak report on exports, China
elected to devalue their currency, the Renminbi, by
1.9% adding further to global deflationary pressures.
While devaluing a currency reduces the cost of that
country’s exports to other countries, it is seldom the
last shot fired and competitive devaluations end
up being self-defeating for all participants. It is the
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economic equivalent of choosing self-immolation
as a form of protest and is the flip side of beggar thy
neighbor policies such as the Smoot-Hawley Act,
enacted in the U.S. in 1930.
The Smoot-Hawley Act was originally intended to
benefit domestic farmers by establishing record high
tariffs on imported agricultural products. Soon, however, it was extended to other goods and services
and was followed by a storm of foreign retaliatory
measures. During the next four years, world trade declined by over 60%. While Smoot-Hawley was not the
direct cause of the Great Depression, it contributed
significantly to the magnitude of economic hardship.
Accordingly, we would view any further currency
devaluation and/or protectionist tariffs as a clear and
present danger to global economic well-being. The
level of opposition to the proposed Trans-Pacific Partnership trade pact should be an effective measure of
the level of protectionist sentiment in Washington.
In addition to being a major economic power, China
is also a major military power. Recently, the Chinese
conducted a huge military parade to commemorate
the 70th anniversary of the end of World War ll and
their battle with Japan. The parade also marked the
first appearance of the much anticipated Dongfeng
(East Wind) missile.
The missile is also referred to as a “carrier-killer” missile due to its ability to go into orbit and, upon reentry to the earth’s atmosphere, be directed to any target, including aircraft carriers. The missile is believed
to have a range between 600 to 900 miles but, more
importantly, it is capable of traveling at 15 times the
speed of sound making it effectively indefensible.
The U.S. currently enjoys global military hegemony
in part due to our fleet of 14 active aircraft carriers
which permit the U.S. to project a superior Air Force
presence anywhere on the globe. The introduction of
the Dongfeng missile irrevocably changes this equation. In the evolution of naval warfare, this development is akin to when aircraft carriers themselves
effectively made battleships obsolete during World
War ll.
New conditions require new policies. Hopefully, the
U.S. and China will maintain a détente that will be mutually beneficial for the world’s two largest economies.
Fiscal Matters
Our reference to military ordnance is not to suggest
imminent hostility. Rather it is to suggest a continuation of longer-term fiscal consequences. In September of 1999, in a much more euphoric economic environment, President Clinton opined: “If we maintain
our fiscal discipline, using the surplus to pay down
the debt and using the savings to strengthen Social
Security, America will entirely pay off the national
debt by 2015.” Our national debt at that time was
$5.6 trillion and currently it exceeds $18 trillion.
Mr. Clinton can be excused for his optimism. No one
at that time could foresee 9/11, multiple wars and
military excursions in the Middle East, Afghanistan,
and Northern Africa; much less the second worst
economic downturn in the nation’s history. (Things
that Donald Rumsfield would later characterize as
“unknown unknowns.”)
The 1980s witnessed the collapse of the former
Soviet Union and the end to the Cold War. Sadly,
the “peace dividend” that many envisioned has long
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since been spent. The recently concluded fiscal year
contained a budget where military spending represented $600 billion, or 54%, of all Federal discretionary spending. According to the Peterson Institute,
this is more than the military spending of China,
Russia, Saudi Arabia, France, the UK, India, and Germany, combined. The Cold War was effectively won
by outspending the Soviet Union. Hopefully, we can
avoid a similar exercise with the Chinese.
Closer to home, after more than 1,400 days without
a correction in the market, volatility returned to the
U.S. stock market during the week of August 24th.
On that Monday, the Dow Jones Industrial Average
opened over 1000 points lower than the previous
close. Both upside and downside volatility characterized much of the trading for the remainder of the
quarter as “preservation of capital” became socially
rehabilitated as a justifiable investment objective.
As notable as the volatility was during the week of
August 24th, what was even more notable was the
absence of volatility in the US stock market during
the preceding 33 weeks. Up until that third week in
August, the S&P 500 had gone the entire year without rising or falling as much as 3.5% from the 2014
year-end close. The domestic research firm Eidosearch
suggests that not only is that a unique experience for
the S&P 500, but nothing like it has occurred for the
past forty years in the 62 global markets that the firm
tracks. Complacency was beginning to prevail.
By quarter end, all major domestic equity indices had
posted negative results of sufficient magnitude to
put year-to-date results in negative territory as well.
After hitting a new all-time high of 2130 on May 21st,
the Standard & Poor’s 500 Index closed down 6.44%
for the third quarter. Results would have been worse
were it not for a 1.9% gain in the S&P 500 on the last
day of the quarter.
Investment Performance
S&P 500
S&P 400
S&P 600
MSCI - EAFE
MSCI - EM
Barclay Aggregate
Goldman Sachs Commodity
Third Quarter
-6.44
-8.5
-9.27
-10.23
-17.9
1.23
-19.3
Year To Date
-5.29
-4.66
-5.49
-5.28
-15.47
1.13
-19.46
example of this point was reflected in a recent article
in Barron’s which compared the performance of the
S&P 500 for four different 15 year periods:
15 Years Ending 4/30/57:
15 Years Ending 9/30/74:
15 Years Ending 7/31/97:
15 Years Ending 8/31/15:
+19.03%
+4.11%
+19.66%
+3.76%
SOURCE: Barron’s
SOURCE: S&P 500
A style return comparison reveals that for the first
three quarters, large-cap growth has outperformed
large-cap value by 7.9%. Similar disparities between
growth and value also exist for mid-cap and smallcap stocks. This disparity has not been limited to the
current year and during the past seven years; only in
2012 did value outperform growth.
Investors who subscribe to the concept of “reversion
to the mean” might conclude that value stocks are
currently more attractive due to their recent lag in
performance. Perhaps, but we suspect that another
explanation is that value stocks have been a victim
of the growth of passive investing. The S&P 500 is a
market capitalization weighted index which results
in the largest companies, as reflected by their market
capitalization, having the greatest weighting in the
index. For example, the ten largest positions in the
index have an aggregate weight of 17% whereas the
bottoms ten have a weight of less than 1%. Apple
and Microsoft are the two largest companies in the
index with a combined weighting of 6%, and therefore those two stocks get 6 cents of every new dollar
going into the index.
On the subject of performance reporting, we have
always felt that if we could choose the start and finish dates for the comparison, we could get the data
to confess to any proposition we wished to make. An
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While the annualized performance for the S&P 500
has averaged 10% from 1928 through 2014, as can
be seen above, it has not been a linear experience.
Growth Environment
In simplest terms, the two primary drivers of economic growth are population growth and productivity. With population growth expected to turn
negative in many countries, including the U.S., productivity should be the primary driver going forward.
This is a good news/bad news story. The good news
reflects productivity levels in the U.S. that are near
all-time highs. Non-financial profit margins are near
12%. The bad news is that they are at levels that are
not sustainable, particularly in an election environment with income inequality at an all-time high.
During the past year, eighteen states have increased
their minimum wage.
The U.S. has not experienced annual GDP growth as
high as 3% since 2005. Few forecasts call for the situation to improve anytime soon. The low growth, low
return environment has been referred to by some
as the “New Normal.” Others have characterized it as
“Secular Stagnation.” The implication being that many
investors need to dial down their expectations for
future investment returns, whether they come from
bonds or equities.
While we hope that these low return expectations
are exceeded, in a low return environment it is more
important than ever to avoid unnecessary investment expense and to concentrate on tax efficiency.
hitting a new record high of $85.7 trillion (a $30 trillion increase in the past 5 years). Consumer balance
sheets are in much better shape contributing to
continuation of the expansion.
What does the low growth environment hold for
investors? Definitions sometimes vary, however, for
most investors a “correction” is defined as a market
drop of 10% or more from a previous high. By contrast a “bear market” requires a 20% decline. Corrections are not uncommon and are a normal part
of the volatility contained within extended bear
markets. Happily, bear markets occur with much less
frequency.
Fed tightening occurred in three instances but in
each case it was initiated from much higher levels of
interest rates than currently exist.
During the past 86 years, there have been at least 8
widely recognized bear markets. While each was in
its own way unique, it may be instructive to review
some of the more common themes that accompanied these sell-offs.
Historic Bear Market Themes
Commodity prices have collapsed, and while valuations are full, it is hard to make the case that they are
extreme.
In short, while conditions can rapidly change, we do
not believe those which are most common to bear
markets exist at this time.
Closing
Our essay began with a discussion of geopolitical
events and we will close with the same topic.
Greece’s earlier threats to withdraw
from either the European Union
and/or Euro appear to have served
to embolden the left-wing elements
of other nations. In France we have
the National Front, in Spain the
Podemos Party, and more recently
in the UK, the opposition party has
chosen radical MP Jeremy Corbyn to
represent them. Closer to home, the
strong showing by Socialist Bernie
Sanders has surprised most political pundits.
Fed
Extreme Commodity
Tightening Recession Valuation
Spike
Great Depression 1929
Fed Tightening 1937
1946 Post WWII
1st Oil Embargo 1972
Fed Tightening 1980
“Black Monday” 1987 Crash
Dot-Com Bubble
Global Crisis 2007
As seen in the above chart, the most common theme
is recession. While GDP growth is currently less than
desired, we are not in recession. As of September
30th, the S&P 500 has enjoyed a total return of 223%
since the bear market low on March 9th, 2009. This
advance, coupled with steady improvement in home
prices has resulted in household net worth recently
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Few reports are more widely read and analyzed than
the minutes of Federal Reserve meetings. The focus
usually tends to center on the Fed’s dual mandate:
full employment and price stability. The latest minutes were notable for the inclusion of the phrase:
“broader financial stability.” This is widely thought
to be Fed speak for concern of ongoing economic
weakness in Europe, and perhaps more importantly,
concern for the slowdown and financial volatility
being experienced in China. This would appear to be
an acknowledgement on the part of the Fed that we
do in fact live in an increasingly borderless economic
village. What happens in Europe and/or China does
in fact impact policy decisions here in the United
States.
The quadrennial tribal right that we know as the
U.S. Presidential election cycle is already in full force.
Accusations and promises abound and issues such
as income inequality, domestic tax policy and the
taxation of foreign based U.S. profits will be hotly
debated.
According to Aristotle, “nature abhors a vacuum.”
Investors feel the same way about uncertainty. This
brings to mind an apocryphal curse, usually attributed to the Chinese but more likely British in origin:
“May you live in interesting times!” Indeed we do,
but for now, the U.S. economy appears to be the pick
of the litter, and modest returns remain preferable to
negative returns.
Richard C. Hyde
Director, Wellspring Financial Advisors
Wellspring Financial Advisors, LLC is an independent
personal wealth management and multi-family o ce. We
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