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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 1 MARKET REVIEW & OUTLOOK | OCTOBER 2015 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 2 MARKET REVIEW & OUTLOOK | OCTOBER 2015 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 3 MARKET REVIEW & OUTLOOK | OCTOBER 2015 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 4 MARKET REVIEW & OUTLOOK | OCTOBER 2015 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 5885 LANDERBROOK DRIVE, SUITE 205 CLEVELAND, OH 44124 216.367.0680 5885 LANDERBROOK DRIVE, SUITE 205 w w w. w e l l s p r i n g a d v i s o r s l l c . c o m CLEVELAND, OH 44124 216.367.0680 MARKET REVIEW & OUTLOOK o ernancial holisticand nancial torisk highmanagement, net-worth individuals estateservices planning, and multiand families. Our comprehensive o erings include family o ce services. investment advisory, income tax planning and compliance, nancial and estate planning, risk management, and multifamily o ce services. w w w. w e l l s p r i n g a d v i s o r s l l c . c o m 5 o er holistic nancial services to high net-worth individuals Wellspring Financial Advisors, LLC is oanerings independent and families. Our comprehensive include personal wealth management and multi-family ce. We investment advisory, income tax planning ando compliance, | OCTOBER 2015