Before I make a decision, some perspective is in order. Since July 22, the S&P 500 stock index has fallen -10.8%, including today’s jaw-dropping plunge. We finally achieved what many market historians consider “a correction.” Corrections happen, fairly often. The magnitude of the drop was not as frightening as how quickly it happened.
To put this drop in perspective, keep in mind that in spite of this today’s drop, the market is still up 6.5% from a year ago. To be hiding in cash in order to avoid this most recent bout of normal market volatility, at current interest rates, a bank certificate of deposit owner would have to hold their CD for 13 years or more to make up for the return on stocks over the past year.
To give more perspective, the “standard deviation” for the stock market is typically around 15%. This means “15 percent, plus or minus.” In essence, occasional 30 percent market declines are all well within the “normal” market environment.
The 2007-2009 decline of more than 50 percent is considered a “black swan” because it’s almost never supposed to happen. With that black swan event in our recent past, investor memories naturally jump to fears of another market rout, when in fact we’ve just barely reached the point where we’d call this a “correction” at all.
This sell-off feels bad, but not because of the severity of the decline. As market corrections go, thus far this has been relatively modest. The sell-off feels horrendous partly because we have short memories. Let’s be honest, tell me what “correction” you remember that didn’t feel awful! It feels even worse now because it happened after the debt ceiling fiasco which has left investors afraid of how our overly large government is bereft of credibility, impotent and incompetent, unable to address the very real challenges we face.
In fact, however, the U.S. economy continues to muddle through, lurching forward in much the same fashion as it has been all year. In April, while spirits ran high and the market reached new heights, weekly jobless claims languished around 400,000 per week. Today’s number, while called “disappointing” by the media, was right at 400,000. What has changed is not the absolute number, but rather the lack of confidence in our ability to turn the tide.
The total number of people receiving unemployment is still at nearly an all-time low since February 2009, when it skyrocketed after the 2008 financial panic. Housing affordability is near an all-time high. Today’s chain store sales met expectations, and are up +4.6% from year-ago levels. Auto sales weren’t booming, but haven’t weakened much except that Honda and Toyota still don’t have much product to sell because of the tsunami. The Institute for Supply Management numbers were weaker than expected, but still indicate growth. Factory orders were down, but not as much as expected. Construction spending is weak, but still up. Falling oil prices, while painful to the portfolio, may prove to be a welcome relief to U.S. consumers.
For the most part, the economic reports announced this week were either neutral or only slightly weaker. There has been little in the U.S. to justify this correction except that consumer and investor sentiment is awful. But therein lays an important clue as to where investors should be looking. Don’t look in the U.S. For all of our warts, and for all of the tragedy playing out in U.S. economic policy, the U.S. economy is limping forward like the cowboy in the old John Wayne movie that just won’t die, no matter how many arrows Washington’s progressive bureaucrats shoot in his direction.
The economic problem is primarily overseas. The debt ceiling fiasco appeared to be causing the market sell-off but when our self-made problem was finally resolved, the markets continued to go in the wrong direction. As bad headlines in Europe continued to get ink, investors have realized that the real problem isn’t with our own governmental incompetence, but rather the natural result of socialist policies in southern Europe.
But, even here perspective is in order. The Greece problem, though not quite resolved, seems to be inching toward a temporary solution. The bad press arrived when the bond prices of Italy and Spain began falling, especially versus German bond prices. Falling bond prices preceeded the meltdown in Greece, too, and the media has begun to paint all of Obama’s progressive partners in Europe as a collection of fiscal basket cases one step away from default.
While I’m no long-term fan of Italy’s fiscal rectitude or Spain’s entrepreneurial zeal, these nations are much more than a hop, skip and a jump from the mess in Greece, which was the poster-child for Enron-style sovereign bookkeeping. When Greece blew itself up, short-term interest rates rose to above 20% as Greece’s sovereign debt fell to cents on the dollar. With Spain and Italy, their interest rates have soared…to about 6.5%. While it’s true that Greece’s rates did go up above 6% on the road to oblivion, it is truly a leap of logic to assume that because Italy’s rates are now above 6%, that they won’t stop until their bonds, too, are selling for cents on the dollar.
Hey, let’s face it. Given the left-wing orientation of the political establishment in much of southern Europe, their interest rates ought to be at least 6%! Perhaps investors across the globe are finally realizing that these socialist welfare states really are much more risky than Germany. I am not going to conclude that disaster is around the bend, simply because Italians are finally paying an honest rate for the lira they borrow.
The fact of the matter is that Europe has some very real problems to resolve, and that paying for these past mistakes will be quite costly. I can only hope that the U.S. Congress is paying attention (although I seriously doubt it). Moreover, China has been working hard to reduce its growth rate from “on fire” to merely “breathtaking.” The end result of these terrible twin trends might very well be a global recession. And given our weak recovery, the U.S. economy might get dragged down in a global soft patch.
So, the investors’ dilemma is this. Should investors sell because the debt-ceiling compromise is a disaster and the U.S. economy is collapsing? I don’t think so.
However, in my view the issue is really whether the rest of the world is falling into a new global recession that threatens the U.S. recovery as well. This is the risk facing our portfolio. The mutual fund model portfolio sold its last (explicitly) international funds in mid-February, when we got rid of our Latin America and Asia investments. Our only international stock holdings are owned as part of a sector portfolio, and (mostly) as holdings in our gold and precious metals fund, which (most days) has been helping to hedge the decline in stocks.
Based on the facts, alone, I would have no trouble standing up to this sell-off. As uncomfortable as it is to own stocks in this environment…or maybe even because it is so uncomfortable to own them, intellectually I think that is the right call.
However, our discipline requires stepping to the side if the market enters bear market territory, which is right around the corner. We are probably a day or so from beginning to take money off the table. The gold position, alone, not only didn’t protect us much (today), it was actually part of the problem.
We often acknowledge our lack of a crystal ball. On days like today, in particular, it would sure come in handy. If we'd had it ten days ago - even better. In its absence, we have a discipline that requires moving money off to the side in a down market. If this sell-off continues, we will have passed “correction” territory and be squarely in the midst of another bear market. If that happens, we have little recourse but to yield to the momentum of the market until more is known about the magnitude of the global slump.
Everyone wants to sell at the top. We’ve never even pretended that is our discipline. We’ve always promised to try to get out of the way of what’s not working. Unless today was capitulation day and the market recovers tomorrow or Monday, then we will move assets out of the way until things stabilize. Remember, we would likely never move all to cash. However, what looks to me like an over-reaction to a more rationally priced Italian bond might be much more serious, so we will follow the discipline and the next two days will determine what we do next.
Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .
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