February 9, 2018

For the second time this week, the Dow Jones Industrial Average fell by more than 1000 points. Markets are now in correction territory, having fallen more than 10% from recent highs. It has been one of the fastest corrections in stock market history. As of last night’s close, this week would go down as the worst week for the market since October 2008, right in the heart of the Great Recession.

The obvious question that remains is why this market is going haywire against a backdrop of good economic news. Yes, interest rates have risen about 10 basis points in the last couple of weeks, but that hardly explains a 10% drop in equity markets. The real fact is that markets were ready for a correction. They had risen a bit too far and valuations were extended. They weren’t in bubble territory which leads to a 20-50% drop. They were just extended. The actual trigger was last Friday’s jobs report, but it could have been almost anything. The Friday employment report was a bit stronger than predicted, and the wage gains, skewed by January specific factors I have mentioned all week, were a touch higher than predicted. But these numbers, by themselves, were simply the ignitor for a 10% correction that could become quite a bit larger before it ends.

The real culprit causing the sudden commotion was professional traders. For the last 21 months they had become complacent in a world of low volatility. They would own stocks, often on leverage, and sell puts underneath the market while buying calls above the market or even using the calls as a leveraged proxy to own the stock. With volatility low, until last week, they would collect the premiums, selling puts and using the calls as a leveraged way to play the upside of the market. But with markets reversing suddenly, the purchased calls will probably end up worthless, and the puts sold would/will decline in value as well, forcing the seller either to buy the stock at lower prices or to roll over the puts at a loss. If this sounds too arcane to understand, let me try to give a more graphic example. Think back to 2008 and houses that were bought with excess leverage. When prices go the wrong way, the leverage serves to wipe out the equity holder. In the case of this market, traders racking up losses making the wrong bets in a leveraged fashion have the ability to unwind the leverage as fast as they can and reverse their bets. In other words, they are forced sellers. Until the selling and deleveraging is complete, markets are simply at the mercy of the unwinding process. Margin calls also come into play as investors owning stocks on margin become forced sellers. Finally, retail investors, including millennials investing for the first time, panic and add to the selling pressure. It is all the cocktail for what is happening.

No one knows when this will all end. It’s the market’s emotions I talked about on Wednesday. But it does end. It might end today, or it could continue for another week or two. But declines this extreme don’t go on indefinitely. To the point of absurdity, 25 days of 1000 point drops would take us to zero. It clearly is nerve wracking when it happens but, trust me, there is an end. If the end is far below fair value when the end arrives, stocks will recover almost as fast as they decline. Bottoms are almost always V-shaped. Selling feeds on itself for all the reasons mentioned above until it exhausts itself. The buyers step in. Those institutional sellers with sufficient reserves will jump in on the upside as fast as they rushed to sell just a few days earlier. Only when the volatility subsides, once both sides of the V are formed, will markets start to calm down. But the memory will linger longer as investors collectively relearn that markets go both ways. In today’s computerized world, it can take days to wipe out months of gains. That’s why all investors need to stay disciplined and pay attention to their asset allocation.

What is fair value? In a world where 10-year Treasuries sell for less than 3%, an equity P/E ratio of 16.4 times estimated earnings is not out of line. One can easily argue that we are at fair value right now. If stocks fall another 10%, it would be a real bargain opportunity. That isn’t a forecast; it’s a statement. In today’s market, the unwinding process has no defined endpoint. And I can’t tell you rationally when the fear that may still be building will dissipate. A day where stocks decline by 5-7% or more on 3-4 times normal volume would probably be a washout event, but the correction doesn’t have to end that way. Emotion simply isn’t easily predictable, nor does it evidence itself the same every time. What I can say is that if stocks fall an inordinate amount, nibble at your favorites, but only nibble. We won’t see a potential all clear until there are two consecutive strong up days. So far, we haven’t seen more than two consecutive up hours.

While I can’t define where or when the bottom of this correction will occur, if we are at or below fair value today and if the economic fundamentals hold together as predicted, then stocks by year end will be higher than they are today even if the correction has another 5-10% to go. I can also point out that, historically, declines this rapid with this much volatility don’t sustain themselves very long. This particular correction is happening against a backdrop of strong fundamentals. It, therefore, should be seen as a mid-course correction and not the start of a bear market.

With that said, I want to switch from market fundamentals to talk about the proposed government spending bill winding its way through Congress. It could be on the President’s desk by the time you read this. To anyone who thought Republicans are fiscal conservatives and Democrats are liberal spenders, this bill should remind us all that members of Congress, regardless of party affiliation, behave like drunken sailors with no inhibition to spend whatever it takes to win votes. The bill before Congress gives both sides all the goodies they could possibly want. That’s the good news. The bad news is that none of the added goodies are going to be paid for. There will be another $300 billion in net spending per year on top of the $1.5 trillion net 10-year cost of the tax bill. Over a 10-year period, this budget, if repeated, would be twice as costly as the tax bill. Some day the cost to service our national debt at any normalized interest rate will be so costly that it will create a crisis of its own. What would that look like? Just look at Europe in 2010-2011 when austerity was necessitated in country after country to avoid default. We can print money to pay our debt, but the paper won’t be worth much if rates, and possibly inflation, are excessive. Congress won’t act until there is a crisis, which means not now. The markets will tell Washington when that occurs. It could be two years from now or six years from now depending when debt service costs so high that they will squeeze everything else. At the present pace, our national debt in a decade will be close to $30 trillion. If the cost is 3%, that would be $900 billion versus about $300 billion or less today. Even Warren Buffet doesn’t have an extra $600 billion to pay the incremental interest. Even worse, my example assumes no recession or intervening crisis over the next 10 years. We all know from real life (i.e. life outside the government) what happens when we spend beyond our means. That is what 2008 was all about. For a short time, life is good. It was great in the Roaring Twenties and it was great in the first decade of this century before the housing crisis exploded.

The only solution is to regain some spending discipline. The alternatives, from austerity to runaway inflation to steep recession, are all painful. Once again, we probably face several years before the crisis comes. The tax law and this spending bill will pull the time of pain forward. Some might tell you that fiscal stimulus will add so much growth and tax receipts that the day of reckoning will never happen. Maybe that is a theory that could close a $100 billion gap. But not $600 billion. I don’t think the spending bill has any direct link to the current market correction. It is a different problem out on the horizon. But in the end, its consequences may prove to be far larger.

Hope everyone got to enjoy the parade in Philadelphia yesterday in some way, even if only through television replay.

Today, actress Rose Leslie from Game of Thrones turns 31. Actor Joe Pesci is 75, and singer Carole King turns 76.

James M. Meyer, CFA 610-260-2220

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