We believe that although a full or partial retest of recent lows may occur, the correction’s worst is over, and if the past is a guide, U.S. stocks will appreciate over the next six-month time-frame, volatility will be with us as the market retests its bottom and then begins to rise. We think that the psychological fears that drove the correction are based on misinterpretations of the fundamental economic data. Commodity price declines are being driven by supply and a strong dollar, not by collapsing demand. A Fed rate hike occurring in December may give the dollar more strength, but its rate of appreciation is likely to slow over the coming year. China’s growth, although slowing, remains robust and supportive of the global economy. Within the U.S., we favor technology, internet-related, software, biotechnology, pharmaceuticals, medical equipment, home-builders, and financial services.
Market Summary
We are in the seasonally difficult period for U.S. equities, and we just had a correction of 12 percent as measured by the S&P 500. U.S. equity market corrections of 10 percent or more outside of recessions are rare. This was the most recent of only 13 such corrections over the last 65 years during periods when unemployment was falling.
As regular readers know, three fears drove the market decline. First, China and EM growth rate slowing. Second, potential Fed rate hikes in September. And third, commodity price declines.
We believe that the correction may retest its lows (or retest them partially, stopping at a higher level than the previous bottom), but that the correction’s worst is over. Economists agree that the U.S. is not in a recession. After such “corrections outside of recessions” end, bottoms take time, but recoveries are strong on average: 10 percent after 3 months, and 19 percent after 6 months. Even if this recovery is slightly below normal, it will provide substantial price appreciation.
One fear is deflation, and some fear that lower commodity prices are an indication that deflation is imminent. Why have commodity prices -- and the profits of commodity producers in the U.S. -- fallen? Economists agree that demand for many commodities in unit terms is up, but a higher dollar has cut the price per unit in U.S. dollar terms even if it is up in local terms. A second cause of falling commodity prices is increased production, especially in oil. Overall commodity price declines in the U.S. are much more a reflection of a strong dollar than of a decrease in demand for commodities.
The next fear concerns an interest rate hike, which did not occur yesterday and which is unlikely to occur until December at the earliest. Some fear that a rate hike will raise the value of the dollar yet further, and thus hurt corporate profit growth in the U.S. This fear is not entirely justified; the dollar’s rate of change has been so fast over the last year that it even if the dollar were to rise another 10 percent in the next year, the rate of change over the next year will decline from the current rate of appreciation. Thus, the high dollar pressure on commodities and export profits will be less in the coming year. The first Fed Funds interest rate hike, is now unlikely to occur until December at the earliest.
Then there is the fear that Chinese and EM growth rates are slowing. This is a fact, and one that has been known for many years. China’s growth rate began to slow 5 years ago, and the world media has consistently reported on the slowing for years (from an annual growth rate above 10 to12 percent to one nearer 5 to 7 percent). Some math helps us out here. The huge increase in the size of China’s economy means that with a 7 percent growth rate, China’s economy does more to help global growth than the 12 percent growth rate they enjoyed 10 years ago!
Europe and U.S Stocks
We are neutral to slightly positive on Europe, and believe that European stock markets will gradually appreciate. How will Europe pay its debts and generate growth? The same way sovereign countries always have -- inflation. It’s only a matter of time.
Within the U.S., we favor technology, internet-related, software, biotechnology, pharmaceuticals, medical equipment, financial companies, homebuilders, and financial services.
Emerging Markets
Emerging markets remain unattractive because their profits are not growing in U.S. dollar terms. Their profits are rising, but their currencies are falling versus the U.S. dollar, thus cancelling out the positive effects of the profit increases for U.S. investors.
Gold very much depends on the dollar; once the dollar stops rising, gold will rally. It has been rising in terms of the euro and yen in recent months.
Investment implications: We believe that although a full or partial retest of recent lows may occur, the correction’s worst is over, and if the past is a guide, U.S. stocks will appreciate over the next six-month timeframe. We think that the psychological fears that drove the correction are based on misinterpretations of the fundamental economic data. Commodity price declines are being driven by supply and a strong dollar, not by collapsing demand, although demand is not growing as fast as in the past. A Fed rate hike in the coming months may give the dollar more strength, but its rate of appreciation is likely to slow over the coming year. China’s growth, although slowing, remains robust and supportive of the global economy. Within the U.S., we favor technology, internet-related, software, biotechnology, pharmaceuticals, medical equipment, financial companies, homebuilders, and financial services.