By Byron Wien, vice chairman, Blackstone Advisory Partners
All through the summer, the United States equity market made new highs in spite of increasing turbulence around the world.
The economy was continuing to grow modestly, earnings were coming through and the geopolitical problems were a long way away. The Ned Davis Crowd Sentiment Poll, which includes transactional data like the put-call ratio, showed that investor mood was very optimistic.
Historically, the market is vulnerable to a correction when optimism is extreme. You don’t know what will cause the sell-off, but you have the uneasy feeling it’s coming.
The market had gone through two years without so much as much as a 10 percent correction and we were due for one.
Identifying the precipitating event is hard and probably unimportant. A few of the geopolitical problems had actually cooled somewhat, albeit temporarily.
Russian troops had pulled back from the Ukraine border; there was a cease-fire in the Israel/Gaza conflict; the Iran nuclear talks weren’t making much progress, but they were continuing; and in the South China Sea issues had quieted down for a while.
However, the situation in Syria and Iraq, which had been invaded by the Islamic State of Iraq and Syria (ISIS), remained serious.
The two threats that may have unsettled investors were the possibilities that the Ebola virus might spread to Europe and the United States, and that the economic slowdown in Germany might abort Europe’s weak recovery and bring the continent back into recession.
The decline in stocks gained intensity as it moved along, with many days down one percent or more on the Standard & Poor’s 500.
Rallies gave way to further declines and eventually the market fell almost 10 percent before prices stabilized.
The correction did pound some of the optimism out of investors’ minds. The Crowd Sentiment Poll dropped from optimistic into pessimistic territory, setting the stage for a rise in the market through year-end.
There may be further declines, but in my opinion the worst is over. I believe that this was a necessary correction and not the beginning of a bear market.
Sometimes, the market is smarter than all of us investors and a sharp downturn precedes a recession by about seven months. I do not think that was the outcome signaled by the September/October correction.
The U.S. economy is actually doing quite well. Real growth is expected to be approaching three percent in the second half of 2014 and growth of 2.5 percent to three percent is expected to continue into 2015.
The economy usually provides some warning signals before a recession occurs. According to an Omega Advisors study, danger is signaled when the yield curve is inverted, unemployment claims are rising, personal income is down, consumer confidence is falling, industrial production is declining, and/or inventories are increasing. Virtually none of these indicators are giving a warning signal now.
There have been some notable earnings disappointments but others did well. More worrisome is the shortfall in revenue growth. Companies have continued their share buyback programs, however, and this has played an important role in earnings per share growth. That is expected to continue.
I believe we are in a prolonged period of slow growth in the United States, Europe and Japan. As a result I think a favorable environment for stock prices could continue for several more years.
I do not expect much in the way of multiple expansion, except perhaps at the end of the cycle when everyone becomes comfortable that the good times are going to last forever and nothing is ever going to go wrong. That’s when the “animal spirits” take over.
During the decline, there was wide suspicion that the end of Federal Reserve monetary accommodation in October had something to do with it. The balance sheet of the Fed was $1 trillion in 2008. It is over $4 trillion now.
There is general agreement that easy money was a factor in the rise in the stock market over the past five years as well as the low level of interest rates. Accordingly, the end of the tapering process was pointed to as one of the causes of the decline.
In addition, there was continued speculation about when the Fed was likely to start raising interest rates. Analysts now think the Fed may act later rather than sooner.
My view is that there is little reason for the Fed to raise rates anytime soon, and when they do finally act, they will do so very gradually. And a Fed increase in rates has been so well advertised that it may not have the deleterious impact everyone seems to fear.
In the period 1950–1980, market analyst, Edson Gould, developed the “three steps and stumble” rule. This was based on the observation that it took three increases in Fed rates before the market impact became severe. A study by Omega Advisors showed that on average the market does not decline significantly until 29 months after the first rate hike.
