FAQs to Consider for Labor Day Weekend.
Q. The market had an abrupt 10% downdraft. Wasn’t that a warning sign?
On August 26, Barclays (LONDON:BARC) published an analysis of the 10 periods of 10% declines. They started with the war year of 1940, when two of the 10 occurred. Those two preceded Pearl Harbor and occurred in the build-up to world war, during the period when the gold standard was still in force, prior to the Bretton Woods agreement, and more than a decade before the Treasury-Fed Accord. So we will dismiss the two 1940 instances as non-modern historical references.
We note that three of the other 8 were in 2008. All of the other eight occurrences resulted in higher returns for the S&P 500 in the next five trading days. In six of the eight times, markets were positive after 20 trading days. In seven of the eight times, the S&P was positive after 50 trading days. In all eight times the S&P 500 showed double-digit positive results after 250 trading days, with the average return being in the high-20-plus percent range.
Downdrafts like those we experienced last week scare investors. Today’s opening is no different. It is that emotional response that sets the stage for a higher stock market. In our view the most recent 10% fall will become number 11 in the Barclay’s list of temporary corrections and number 9 in the post-war list. We didn’t panic or sell. Three of our clients directed us to sell and revoked our discretion to make the decision for them. The rest allowed us to manage their accounts with our disciplines, and we did. They voiced concerns, as they should. They asked questions, as one might expect. They wanted the dialogue, and they received it. But they didn’t panic and therefore are much better off than they would have been had they thrown in the towel when the market was down 1000 points.
Q. OK, what about the Fed?
What about it? We have been expecting the Fed to “lift off” in September. My colleagues and I have written about this many times, and we have repeatedly argued why we think it is time for the Fed to make the first move. All signs point to it. Vice-Chair Fischer alluded to it in his carefully worded comments at the Jackson Hole symposium last week. Others on the FOMC have as well. We expect the departure from the zero interest rate boundary to occur in September.
Q. If you are correct and the Fed hikes a quarter point in September, what will that mean for markets?
We do not know, of course, but we believe it will be a positive event. Markets can handle news and facts, whether they are good or bad. It is uncertainty and the immeasurable uncertainty premium that distracts markets from fundamentals and propels the emotional roller coaster. We think a Fed hike will be greeted with a positive market response and will lead to a higher closing stock price level by the end of the year. Market agents may realize that a single Fed hike is not the end of the world. The big risk in our view comes if the Fed doesn’t hike in September. If no rate move materializes, market players will no longer feel that they understand all of the Fed talking heads that have been preparing markets for months.
Q. Over the weekend we were asked if we were worried about the events in Japan.
The answer is yes. Civil unrest and large demonstrations are always a worry. Policy extremes are, too. Here is the Japan summary sent to me in a private email. We agree with the factual description. We thank the sender for sharing this note:
The economy is going nowhere – it contracted by 1.8% in the last quarter – no significant economic reforms have taken place; despite all of the hype about a 3rd arrow, public sector debt will exceed 250% of GDP this year, and it will keep growing next year, and the year after, and the year after that. The Bank of Japan is now buying virtually every new bond the government issues, such that by 2018 the balance sheet of the BOJ will be larger than Japan's annual GDP! …In an aggressive, beggar-thy-neighbor devaluation, the yen is down 61% vs. the US$ and 66% vs. the RMB since Abe-Aso came to power 2.5 yrs. ago.
From a market observer and money manager’s view, however, the picture with regard to Japan is somewhat different. For us, the use of currency-hedged Japan stock market exposure has been and continues to be a success. Japan has been in a “liquidity trap” for many years. When a country is in that position, the only response to pressures is to do more. So Japan is doing more. That is all it can do until there is enough political will to actually accomplish needed reforms.
QE responses to liquidity traps are bullish for asset prices. Simply put: the ultimate value of an asset is infinity if you use zero as the interest rate to discount the future cash flow. That math is straightforward.
Let's sum up the Labor Day discussion we will have at Leen’s Lodge with a few friends. How long can we continue in a worldwide liquidity trap? How much more QE is coming from sources other than the United States? What will happen to currency exchange rates as the Fed moves the US interest rate away from zero while others move in the opposite direction or maintain an already zero-based policy? What will a Fed move mean for relative asset prices? Is the US economy strong enough to withstand these shocks and volatilities? Is the US election cycle a risk now that Sanders and Trump are emerging as more robust campaigners? Could we have a four-way brawl next year with Republican and Democrat traditional tickets and Trump and Sanders both running as independents?