No sooner did the market put the Greek drama to rest, China’s government dumped several poorly timed and mind-boggling tactics on the market in order to stop their plunging stock market. The timing of their moves to devalue their currency and halt trading in 50% of the stocks trading on the China exchange couldn’t have been more poorly timed for the U.S. market to react rationally to their actions as half of Wall Street was on vacation during late August. Not to say the Wall Streeters weren’t paying attention – they were. But, their instinct was to shoot first and ask questions later, which led to the late August blood bath.
Now, everyone is pointing to a slowdown in the Chinese economy for the market selloff. We don’t buy it (see Updated 2015 Outlook section below). Where was all this fear of a slowdown as the Chinese Shanghai Composite index appreciated over 160% over a 14 month period from May 2014 to June 2015? (See chart below left.) This rally happened all the while Chinese GDP and earnings growth were slowing, which is a fact we’ve pointed out in our newsletters several times over the past three years. (See chart below right which shows electricity consumption – the best proxy for GDP growth.) Did anyone ask questions about the 30-fold increase in Chinese retail margin investment accounts during this time or that their stock market was trading at over 80 times earnings at the peak? The answer is no.
The Chinese government created a casino out of their stock market and given that the gaming haven of Macau has become off limits to many, this was the next best thing. Nobody was concerned until the Chinese indices started to retreat significantly and the Chinese government made some very poor choices to halt the plunging stock market like arresting short sellers and anyone, including journalists, who spoke negatively about the stock market. Then they systematically halted trading in over 50% of the stocks that trade on their exchange. This isn’t exactly a confidence booster. If anything it just increased the number of pent up sellers who didn’t want to be the last one holding the bag. The icing on the cake was the devaluation of the Chinese Yuan which was presumably done to maintain their competitiveness in the global markets, following the lead of Japan and Europe. This action created another leg down in the Chinese market and began August’s correction/bear market in stock markets around the globe.
China wasn’t the only concern for the market this quarter. The market also had to deal with an indecisive Fed as they pondered the first rate hike in almost a decade. While the Fed decided not to hike, their rationale for not hiking didn’t inspire confidence, rather it incited another stock market pullback. Then, Volkswagen, the largest car manufacturer on the planet, admitted to doctoring vehicle emissions equipment which sent reverberations through the already fragile European economy. Lastly, Hillary Clinton laid out a portion of her presidency platform which would target pharmaceutical pricing, effectively installing price controls on drugs, sending biotech stocks into a tailspin. The stock market pounded the nail that stuck out the farthest. This shows the fragility of the stock market mindset when such preliminary political rhetoric is taken to be gospel, particularly considering that Clinton may not even win the Democratic nomination, let alone the presidency.
The title of this section of our newsletter included a famous quote from the late-great Yogi Berra –“It’s Déjà vu all over again”. The stock market is following the playbook from the fear-inspired correction that took place in 2011 following the U.S. debt downgrade. The chart below shows an amazing correlation between the current correction and that of 2011. Obviously, the rest of the story for the current correction has yet to play out, but as we detail further in our section below entitled, “Nothing to fear but fear itself” we expect the stock market to emulate 2011 and push higher into year end.
After a reasonably good first half of 2015 that saw a fairly narrow trading range for the major indices and positive returns particularly for small caps, the fear-induced correction of August and September more than wiped out those positive returns quite rapidly as the chart above shows. The Russell 2000 Index dropped -11.92% in the quarter which was its worst showing since the third quarter of 2011. This drop wiped out the absolute gains of the first half and its relative lead over the large cap S&P 500 which fell “only” -6.44% in the quarter. The year-to-date lead for the Russell 2000 over the S&P 500 was also relinquished despite better earnings growth being posted by small caps relative to large caps over the past several quarters. The Russell 2000 trails the S&P 500 year to date -7.73% to -5.29%, respectively. From a sector standpoint, no sector finished in the black for the quarter. As is typical in a correction phase of the market, Utilities (-2.71%) and Staples (-4.61%) were the relative outperformers in the quarter. Also, as one would expect, the worst performers were the cyclicals like Energy (-34.5%) and Materials (-21.3%) which plummeted on deflation and growth concerns. Year to date through September, all sectors are down as even Healthcare relinquished its positive return as biotechs swooned in the last couple weeks of the quarter. Healthcare is still the relative leader down only -3.6% and is followed closely by Technology (-4.0%) and Financials (-4.1%). Similar to the quarterly performance, the worst sectors on a year-to-date basis are Energy (-39.6%), Materials (-22.8%) and Industrials (-12.5%). The table below highlights the returns for the third quarter of 2015 and year to date for the popular indices.
From a style perspective, the Russell 2000 Growth Index underperformed the Russell 2000 Value Index during the quarter. The weak performance of the biotech industry within Healthcare as well as outperformance by interest-sensitive sectors like REIT’s and Utilities, both of which have heavier weighting within the Value index explain the Value index’s outperformance. The first two tables below highlight the performance of the Russell 2000 style indices by sector. Within small cap stocks, there has been a trend in place since April 2014 in which the performance of small caps is linearly worse moving down the market cap spectrum. The third table below highlights the performance differential by market cap quintile. As highlighted in red, there is a significant divergence once again this year.
The U.S. stock market posted a miserable quarter, particularly for small caps, but as you can see in the table below, the international markets were, in many cases, even worse. The European markets were weak as they tend to have more direct exposure to China than the U.S.; however, the Asian markets which are the most exposed to China were even weaker. China’s stock market was the weakest in the quarter, but it’s hard to feel too badly for them given their markets skyrocketed +160% over the trailing fourteen months before retreating. Volatility, which had been quite tame up until August, surged +34% during the quarter as angst spread throughout the market. Interestingly, despite all the talk of commodity deflation and slowing of China’s economy, iron ore actually rose +2% in the quarter.