There is an old stock market saying that is attributed to economist Paul Samuelson, “The stock market has predicted nine out of the last five recessions”. The latest snap down in the market reminds us of this old saying because as we’ve highlighted below, the data doesn’t support the speculation that a U.S. recession is right around the corner. One thing that has thorougly shocked us is the tremendous increase in volatility or the “fear index” as many like to call it. As the 20-year chart below shows, the volatilty index or VIX spiked well beyond 50 during the August 24th swoon. Note that the index got nowhere near that high following the 9/11 terrorist attacks which was a world changing event. The index only went above 50 during the Great Recession which included the meltdown of banks, investment banks, the housing market, and as millions of people around the globe go into bankruptcy. It certainly doesn’t seem to us that we are anywhere near this outcome currently. It appears that investors are afraid of their own shadow these days and that even the simple mention of something negative causes the panic button to be pushed. Maybe it’s the “CNN Effect” turned “CNBC Effect”, where every news story becomes a “collapse”, “plunge”, or some other hyped-up adjective to describe normal every day occurrences in order to drum up sagging viewership.
Fingers are pointing to China as the culprit for the correction but we don’t buy it
It’s been amazing to watch how many people have pointed to China as the rationale as to why our stock market corrected recently and our economy is going to go into recession. Where were all these fear mongers while the Chinese stock market skyrocketed +160% over the past fourteen months? Yes, the Chinese government has allowed their stock market to surge and collapse uncontrollably and has made numerous policy missteps along the way that we highlighted earlier in this newsletter. And yes, China growth has been slowing and it has caused the economies of many countries, like Brazil, Australia, and Russia to suffer as their decade-long binge on basic materials came to an end as one too many ghost cities was built. However, this change isn’t a new phenomenon.
Anyone who has been paying attention to commodities and the simple statistics that are reasonably available from China would have noticed the economic slowdown started almost five years ago and has been consistently slowing since then. (See the electricity usage chart above). The first chart below left shows the Goldman Sachs Commodity Index. Notice the inflection in commodities was exactly when China began their decade of growth. Below right is the chart of crude oil. It’s almost identical. Then the third chart below is the Baltic Dry Freight index, which is a proxy for commodity demand in China. It is remarkably correlated to the commodity charts. Note that the line has recently hooked up despite claims that China is in recession. Lastly, the fourth chart below represents Brazil’s economic confidence index which has declined in sympathy with China’s demand for all things commodity. We’ve called this retreat out in our newsletter on several occasions in the past three or four years. That said, China’s slowing isn’t a death knell for the U.S. economy and stock market.
We liken the recent pullback in the stock market to a pullback that is typically seen in front of a Fed rate hike but that was accentuated by Chinese policy missteps and devaluation of the Chinese Yuan. Recall that last quarter we highlighted that in front of any rate hike there has been a minumum correction of at least 8%. The correction that we’ve had so far would be on pace for a “typical” correction in front of a rate hike. The table below shows all of the “non-recessionary” corrections in the market since 1983. Note that we’ve had a similar correction in four of the last six years. It’s hard to know what the cause and effect are but it was clear the market was anticipating a rate hike by the Fed, if not in September, then December. Despite the October 2nd weak jobs report (which doesn’t make much sense either) we wouldn’t be surprised to see the Fed hike in December as it appears the job market is far tighter than most believe.
Despite a decade of China GDP growth north of 10% from 2000 through 2010, the U.S. GDP, as shown in the chart immediately below, hovered between 1% and 4% until the great recession and since then has returned to that similar range. Our economy hasn’t shown anywhere near the sensitivity to China’s fate in both good and bad times as many would lead you to believe.
In fact, the trade data in terms of exports to and imports from China are both up modestly through July, contrary to the claims of dramatic slowing in China. The tables immediately below show 2015 data compared to 2014 data. Also note that imports from China dwarf our exports to China which should be beneficial to the U.S. consumer if China is exporting deflation.
China’s not as meaningful to the U.S. economy as many believe. We can decouple from their economic slide should it continue as they are in a distant third place in terms of exports behind Canada and Mexico. Only 7.4% of U.S. exports go to China. Additionally, only 13% of the U.S. GDP is attributable to our export economy in total. Therefore, less than 1% of U.S. GDP is directly attributable to exports to China. Profits generated by U.S. companies selling goods and services overseas is another story.
The relatively strong U.S. dollar has also caused significant angst amongst U.S. multinational companies. As our U.S. dollar has strengthened over the past year versus most other currencies around the globe, it’s made U.S. goods and services comparatively more expensive. This trend has caused many U.S. multinationals to report relatively weaker sales over the past year. However, according to Cornerstone Macro, for every dollar of sales that are made overseas, we sell 2.5 times as much in domestic trade. That said, companies like Caterpillar and Joy Global who are experiencing the double whammy of slowing demand for commodities and a weaker dollar are feeling recession-like trends which have led both to announce significant layoffs in recent months. Notice the difference in job creation in the two charts below. On the left is the job growth for small businesses which are primarily domestic focused and on the right is the job growth for large businesses which have more international exposure.
Undoubtedly, the domestic focused small businesses aren’t having to deal with the foreign demand issues caused by a slowing China and the strong U.S. dollar and are showing signficantly more robust job growth than the large, multinational companies. The chart below left shows how the U.S. corporate profits from outside the U.S. have fallen over the past year as the U.S. dollar strengthened. The impact of the U.S. dollar strength has played out in the stock returns for the S&P 1500 Industrials. The chart below right shows how much better the stocks of domestic focused companies have performed relative to those that have more international sales exposure. The difference is 800 basis points, most of which has occurred in the last 12 months as the U.S. dollar has strengthened. This strengthening has caused the profit growth for the S&P 500 Index to flat line on a year-over-year basis.
While we’ve been making the case that the U.S. economy can decouple from China and the rest of the commodity-dependent world, the one thing that has us concerned that could bring more immediate pain to companies with foreign exposure is the amount of finished goods inventory in the channel in China. The chart below shows a spike in finished goods inventory that has accumulated in China recently. Until this excess inventory gets pushed through the channel, an acceleration in China growth isn’t imminent.
Calls for a U.S. recession seem misplaced based on the data
Recently there have been numerous news reports and high-profile talking heads who’ve speculated that the U.S. was on the brink a recession. As usual, it seems the stock market’s action was influencing opinion because as you’ll see in the charts below, there are few statistics that point to anything but continued growth for the U.S. economy. From a pure duration standpoint, this economic expansion has been relatively short as the first chart below shows, and has currently extended 14 quarters versus the average of nearly twenty. The second chart below shows that if the LEI (Leading Economic Indicators) moves just a bit higher, history shows that we have another four to eight years before the next recession. Additionally, our economy has never gone into recession unless we experience spikes in both oil and interest rates. Both of these are at historically low levels which makes a recession highly unlikely.
The tremendous amount of stimulus in the global economy hasn’t yet worked its way through the system. Remember that Europe’s quantitative easing program only began in March of this year. Also, numerous other central banks around the globe have cut interest rates. The chart below shows this trend that global interest rates have recently taken a turn down. Historically, there has been a high correlation between global interest rates and global PMI (Purchasing Managers Index) acceleration. If history holds, a turn in global growth is imminent.
As the chart below shows, it appears that Europe’s quantitative easing program has at least instilled a bit of confidence in the Eurozone economy despite having more exposure than the U.S. to the CRaB (China, Russia and Brazil) countries whose economies are slowing at best (China) and plummeting at worst (Russia and Brazil). The two charts side by side below show the CRaB’s EPS growth since 2000.
Meanwhile in the U.S., our economy doesn’t seem to be showing any signs of imminent recession. As the four charts below show, it all begins with jobs in the upper left picture. Jobless claims are well below the best levels of our last expansionary period. This level results in higher wages as the job market tightens and employers are forced to compensate employees to retain them as shown upper right. A stronger employee base with good wages leads to higher confidence to make large ticket purchases like cars and houses. The charts below left and right highlight this phenomenon. Auto sales in September hit a cycle high of over 18 million vehicles sold on an annualized basis and while the housing index, which measures the sentiment of builders, is approaching 2006 highs, the actual number of homes being sold is just over half of what was sold at the last peak. This level leaves plenty of room for the housing sector to continue to strengthen in the coming years.
Often times the bond market is credited with sniffing out a a recession far in advance of the equity market. However, based on the chart below, they don’t see a recession yet either. In fact, there has never been a recession without the yield curve first inverting. The current yield curve is steeper than normal and steepening. Is the bond market smelling inflation on the horizon?
Bringing it all back to small caps
Inflation has been absent for quite some time as evidenced by our low interest rates and has caused some to worry that we’re entering a deflationary period which would be bad for stocks and corporate earnings. Case in point is the impact that the plummeting price of oil has had on energy company earnings. When combined with the stronger dollar that we’ve witnessed for the last year, it has served up a perfect storm for an earnings downturn this quarter. However, keep in mind that by January we’ll be lapping both the collapse in oil prices and the pinnacle in U.S. dollar strength. This should allow earnings comparisons to inflect positively starting in the first quarter of 2016. This inflection should give the stock market renewed optimism about the future and be a catalyst for another leg up for equities. The chart and table shown below highlight the sensitivity of small cap earnings to GDP growth. In a 2-3% GDP growth economy, small caps should be able to grow earnings at a multiple of four to five times this pace.
With the stock market trading at its long term average of 15 times earnings and with a potential acceleration on the near term horizon, the case for the stock market advancing is compelling. We believe this is a good time for active management where our fundamental research could lead us to discover good companies with growing earnings for which they will be rewarded again. The chart below shows that small cap stocks currently trade at a relative valuation discount to large caps. When this situation occurs, small caps outperform large caps by an average of 6% in the following twelve months. We haven’t witnessed this type of positive setup for small caps since the early 2000’s. Stay tuned and remember to check out the trivia section of the newsletter for other compelling near-term setups for small cap stocks.