The stock market has greeted 2016 with a rude jolt, as the S&P 500 has fallen about 8% in two weeks. As was the case last summer, fears over China seem to be driving the market. Those fears are not unfounded; clearly the Chinese leadership is struggling with the transition to a more consumer-oriented economy. For several years seemingly endless Chinese demand drove commodity prices higher. As that demand has slowed, commodity prices have cratered. Oil is the best-known example, with prices down over 70% in a couple of years and down about 20% in 2016. Other commodities have fallen precipitously as well.
Still, our economy continues to move forward, slowly but steadily. Lower oil prices hurt a variety of companies in the US, not just oil exploration companies but their many suppliers as well. Of course other companies and, more importantly, consumers benefit from lower oil prices. We have low unemployment and minimal inflation, and personal balance sheets are in decent shape. Please keep in mind that American consumers make up more than 2/3s of our GDP, while exports to China represent just 1% of GDP. I’m not suggesting a Chinese recession would be irrelevant to our economy, but I feel the market is overstating the potential impact. Our economy has too much going for it for me to predict a significant recession in the near future. And if we don’t go into a significant recession, I simply don’t expect a market collapse like we saw in 2008.
If it feels like the stock market has been difficult for longer than just the past two weeks, you are right. Last year the S&P 500 was up about 1% on a total return basis. However, that doesn’t tell the whole story. We tend to buy value stocks, which are stocks that generally grow more slowly but are priced at a discount to the market to compensate. Over time value stocks have performed a bit better than their flashy counterparts, growth stocks. Last year bucked the longer-term trend, however, as large growth stocks had a return of about +5% vs large value stocks’ return of -5%. We also own smaller stocks in the portfolio, and last year that hurt as well. The mid-sized value stock category fell by almost 6%, and smaller value stocks fell by over 8%. So we were swimming upstream against a pretty strong current.
These big-picture stock movements often persist longer than we would like, as so-called momentum investors buy the stocks that are “working” and sell the rest. Todd Sullivan, who writes a value-oriented blog, puts it this way:
Momentum Investors believe that stock prices carry all the information necessary with which to make investment decisions. Economic fundamentals are not a factor.... This is emotional investing. It has no basis but for a price trend which ‘feels good’ or ‘feels bad.’ There is no connection to fundamental returns with this approach.”
The success last year of stocks like Netflix, Amazon and Facebook resulted in part from improving fundamentals but even more so from momentum investors buying the stocks, even as they kept going up. These are some great companies, but they each trade at earnings multiples of 100x or more (while most of the stocks we own trade at an earnings multiple in the 10-20x range). The growth required to justify such valuations is substantial, even staggering. Ultimately the fundamentals matter, so even if those companies continue to succeed I suspect their stocks will not.
That brings us back to the stocks we own. In recent letters I have expressed some caution about the returns we were likely to earn on stocks in coming years. As stock prices fall, future returns look more promising – after all, we are buying stocks at cheaper prices. I still don’t see huge returns in the near future, but I feel more optimistic about how our stocks will do than I did 18 months ago. The prices we are paying are more attractive, and that should lead to better returns.
You may have noticed more trading activity in the past week or two. With the market’s weakness we have been able to buy some high quality stocks at good prices. That is not to say we won’t see lower prices tomorrow - markets are of course unpredictable. But we are long-term investors, and we know difficult periods come and go. When the sun shines on the market again, I feel confident the stocks we own will do well.
Please feel free to get in touch with any questions or comments.