-Peter Lynch

   

-Matt Keeling, May 2014 newsletter

I was beginning to feel like the boy who cried wolf. The markets had gone more than four years without a correction. Yes corporate profits were up, yes unemployment was down, and yes economic growth had been positive although tepidly so - but stock markets still tend to correct every once in a while whether things are good or bad. In 1984, 1987 & 1997 the economy was humming along with growth rates substantially higher than we see now - yet the markets still had selloffs during those years that qualified in correction level. A correction is typically defined as a decline in the markets of 10-20%. Anything short of 10% is just typical volatility, and anything in excess of 20% is considered a bear market. That 1987 correction technically was a bear market as the Dow sold off 23%, but that decline was all in one day and the rally was so quick that it's usually lumped in with the corrections. So the markets have finally corrected, just as the boy who cried wolf eventually did see the predator. So what caused it? Is it over? And what do we do now?

Everyone has been pretty quick to jump on China's devaluation of is currency as the cause of this decline. I wouldn't call it the cause; I'd call it the trigger. There were several factors that had begun to make people worry if the continued market upswings might have gone too far. Commodity prices have been dropping for the entire year, making companies that sell, refine, ship or make equipment for drilling, mining or agriculture susceptible to losses or at least slowdowns in profits. Japan and the Euro zone have been working very hard to drive down the value of their currencies - and it's been working. There are different industries that react in different ways to a big shift in relative currency values like that; some good and some bad, but it changes the trends and not everybody reacts well to those changes. There was also a worry that at these very low prices U.S. oil and gas drilling, which has expanded greatly over the last few years and is responsible for a huge chunk of working class job gains over that time, would become uncompetitive with the Middle East. I think those fears are overblown as the improvements in technology are making domestic drilling profitable at lower and lower prices - but not everybody agrees.

Then there is China. China is trying to do something that has never been done in economic history. They are trying to transfer from a manufacturing / agricultural / export country into a country with domestic consumption led by a substantial middle class. But that has been done before! The U.S. did it, Canada did it, Japan did it, Turkey did it - what makes China so unique? China is trying to do it, but keep full governmental control over the economy at the same time - that's never been done before. In every other case; developing export led countries that have shifted into middle class dominated, domestic consumption based economies have done so either by having capitalist economies to start out with - like the U.S. - or by greatly lowering government control over the economy. Sometimes by force; like with Japan after WWII, sometimes by happenstance like East Germany after the wall came down - and sometimes by design like the pro-capitalist reforms Brazil and India have undertaken in recent years. I recently heard an analyst of China make a very smart comment on television - I wish I had kept some notes so I could make proper attribution - but in effect he said we have to stop thinking that Chinese leaders are so much smarter than everyone else and they won't make a mistake. What we've seen over the last few months is China making several mistakes and whether those mistakes are actually slowing down economic growth in China or just pulling the veil away and letting the rest of the world see that growth is slowing down in China remains to be seen. But either way if economic growth in the developed world is about 2% (that's probably being generous) and China stops growing at 10% and drops to

6-7% growth - that brings down the worldwide growth rate which in turn lowers worldwide demand for goods and services. The good news is the U.S. as a net importer of goods which consumes almost everything manufactured domestically is far more isolated from an Asian or European slowdown than other countries.

A possible Chinese slowdown has been affecting things since the first of the year, and the markets began responding several months ago - the market highs for this year were back in May. The Chinese stock markets are off almost 40% from their highs as of this writing, although they are still up for the year, and back to that trigger again - China lowered its currency value 20% vs. the dollar all of a sudden a few weeks ago. The reason I'm calling it a trigger and not a cause is because we really should have expected some kind of currency adjustment by China. Europe and Japan as already mentioned have been doing everything in their power to drop their respective currencies' values. The difference is the Yen and the Euro float in a worldwide market, so the Bank of Japan (BOJ) and European Central Bank (ECB) can lower the currency values but only by doing some version of what the U.S. was doing between 2010-2014, that is buying their own bonds on the open market to create more Yen or Euros. China doesn't float it's currency it in effect declares what its currency is worth. So the only way China can do what the BOJ and ECB have done is to simply come out and say they are lowering their currency. Trust me: if Japan had a mechanism to lower their currency 20% all at once they would have used it. While lowering the value of their currency is understandable given what everybody else is doing, making such a huge move all at once was probably another mistake as it drove lots of international investors out of their stock markets. But in some ways it just reaffirmed to the international community that China isn't like the Euro Zone or the U.S.   There is no transparency in their system and you can't trust that any numbers they put out are correct. At the end of the day, this currency move by China was the excuse for lots of people worried about world growth rates or simply worried about the markets going up for this long without a correction to finally sell.

There's a famous expression on Wall Street that the market has predicted 9 of the last 5 recessions. What that means is sometimes the stock markets correct and that either causes or simply predicts a coming recession, and sometimes stock markets correct and the economy isn'  really affected at all. Ronald Reagan famously said after the 1987 Black Monday crash "Always remember that the stock market isn't the economy." I think this is one of those times where the market corrected because it was overdue to correct - but it's not indicative of a coming recession at least not in the U.S. Quite the contrary, U.S. GDP growth in the second quarter of this year was just revised up to 3.7%, a robust number at any time but especially compared to recent history and in comparison to the rest of the developed world. That doesn't mean the markets won't be volatile or that the markets might not test the lows from August 25th. Even sharp correction and recovery cycles take several weeks or even a couple months so don't be surprised to have big swing days even into October. I'd like to think it's going to be shorter than that as the way we use technology to trade today seems to compress these time frames a little bit over what they were in the past - but there's no way to know for certain.

If by now we mean over the next few months and not necessarily "today" we might want to look at being a little more aggressive with our investments. Bonds are less volatile day to day, but in a rising rate environment are less attractive long-term. Also if you have any money that you're dollar cost averaging in to the markets, or you haven't yet maximized your retirement plan contributions - now might be a good time to do those things. Otherwise, your investment plan should have been structured with a typical correction in mind. Just because we had that correction also doesn't mean we won't have another for four or five years again like we did last time. That correction every 500 days statistic is an average, just like if it rains on average once a week it doesn't mean rain on Wednesday insures sun on Thursday. After a full recovery from this correction we could see another one in six months, or a year or three years. Having to live through those tense moments is why stocks pay you better returns on average than investments where the principal doesn't change.   I'm just glad we finally experienced the correction so I can stop talking about it.

As always if you have any questions about your specific investments whether they are managed by Keeling Financial or somebody else - please give us a call. We are also accepting new clients, so please feel free to refer your friends, family or customers to our office. The initial consultation is always free of charge.