In the financial markets only one thing is certain: if you panic and allow fear to guide your investment process, you will lose money.
We all wish we could call every high in the markets and time every low to the day, and you will hear plenty of pundits trying to call the day-to-day and week-to-week twists and turns. But that’s a dream.
Everyone has heard the trite saying that the early bird catches the worm. Unfortunately, that aphorism doesn’t hold water when it comes to the financial markets–there’s not much of a penalty for being a little late to buy and a little late to sell. In fact you’re probably better off being late to the party than trying to anticipate major market moves and shifts in economic conditions.
Consider the most recent bear market in stocks that lasted from October 2007 until March of 2009. The total decline for the S&P 500 over this period was about 56 percent from closing high to closing low. If you had identified the exact top and the exact bottom to the day, you could have obviously avoided that entire decline. But you didn’t have to be particularly accurate to spare yourself all of that pain.
Let’s assume you were nervous about the markets and the burgeoning subprime crisis in April, 2007 and decided to sell out of the market six months before it topped out. If you had done that, you would have avoided a 50.9 percent total market decline to the March 2009 market trough. In other words, despite the fact you called the top a few months early, you still would have avoided about 90 percent of the ensuing carnage and undoubtedly would have attracted the admiration of fellow investors for your foresight and wisdom.
But what if you were six months late calling the top? You might have felt the concerns over subprime mortgages were overdone and that the economy would skirt recession, an all-too-common call in late 2007 and early 2008. But by April of 2008 it was fairly obvious to all but the most ardent and committed bulls that the US economy was slipping into recession. The investor who waited until that moment to take off their rose-tinted glasses and sell stocks would have incurred little real penalty for their tardiness. If you sold stocks six months after the market’s top, you would have avoided a decline of about 48 percent to the March 2009 lows.
In other words, the investor who was six months late in recognizing the looming recession did almost as well as the investor with outstanding foresight.
Let me give you an even more extreme example: The S&P 500 collapsed more than 86 percent between 1929 and 1932. If you happened to be six months early recognizing the top, you would have avoided an 81 percent decline. If you were six months late, totally missing the 1929 crash, you still would have saved yourself a 76 percent decline to the 1932 lows.
And amid the choppy sideways market of the 1970’s you would have actually been better off selling six months late than six months early.
My point is not that you should ignore economic conditions or the action in the broader stock market averages–whistling past the proverbial graveyard is completely irresponsible. However, the fascination many pundits have with making early market and economic calls is downright silly.
In fact, investors who follow that sort of advice are more likely to get hurt. Last summer, many pundits called for a double dip recession and a major new bear market in stocks. A few months later, it became obvious that the US economy was re-accelerating and the summer weakness was just a temporary lull–stocks embarked on a significant rally from late summer through the spring of 2011. If you tried to be early calling the top, you likely got whipsawed that summer, selling out of your positions at the worst possible time, when stocks were most depressed. You would have been far better off simply monitoring the data and waiting for real signs that the downturn was more significant before you hit the “sell” button.
The only thing that investors shouldn’t tolerate is stubbornness. The market will at times humble us all and make a mockery of our forecasts, no matter how well informed. Those who continually refuse to shed their bullish outlooks or appear on television to say that in the long run the market always goes up, will lose money. The same is true of those pig-headed permanent bears who never really bought in to the massive market rally since the March 2009 lows.
Do not panic over a single economic data point or one day’s trading action in the S&P 500–no matter how frightening. There’s no need to call the exact top. Do not allow pundits’ sensationalism or the latest headlines in the financial news to cause you to panic–you are much better off stepping back and analyzing the indicators to make an informed decision.
On Thursday, Aug. 4 the Dow Jones Industrial Average tumbled more than 500 points and the S&P 500, trading over 1,300 just a few days ago, slumped well below support at 1,200. The S&P 500 is now down for the year and roughly 13.5 percent off its 2011 highs, a significant market correction. Commodities sensitive to global economic conditions such as crude oil also tumbled–US benchmark West Texas Intermediate (WTI) is now back under $90 per barrel (bbl) while Brent is under $110/bbl, down from highs of close to $130/bbl earlier this year.
Even some markets that are traditionally seen as safe havens got hit on Thursday. Gold prices fell about $15 per ounce on Thursday and showed no signs of strength even when the market sell-off became extreme. Financial news giant CNBC even held a special feature about the market’s crash.
The question we fielded from many investors is, “What happened?” Or more accurately, what changed between the close on Aug. 3 and the open on Aug. 4 to catalyze declines of 4 and 5 percent in most major stock indexes?
The most common justification cited in the financial media was that investors were concerned about the US slipping back into recession after a sub-par economic expansion over the past two years. While investors are undoubtedly concerned over a bout of weaker-than-expected US economic data, this is not a particularly satisfying explanation for Thursday’s big sell-off. The only major piece of US economic news released on Thursday was the weekly initial jobless claims data, which shows the number of Americans filing for first-time unemployment benefits. The initial jobless claims number was better than expected and continued the recent trend of a steady decline in claims.
I actually read a headline on a major financial news website that said the employment number was weak and reflected a “stalled” US economy. This is an egregious distortion of reality: Thursday’s initial jobless claims data was the best (lowest number of claims) for any week since the first week of April, before economists began uttering the words “economic soft patch.” Check out my chart below for a closer look at initial claims data.
This chart shows the four-week moving average of initial jobless claims for the past two years. Economists tend to watch the four-week moving average as it smoothes out week-to-week distortions in the claims data.
As you can see in the chart, initial jobless claims topped out in early 2009 and declined steadily into early 2010. Claims data then stalled for a few months around 425,000 or 430,000 before falling sharply in early 2011. Employment data is typically considered the most important of all economic indicators because employment drives consumer spending, confidence and credit.
That’s why the sudden bump in claims data in April through June of this year was cause for concern: Weakening jobs creation and more layoffs undoubtedly took a bite out of consumer spending, the most important component of gross domestic product (GDP). To make matters worse, a spike in energy costs hit disposable income for many Americans, further weakening growth on the margin.
The slackening employment statistics were the first sign of economic weakening this year. But these trends have reversed markedly since late May and early June. The continued decline in both the raw data and the four-week moving average hardly constitutes a weak number or a sign of a stalled economy. Rather, the initial claims number released this week is a sign that the economy is beginning to emerge from a soft patch.
The truth is that there is no single data point that can explain yesterday’s sell-off.
A better explanation for the carnage: a classic market panic and shakeout made worse by the fact that institutional traders in the US and Europe tend to be on holiday and, therefore, less active in August. Quick shakeouts of this nature aren’t exactly common, but they are a painful feature of every bull market in stocks. The good news is that a market panic of this nature breeds opportunity for investors with cooler heads.
There are really two major headwinds facing the market now and neither is new: investors are concerned about weakening economic data and the European credit crisis. As I noted before, Thursday’s economic data was encouraging, but data has generally disappointed expectations over the past few months. Concerns about Europe’s sovereign debt crisis have been heightened by the recent spike in yields on Italian and Spanish government bonds; one of the points I’ve made repeatedly over the past 18 months is that the biggest risk in Europe is the contagion spreading from small economies such as Greece to meaningful markets such as Italy.
In regards to the first point, I continue to believe that concerns about a second US recession are vastly overblown, as was the case in the growth scare during the summer of 2010 or a similar scare in the summer of 2004. Although the economic data has undoubtedly weakened, there are actually signs that we may be close to exiting the spring/summer soft patch and setting up for at least a modest re-acceleration of growth through year-end.
Some examples of better-than-expected data are the steady downtrend in initial jobless claims I highlighted above. Even more impressive was the far better-than-expected July Employment Report released on Aug. 5. Even the permabears struggled to find negative news in the July Employment report; the unemployment rate dropped, non-farm payrolls grew more than expected, private payrolls grew more than forecast, last month’s numbers were revised sharply higher and average hourly earnings soared. This Employment report seems to back up the positive signals from Thursday’s jobless claims data and Wednesday’s better-than-expected ADP employment release.
The unemployment rate is the most widely cited statistic in the Employment report. But it’s not particularly useful or predictive because it’s based on two different surveys taken by the Bureau of Labor Statistics (BLS). Furthermore, changes in the size of the labor force tend to skew the data.
I watch two statistics in the release most closely: private non-farm payrolls and average hourly earnings. These are the most valid leading indicators of economic growth. Let’s start by looking at private non-farm payrolls:
This chart shows the monthly change in private (excludes federal, state and local government) jobs for the past few years. As you can see, jobs growth turned positive in early 2010 and trended steadily higher until early 2011. Payrolls numbers can be volatile from month to month but the drop in May and June certainly looked meaningful: The US created 241,000 jobs in April, 99,000 in May and just 80,000 in June.
Keep in mind that these are revised numbers released today–when the June data was first released a month ago, BLS estimated the country created only 57,000 private sector jobs in June. When the May data was first released on June 3, the government reported only 83,000 private non-farm payrolls jobs that month. In total, today’s Employment Report revised prior months’ data higher by 56,000 jobs, historically a large revision to this data series.
At any rate, today’s stronger-than-expected release showing 154,000 new jobs created suggests that the labor market is healing as US jobs creation surges higher. Another point I must drive home is that investors should NOT ignore the ADP data released every month. While the ADP data may not be a great predictor of the BLS numbers, I have often found that when the ADP numbers are higher than BLS, subsequent revisions tend to push BLS numbers more in line with ADP.
There’s plenty to like inside these numbers as well. For example, goods-producing employment jumped 42,000 in July compared to a revised 16,000 in June and 20,000 in May. Manufacturing jobs are one of the major components of goods-producing payrolls; in May the US added 24,000 manufacturing jobs, the most since adding 28,000 in April and well up from just 7,000 in May and 11,000 in June.
The devastating Sendai earthquake that struck Japan in March was one temporary factor that undoubtedly weakened manufacturing activity around the world. Shortages of components in key industries such as automobiles caused factories to shut down earlier in the year than is normally the case. The earthquake is also one factor behind the weakening of the widely watched Manufacturing Purchasing Manager’s Index (PMI)–Manufacturing PMI weakened to 50.9 in July from extremely strong levels above 60 earlier this year. A reading over 50 indicates expansion of manufacturing activity. That manufacturing employment is now clearly rebounding strongly suggests that the aftereffects of the Sendai earthquake are abating and that Manufacturing PMI is near a major bottom.
What’s even more bullish is the rebound in average hourly earnings, a measure of workers’ income. In July, US average hourly earnings grew 0.4 percent, the fastest rate of growth since the economic recovery began in March of 2009. Faster income growth, coupled with a weakening in energy and food prices, spells more disposable income for consumers and a likely up-tick in US consumer spending this quarter. This will undoubtedly result in upward revisions to third-quarter US GDP data.
And even the so-called weak economic data released this week, including the Manufacturing and non-Manufacturing Purchasing Manager’s Indexes, were not at levels that indicate recession. These indexes simply suggest a slow pace of growth. As noted above, today’s employment report suggests PMI numbers are near a bottom and have been artificially depressed by external factors such as the Sendai earthquake.
Bottom line: Forecasts that the US is about to slip into another recession have little basis in the economic data. These fears are overblown and exaggerated. I would need to see more persistent weakness in the data and a reversal of today’s extremely bullish Employment release to start worrying about a recession.
The EU Credit Crisis
There are some concerning trends emerging in Europe that should be monitored carefully. However, I don’t see cause for the outright panic witnessed over the past few days.
As I have written consistently for more than 18 months, Italy is the lynchpin of the EU crisis. That’s because Italy is the third-largest economy in the eurozone and therefore must be considered part of the “core” economy of Europe. This distinguishes Italy from Greece, Portugal and Ireland; all three of these countries are tiny and next-to-insignificant for the EU as a whole. Even more laughable are the articles I’ve read about the contagion spreading to Cyprus. Cyprus is a lovely island, but its $25 billion economy is about the same size as that of Vermont, the smallest US state in terms of GDP.
Germany and France can bail out Greece, Ireland and Cyprus but they can’t easily cover the tab for Italy or, for that matter, Spain. At the same time, Italy’s high public debt makes it the most vulnerable of the core European economies. Any contagion from the periphery of Europe to the core runs straight through Rome.
This makes the extreme spike in Italian bond yields a cause for significant concern–check out my chart below for a closer look.
As this chart shows, the yield on the Italian 10-year bond has jumped to over 6 percent compared to less than 5 percent as recently as June. The Italian 10-year now yields about 375 basis points (3.75 percent) more than the German 10-year bund, the EU’s benchmark of fiscal responsibility. This yield and the spread over bunds must come down if concerns about the EU are to ease. The market is unlikely to rally until Italian government bonds yield less than 5.5 percent.
While Italy remains a concern, this risk has been blown out of proportion by global markets. First of all, markets in Europe are notoriously thin and volatile in August as this is the peak month for holidays. Europeans take their summer holidays seriously; many of you have probably read news stories about various European leaders who have delayed their holidays for discussions about the crisis. Only in Europe is a delayed vacation a news story. This traditional lack of liquidity in August is not causing the spike in yields, but it’s probably making the situation look worse than it is.
Some investors have also said the EU’s July decisions to expand the capabilities of the European Financial Stabilization Fund (EFSF) have been insufficient to stem the crisis. This is not a valid argument because these changes have yet to take effect. The proposed changes must be approved by national Parliaments. That won’t happen until September, unless the crisis truly spins out of control and policymakers are forced to take early action.
While the markets wait for the EFSF changes to be instituted, the European Central Bank (ECB) is apparently willing to fill the vacuum. The ECB is now entering the interbank loan market to ensure that it continues to function and to keep interbank rates from spiking. The central bank also hinted that it may be ready to start buying the bonds of governments such as Italy and Spain should conditions in these markets continue to deteriorate or if these countries were locked out of the private-sector markets. The ECB would clearly like to wait for the EFSF changes to take effect, but the bank appears to recognize that might not be possible.
There are plenty of additional changes EU governments could make to quell the crisis. Italy, for example, could accelerate some of its planned austerity measures. The country has already implemented enough cuts to bring its budget into balance by 2014 but this could be accelerated without creating too much additional hardship. The EU might also decide that they need to beef up the size of the EFSF to quell the crisis.
By far the most encouraging sign for investors is the lack of any real contagion into global bond markets. The US interbank lending market has been quiet. There’s been no spike in the so-called TED spread–the spread between interbank and government rates–as there was back in 2008-09. US corporations, including those with ratings well below investment grade, continue to sell bonds at near record-low spreads.
Italy is a market to watch, but the Europeans are taking steps to ensure the contagion doesn’t spread to Rome. In typically gradualist fashion, I think the EU will continue to address these concerns and I expect Italian yields to settle over the next few months.
Furthermore, if markets were really worried about a US debt downgrade, then why are US government bond yields near record lows? The US Treasury’s funding costs are actually declining, even though the country is likely to be downgraded from triple-A status at some point over the next six months. This hasn’t really impacted corporate bond yields.
At any rate, nothing really changed in European or US credit markets on Thursday to drive a 512-point sell-off in the Dow.
How to Play the Sell-off
There have been no fundamental changes to the outlook that justify the recent sell-off. It seems that markets are simply reacting to a number of fears that have been circulating for the past few months, including the economic slowdown and the EU credit crisis. Panic has a way of building on itself, particularly in thin summer markets. Individual investors often get caught up in the panic when a sell-off triggers stop loss orders that push the market down further, triggering more stops.
These extremes of emotion are obvious in Friday’s market shakeout as well. The S&P 500 opened higher on the near-flawless Employment number then sold off sharply, down more than 2 percent at one point and plummeting below last December’s lows. The selling pressure was finally exhausted, prompting a market reversal by midday.
This is textbook market action: a panic-driven selling capitulation that cleans out the weak bulls and sets us up for a significant rally into the final months of the year. Check out my chart below.
This chart shows the S&P Volatility Index commonly known as the VIX. When the VIX spikes, it indicates that traders in the S&P options market are worried about a major explosion in market volatility–the higher the VIX, the greater the fear. Major spikes in the VIX tend to correspond to important market lows.
On my chart, for example, you can see how a major spike in the VIX in June and July of last year corresponded to the absolute bottom for the S&P 500 last summer. The spike on Friday suggests a similar level of absolute fear.
It’s likely we’ll see a few more spikes to the downside in coming sessions, but this market looks close to an important low. If the economic data gradually improves over the next few months I expect we’ll see new 2011 highs by year-end. I’d put the odds at better than 50/50 that the intra-day low on Friday Aug. 5, 2011, will mark the lows for the year.
This market action is scary and, if you watch the intra-day swings, extremely tough to endure. It’s also the best buying opportunity you will see for many months. Even the best positioned, most conservative and steadiest stocks in my coverage universe have been hit in the selling climax despite absolutely no change in risk or fundamentals. On Friday, we saw what amounts to a mini flash-crash in many names. This affords investors the opportunity to buy stocks at valuations they could only dream of a few months ago. This is an even better opportunity for income-oriented investors, offering a chance to lock in yields of 10 percent or more in quality stocks that were yielding 6 or 7 percent a few days ago.The Personal Finance Portfolio features some of the world’s best growth- and income-oriented stocks, many of which are now trading at dream prices. To learn more, please visit us at Personal Finance.