Thoughts on January 2016 Market Correction

The purpose of this commentary is to share briefly our views on some of the recent events that have impacted the capital markets in the United States. What appears to be a case of near market hysteria and panic should, as always, be looked at in perspective. Even a ~ 10% decline, unnerving as it is, in the broader context of the capital gains realized since 2009, should be viewed as a normal correction in a long term, secular bull market as historically market corrections happen at least once a year.

The current market malaise is almost entirely a result of a widespread negative sentiment engendered by the substantial drop in the price of oil and other commodities, and the economic slowdown in China with the attendant fear of economic contagion spreading to the rest of the world.

It is our view, however, that the fundamental drivers and underpinnings of the market are healthy and remain in place; i.e. still very low interest rates, nonexistent inflation, good corporate earnings (except for the oil patch), low unemployment, low but steady GDP growth, accommodative monetary policy for the foreseeable future, and a strong dollar.

1. Let us look at oil.

As usual oil is both a blessing and a curse. Low oil prices act as a tax cut for Americans and benefit consumer spending on cars, travel, retail, household appliances etc. Consumer spending represents 65-70% of our GDP, so that we should all welcome low oil prices.

Low oil prices are a curse in that they severely and negatively impact our domestic energy industry which continues to have a high cost of production, in spite of technological advances made in the oil patch. It is estimated that the current average cost of extracting a barrel of oil through the fracking process is about $50 a barrel. With the world price of oil at ~ $30, it is easy to see that the domestic oil industry today is being severely tested.

Since the beginning of the industry the price of oil has never been determined exclusively by market forces of supply and demand. There has always been a heavy dollop of geopolitical premium, both positive and negative, in determining the price, given where a lot of energy resources lie. Today, in our view, that negative premium is in the range of 25-30 dollars a barrel, which tells me that under current world economic conditions a barrel of oil should be selling at ~$55-60.

We believe that everyone is aware of the political and economic disputes between Saudi Arabia, Iran, Russia, and the American frackers, so that it is not necessary to delve much into the issue.

Suffice it to say that the Saudis’ goal is to punish both Iran and Russia politically and economically, as both need oil in the $120 range to balance their budget, and to undermine the U.S. frackers ability to compete in the market place. We believe that this is a very dangerous game that is being played that may result, in the not too distant future, in enormous pressure being applied on the Saudis, both physical and otherwise, by the rest of OPEC and other world countries to change course.

Over 300 billion dollars of energy related investment projects have been delayed or abandoned in the past year and a half worldwide. This will lead to future reduction of supply within the next two years. The equilibrium balance of supply and demand in oil is very tenuous, currently ~94.5 million barrels supply daily versus ~93 million barrels demand. It won’t be long before the balance will be reversed!

2. Let’s look at China.

To date, since August 2015, market action has really been all about China. With a GDP of ~ 10 trillion, two thirds the size of ours, China is the second largest economy in the world.

China’s current malaise does not directly impact the U.S., as our exports to China represent only 1% of our GDP. However as the largest importer of commodities in the world, copper, iron ore, zinc, soy beans etc., China can have a major impact on the economies of the emerging countries which are largely commodity dependent. The Chinese slowdown has indeed infected emerging countries throughout the world, such as Brazil, Argentina and even Australia. The threat of contagion to the USA feared by the market, which could lead to a recession here, is in our opinion, rather limited.

The law of large numbers has also caught up with the Chinese. Once the economy reached a certain size, it was inevitable that they could no longer grow at 10-12 % a year. Slower population growth and a shift to a more consumer based economy have also contributed to a growth outlook of ~7-7.5%, a very healthy growth nonetheless. We do not believe that the market has properly factored in this still substantial growth rate.

As dyed in the wool communists, but only budding capitalists, the Chinese do not as yet understand the intricate workings of market based institutions. Their attempt to manage the market value of the Yuan, their clumsy efforts to introduce circuit breakers in their version of the stock market and to prevent large institutional holders from selling their shares, has led to falling confidence that the Chinese know how to manage their economy. In our view this has been a major factor in creating the fear of contagion and in the recent worldwide market decline.

3. Let’s summarize and put the recent market drop in perspective.

1. Corrections of 10% or even more happen all the time in a secular bull market.
2. Historically market drops are often quickly followed by reversal and recovery to new highs.
3. Statistically market drops make future gains more possible.
4. We need to think long term and be willing to wait through long pullbacks
5. One can take advantage of market drops by dollar cost averaging.
6. A contrarian approach would argue for investments in the most stricken areas of the market
7. Oil is a volatile commodity. It will be needed for a very long time and its pricing will eventually reflect its true economic value. In our opinion it is not ~30!
8. Finally as Buffett would say, let’s be greedy when everybody else is fearful, and be fearful when everybody else is greedy.