Recapping the August Correction


Between May 21st and August 25th, US stocks as defined by the S&P 500 slid by 12.4%, leaving the index down 5.4% on the year and down 2.3% over the last year..  A correction is defined as a slide of 10% or more, while a bear market is a decline of 20% or more.  The S&P 500 is currently down 10.0% from the May 21st record.   The Chinese stock market is off 38.8% from its June 12th high, down 0.9% on the year and still up 38.1% over the last year.  US stocks are on the low side of fair value.  Chinese stocks could fall another 50%, yet still be overvalued.

We were pleased that a number of our clients added cash to the accounts in the last two weeks.  We happily invested those additional funds in stocks, though it will be a few months before US stock market resumes its upward trajectory.  When the stock market has a "heart attack" as we saw in the last three weeks, it takes time before the market "gets back to the gym."  Investors remain skittish and race to sell any rally.  Earlier in the year January through June, retail investors purchased $83 billion in equity mutual funds as the S&P made multiple record highs.  In July and August, investors sold $56 billion - a classic example of buying high and selling low.  We still believe our year-end forecast of 6% gains of 2015 in the S&P 500 is reasonable, which would be 13.5% higher than Friday's close.

We addressed concerns about China in our August 22nd commentary.  The main thing we're tracking now is "how will the Chinese government switch from a 'command and control' economy to an economy flexible enough to provide for China's 1.36 billion in population?"  Governments are commonly at greatest risk from the frustration of "rising expectations."  China is the second largest economy after the US, but 89th in per capital income (out of 187 nations - US is 15th.)  We won't know the answer to that question for years.

The US Employment Situation

Of current interest to us is the latest jobs report and its significance for an increase in interest rates by the US Federal Reserve Bank in September (or more likely, we think, October or December.)  Friday's report showed an increase of 171K jobs, with an unemployment rate of 5.1%.  Generally, economists feel that a rate of 5% or less represents "full employment."  If so, why don't Americans feel "fully employed?"  The answer is that the labor participation rate (number of Americans at working divided by the adult population) at 62.6% is well down from the 66% rate that prevailed for a decade through 2008.  Wages are not growing, not even keeping up with inflation.

From peak in January 2008 through trough in February 2010, the US shed 8.7 million jobs.  A new high in total employment was set in May 2014, regaining those lost jobs - good news right?  Not so good.  Between January 2008 and present, the US added 18 million adults to the employment pool, but only gained a net of 3.9 million jobs.  142 million Americans are at work, but "full employment" should be closer to 150 million (current working population of 228 million X 66% participation rate.)  The "true" unemployment rate is closer to 9.7%.  Is it any surprise that millions of Americans, particularly blue collar Americans without college degrees, are mad as hell about our political situation.  Which leads us to:

The Trump Insurgency

Donald Trump presently dominates polls of Republican voters, with twice the popularity of Ben Carson and three times the popularity of Jeb Bush.  In general election matchups, he's the only Republican candidate to match Hillary Clinton.    

Mr. Trump was born into a well to do NY real estate family of Scotch/Presbyterian heritage. Trump parlayed a University of Pennsylvania education and the recovery of the New York City economy into a real estate empire embracing apartment buildings, hotels, casinos and golf courses.  His net worth is currently valued at $3.5 billion, but it should be noted that, after bankruptcies in subsidiary companies in 1991, 1992, 2004 and 2009, Trump has very little equity in property.  He licenses the Trump name to other developers and provides management services through the Trump Organization.  Other investors (many from China and Japan) take the risks.  Most Americans and international viewers are familiar with Donald Trump from "The Apprentice" reality show.

He was married to Ivana Trump from 1977-1992 (three children), Marla Maples from 1993-1999 (one child) and is currently married to Melania Knauss (one child.)

After flirting with presidential runs in 2000 and 2012, Mr. Trump announced for 2016 on June 16th.  To the general astonishment of pundits, Republican party officials, the other Republican candidates (16 at last count), comedians and ourselves, Donald Trump blew away the competition (see the latest Real Clear Politics "poll of polls.")  Incredibly, the more outrageous Mr. Trump acts, disparaging Hispanics, women reporters, women in general, other politicians, veterans and POW's, the higher he scores at the polls. 

Our only reasonable explanation is that American are so unhappy with establishment politicos and are so aggrieved by their sense of economic and social malaise that they're will to take a chance on him.  Starting in the 1990's and accelerating since 2000, American society divided into the "have's" - credentialed, educated, urban information workers, and the "have-not's" - minimally educated suburban and rural manufacturing or service workers for whom a house, job, medical care and retirement benefits are increasingly insecure propositions.  As we said about China, "governments are commonly at greatest risk from the frustration of 'rising expectations.'" 

We've talked about the "biblical plague of Republican nominees."  Thanks to the collapse of campaign finance laws, anyone with a billionaire backer and a dream can run for president.  Donald Trump engenders more "trust" than the other 16 candidates because, as a billionaire himself, he isn't "owned" by David & Charles Koch, Sheldon Adelson, Woody Johnson, Ken Lagone, David Geffen or any number of major donors, Republican or Democratic.  His insults are interpreted as "truth to power" by his fans.  These 30 supporters from a broad political spectrum explain "why they believe that the billionaire real-estate developer will treat them any better than the career politicians they mistrust."

Electoral college math still favors the Democratic nominee, but Mr. Trump's surge is the first time in two years we think any Republican has a chance to beat Hillary Clinton.

The Fed's Next Move

The US Federal Reserve primary function is as follows: Conduct the nation's monetary policy in pursuit of full employment AND stable prices.  Keep the unemployment rate low (under 5%) and inflation contained (around 2% annually.)  Many observers demand that the Fed raise rates now because they fear that an unemployment rate below 5% will spike inflation.  As we observed above, there is still quite a bit of slack in the employment situation.  Meanwhile, thanks to the collapse of commodity and energy prices this year, inflation in the US for 2015 is projected only at 0.1%.  Reasonably speaking the Fed could do NOTHING for the rest of the year and still satisfy the Fed mandate.  However, the Fed also cares about "market psychology" - investors who panic if they think the Fed is not vigilant about inflation.

We believe the Fed will resolve this contradiction by raising rates 0.25% ONCE between now and year end, then sit tight until inflation escalation is more apparent.