The Fear of Fear Itself

behavioral-finance

With the United States & Europe mired in depression, newly elected US president Franklin D. Roosevelt. delivered these words in his first inaugural address:

This is preeminently the time to speak the truth, the whole truth, frankly and boldly. Nor need we shrink from honestly facing conditions in our country today. This great Nation will endure as it has endured, will revive and will prosper. So, first of all, let me assert my firm belief that the only thing we have to fear is fear itself-nameless, unreasoning, unjustified terror which paralyzes needed efforts to convert retreat into advance. In every dark hour of our national life a leadership of frankness and vigor has met with that understanding and support of the people themselves which is essential to victory.

We think often of these words when daily is seems like our politicians and media come up with new ways to terrify us.   Sure, fear gets our attention, but fear also prevents us from making good decisions and can force us into making bad decisions.

5 days into the New Year, here are the headlines of the past week:

  • Stock Markets Shudder After Chinese Stock Plunge Forces a Trading Halt
  • US Stocks Have the Worst Start to a New Year Ever
  • North Korea Says It Detonated Hydrogen Bomb for First Time
  • Iranian Protesters Sack Saudi Embassy
  • Iran accuses Saudis of hitting Iran's embassy in Yemen
  • Obama's Tears Over Gun Control Prompt Conspiracy Theories

Is it any wonder that the CNN Fear & Greed Index currently shows "extreme fear?"

Here are some headlines that did not get much coverage:

  • Robust Hiring in December Caps Solid Year for U.S. Jobs
  • U.S. Car Sales Set Record in 2015
  • US Economy Resilient with Robust December Hiring in Manufacturing

As journalists often say, "Bad news is good news, and good news is no news."

For the first week of 2016, the Shanghai stock market declined 9.97%, Shenzhen index declined 14.30%, major European markets declined 5.25-8.32%, S&P 500 declined 5.91% and the NASDAQ declined 7.24%. 

S&P 500 vs Shanghai index - 12 months through January 8th, 2016

The market cap of Chinese stocks is $7 trillion versus $22 trillion market cap of US stocks.  The Chinese economy is the second largest after the United States.  As we have often observed, China needs to make the transition from export to consumer driven growth.  This process may play out over a decade or two.  Along the way, Chinese politicians WILL make bone-headed decisions that increase the pain of the transition.  It took the Great Depression and World War II for the US to make that transition; the Japanese have yet to complete the transition.

In this context, should we go to 100% cash?  No!  In our experience, sharp declines as we saw last week mark the end of bear markets, not the beginning.  The "weak hand" investors vomit up their positions in a final crescendo of selling, at which point stocks bungie back and continue to rise.  US stocks plunged 26% in the first ten weeks of 2009, following a disastrous Q4 2008.  Many people liquidated their life savings at fire sale prices in Q1 2009.  Yet, those investors who did NOTHING in 2009 saw gains of 23.5% by the end of that year and gains of 126.3% through year end 2015. 

The S&P 500 is off just under 10%, the official definition of a correction and a level we saw in August 2015.  We believe, however, that a "stealth" bear market began August 2014.  More than half of S&P 500 stocks are down 20% from their highs with many energy producers down 60-80%.  We don't expect US stocks to fall 26% in the next ten weeks, nor do we expect US stocks to rally 23% by year end.  We do expect stocks to gain at least 5% from the start of year levels, which would be 12% above Friday's close.

In particular, we're watching the price of oil, which hit 7 year lows earlier this week.  We regard the price of oil as "the world's tachometer" - falling prices indicate overall weakness in world GDP, while rising prices indicate strength.  This chart shows a temporary imbalance between production (high) versus consumption (low).

High cost rigs will shut down through 2016, bringing supply and demand back into line, and with that, rising prices.  For now, American families should enjoy the $1000 gift in lower driving and heating expenses.

Towards the end of last year, we harvested tax losses in our emerging market and commodities positions.  We're holding that cash in reserve, will redeploy back into the markets later this quarter when prices stabilize at lower levels.