Economy and capital markets
Volatile Markets, Healthy Banks, and a Strong U.S. Economy
We currently find ourselves in a period focused on pessimism surrounding global growth prospects. It’s true that declining commodity prices, primarily in energy and metals, have impacted exporters such as Russia and Brazil. And after years of extraordinary economic expansion, China is in transition to a slowing phase, but in our view, it is still producing robust growth. Despite the deflationary winds blowing from overseas, the U.S. economy is in its best shape since the Great Recession, with rising employment, rising home prices, low inflation, and improving consumer sentiment.
Some positives and negatives to the economic and investment background include:
U.S. consumers are riding favorable trends
With firming employment, stable to rising home prices, and lower energy costs, it is no wonder that U.S. consumer spending is on the rise. Consumers are also enjoying multi-decade highs in the housing affordability index. Furthermore, real wage growth, conspicuously absent during most of the recovery, may be set to improve. Automobiles are flying off dealer lots at the fastest pace in 10 years, according to the Wall Street Journal, but auto workers are threatening walkouts looking for better pay.
Employment has recovered since the Great Recession leaving employers with fewer skilled workers to fill available jobs; this may pressure wages upward. More evidence of strong discretionary spending is found in the resurgence of cruise ship operators in tandem with lower fuel costs. While the consumer may feel dour about capital markets (see next section), we don’t see a slowdown in consumer spending anytime soon.
Investor sentiment low, even though correction was overdue
Various measures of investor sentiment are hitting multi-year lows, including the Investors Intelligence Bulls and Bears (below). We have not witnessed similar levels of bearishness since the beginning of the European debt crisis in 2011. Investors tend to favor low prices for buying stocks but don’t like the uncertainty that accompanies them.
Markets just emerged from one of the longest periods ever without a 10 percent correction (about three years), so we were clearly overdue. We also think investors are anchoring on the peak stock prices reached earlier this year rather than on the gains attained throughout this market cycle. Market bottoms are sometimes established during times of extreme pessimism. Check out 1998, 2002, 2008, and 2011 for other recent periods when this ratio fell below 1.
Investor sentiment can stay depressed for a long period like 2008 – 2009, so the current market malaise may get worse before it gets better. The Financial Times recently reported that Saudi Arabia has withdrawn tens of billions of dollars from asset managers as it looks to cut a widening budget deficit attributable to low oil prices. Norway, with the world’s largest investment portfolio or sovereign wealth fund, may not be far behind. The cascading effects from the rapid decline in commodity prices are having an impact on global capital markets.
Banks experience historic high capital levels, but earnings don’t follow
Now that the Great Recession is behind them, financial institutions are experiencing historic capital levels and some of the lowest interest rates in a generation. Tim Malecha, CliftonLarsonAllen principal serving financial institutions, wonders if the lessons of the recession will have a lasting impact on the industry.
“Financial institutions are probably in the strongest capital position they have been in my lifetime,” says Malecha. He cites higher capital requirements since the recession as one reason. Community banks have also had some good years recently, with some of those earnings retained as capital. An upswing in M&A activity can be attributed to higher-than-usual capital reserves, Malecha says.
But more capital hasn’t necessarily translated to higher earnings. While institutions may have more capital than they’ve ever had, earnings haven’t followed suit. Malecha says he believes this imbalance is caused by three factors:
- The cost of complying with stricter regulations
- The lowest interest rates in a generation
- Low loan demand
Most traditional banks make the vast majority of their earnings on the “spread” between their cost of funds (typically deposits) and return on funds (lending). With interest rates so low, the spread has become compressed and this has a dampening impact on earnings. Low rates are a boon for borrowers but punitive on depositors.
Due to a lack of robust loan demand, institutions have more liquidity on their balance sheets. These liquid assets are typically moved to their investment portfolio, which is very low-yielding due to interest rates. Malecha says a gradual increase in interest rates — which may now be on the horizon — would be welcomed by most financial institutions.
M&A activity among financial institutions is picking up, although Malecha says sellers are not getting the prices of 10 to 15 years ago. A decade ago it was common to see multiples of two or three times book value; now 1.5 to 1.75 times book value is more prevalent.
Volatility is the norm, not the exception
Since 1980, the S&P 500 has been positive in 27 of 35 years, a 77 percent win rate (bars above the line in the Intra-Year Declines chart below). However, to achieve that win rate, investors had to sustain average intra-year drops of 14 percent during that same time frame (red dots). The last three years (2012 – 2014) saw intra-year drops well below the average, which is why we believe investors are feeling more despondent than the fundamentals would support. Volatility is picking up, but we believe this is normal, especially as the Federal Reserve is on the brink of raising short-term interest rates for the first time in eight years.
No one knows if the current drop in stock prices will lead to larger declines or if it will end soon. According to Dimensional Fund Advisors, a leading global investment firm that has been translating academic research into practical investment solutions since 1981, U.S. stocks historically have delivered above average returns over one, three, and five years following consecutive negative return days, which resulted in a 10 percent or more decline. It is tempting to sell after such a swift and large decline in hopes of avoiding further losses, but with millions of investors and computers sifting through information quickly, market timing is a difficult game to win. Investors who embrace dramatic stock price changes as an outcome of liquid markets are in a better position to succeed long term than those who are easily moved by declines and are inclined to act on urges.
Stick to your long-term financial plan
Managing our emotions is especially crucial during market downturns. Uncertainty about the future is a given for investors, but we tend not to focus on that during market upturns. During bearish periods, our perception of uncertainty changes and we may be motivated by fear to deviate from a long-term investment strategy. A well-diversified portfolio consisting of stocks, bonds, cash, and real estate, designed with your ability and willingness to take risk, is your best defense against down periods. Based on the sentiment indicators we are witnessing, there is a lot of fear out there. But as Warren Buffett so wisely said, “Be fearful when others are greedy, and greedy when others are fearful.”