By Byron Wien
All through the summer, the U.S. equity market made new highs in
spite of increasing turbulence around the world. The economy was
continuing to grow modestly, earnings were coming through and the
geopolitical problems were a long way away.
The Ned Davis Crowd Sentiment Poll, which includes transactional
data like the put-call ratio, showed that investor mood was very
optimistic. Historically, the market is vulnerable to a correction
when optimism is extreme. You don't know what will cause the
sell-off, but you have the uneasy feeling it's coming. The market
had gone through two years without so much as much as a 10%
correction and we were due for one.
Identifying the precipitating event is hard and probably
unimportant. A few of the geopolitical problems had actually cooled
somewhat, albeit temporarily. Russian troops had pulled back from
the Ukraine border; there was a cease-fire in the Israel/Gaza
conflict; the Iran nuclear talks weren't making much progress, but
they were continuing; and in the South China Sea issues had quieted
down for a while. However, the situation in Syria and Iraq, which
had been invaded by the Islamic State of Iraq and Syria (ISIS),
remained serious. The two threats that may have unsettled investors
were the possibilities that the Ebola virus might spread to Europe
and the United States and that the economic slowdown in Germany
might abort Europe's weak recovery and bring the continent back
into recession.
The decline in stocks gained intensity as it moved along, with
many days down 1% or more on the Standard & Poor's 500. Rallies
gave way to further declines and eventually the market fell almost
10% before prices stabilized. The correction did pound some of the
optimism out of investors' minds. The Crowd Sentiment Poll dropped
from optimistic into pessimistic territory, setting the stage for a
rise in the market through year-end. There may be further declines,
but in my opinion the worst is over. I believe that this was a
necessary correction and not the beginning of a bear market.
Sometimes, the market is smarter than all of us participating
investors and a sharp downturn precedes a recession by about seven
months. I do not think that was the outcome signaled by the
September/October correction. The U.S. economy is actually doing
quite well. Real growth is expected to be approaching 3% in the
second half of 2014 and growth of 2.5% to 3% is expected to
continue into 2015. The economy usually provides some warning
signals before a recession occurs. According to an Omega Advisors
study, danger is signaled when the yield curve is inverted,
unemployment claims are rising, personal income is down, consumer
confidence is falling, industrial production is declining, and/or
inventories are increasing. Virtually none of these indicators are
giving a warning signal now. There have been some notable earnings
disappointments (including IBM, Amazon, AT&T, McDonald's and
Coca-Cola), but Apple, Caterpillar, Microsoft and others did well.
More worrisome is the shortfall in revenue growth, and because
margins are no longer increasing, net profits have only improved
modestly. Companies have continued their share buyback programs,
however, and this has played an important role in earnings per
share growth. That is expected to continue.
I believe we are in a prolonged period of slow growth in the
United States, Europe and Japan. As a result I think a favorable
environment for stock prices could continue for several more years.
In my mind, valuations are not excessive and equities can
appreciate in price in accordance with earnings increases. I do not
expect much in the way of multiple expansion, except perhaps at the
end of the cycle when everyone becomes comfortable that the good
times are going to last forever and nothing is ever going to go
wrong. That's when the "animal spirits" take over.
During the decline, there was wide suspicion that the end of
Federal Reserve monetary accommodation in October had something to
do with it. The balance sheet of the Fed was $1 trillion in 2008.
It is over $4 trillion now. There is general agreement that easy
money was a factor in the rise in the stock market over the past
five years as well as the low level of interest rates. Accordingly,
the end of the tapering process was pointed to as one of the causes
of the decline. In addition, there was continued speculation about
when the Fed was likely to start raising interest rates. The
consensus had been that the first rate rise would occur in the
middle of 2015, but the recent decline in the stock market, along
with low inflation, some soft economic data and continuing high
unemployment, has caused many analysts to think the Fed may act
later rather than sooner. My view is that there is little reason
for the Fed to raise rates anytime soon, and when they do finally
act, they will do so very gradually.
A Fed increase in rates has been so well advertised that it may
not have the deleterious impact everyone seems to fear. In the
period 1950--1980, an eccentric market analyst, Edson Gould,
developed the "three steps and stumble" rule. This was based on the
observation that it took three increases in Fed rates before the
market impact became severe. A study by Omega Advisors showed that
on average the market does not decline significantly until 29
months after the first rate hike.
In October, I spent a week in the Middle East to visit clients
and get some feeling for the mood there. It was not cool in terms
of temperature -- in the high 90s minimum every day -- but there
was no sound of artillery in Qatar, Saudi Arabia, Dubai or Abu
Dhabi. I would like to say there is a consensus on Israel/Gaza or
Syria/ISIS/Iraq, but there is not. I did observe that the conflicts
in the region are not a part of everyone's daily conversation in
the places I visited. Most of those living there are focused on
economic opportunity, and the price of oil is more important to
them than the fighting in the western part of the region. A range
of opinion exists on what price is necessary for Saudi Arabia and
others to finance their domestic activities. Some believe $80 will
do it and there are estimates as high as $110. Oil is priced in
dollars and the strength of the American currency has obviously
increased its purchasing power. The prevailing view is that the
price of oil is generally influenced by cyclical factors. Since the
economies of the United States, Europe and China are slowing, you
would expect weaker demand to be reflected in the oil price. North
America is also becoming more energy self-sufficient as a result of
hydraulic fracking and conservation. The emerging markets, where
the incremental demand is expected to come from, are not growing as
fast as they were previously. On the other hand, the expanding
middle-class throughout the developing world will want motorized
vehicles, and this will drive future prices higher. In the meantime
the present price is sufficient to finance current operations in
the producing countries. If some capital projects need to be
deferred because of insufficient funds, it is not a great
tragedy.
Turning to the major geopolitical issues in the region, most
expect Iran to have a nuclear weapon eventually. In the current
negotiations they will keep deferring deadlines by a few months
until they are finally within weeks of producing a nuclear device.
Their hope is that if they stop short of processing an actual
weapon they can defuse the issue and justify some sanctions being
lifted. Iran is using its willingness to financially support
American efforts to combat ISIS as a way to move the nuclear
negotiations forward on terms closer to their objectives. People in
the region view Iran as a potentially great commercial opportunity
with a modern, well-educated population yearning for a higher
standard of living. The clerics are holding the country back, but
that restraint is not expected to continue indefinitely. If Iran
does have a bomb, it does not seem a threat to their Middle East
neighbors. There are countless Iranians everywhere in the Middle
East and their countrymen don't expect to be harmed by them. There
is some concern about the arms race that might be precipitated by
Iran having a nuclear weapons capability. That would destabilize
the region somewhat but nobody in these countries expects the
weapons to be used and if they are, certainly not on them.
The Israel/Gaza hostilities are viewed as a civil war that is
likely to go on forever. It is totally separate from the
Sunni/Shiite conflict. Hamas will never accept Israel's right to
exist, and wants a right of return for former residents and a
restitutions of all the pre-1967 territory. Israel will never
withdraw from all of its West Bank settlements. There will be
periodic cease-fires, but peace will prove to be unattainable.
There is the feeling that as long as Israel is preoccupied with
Gaza, the likelihood of a strike on Iran's nuclear facilities is
reduced.
If there were any geopolitical issue that troubles those living
in the Middle East, it is the rise of ISIS. This is a more
formidable military force than has ever been seen in the region
with the exception of Israel. What's more, ISIS has been effective
in using social media as a primary tool to recruit combatants from
all over the world who are willing to fight to create an Islamic
caliphate in the region. For disaffected young people with limited
economic prospects, the opportunity to do what they perceive as
God's will and get paid for it, while fighting beside others who
believe fervently in the good of their efforts, is very appealing.
Airstrikes have blunted ISIS encroachment in Syria and Iraq, but
there has been no successful effort to retake territory that ISIS
has already gained. That can only be done by troops on the ground.
So far Kurdish forces have prevented ISIS from taking over the city
of Kobani on the Syrian border and some moderate Syrian rebels have
neutralized ISIS advances in Syria, but the idea that troops from
moderate Middle Eastern nations like Jordan, Turkey and Saudi
Arabia might be sent to Syria and Iraq to
fight ISIS has gone nowhere. I got the feeling that no country
(especially Saudi Arabia and the United Arab Emirates) in the
Middle East, other than those already committed, wants to get
involved militarily in the conflict with ISIS. There is no appetite
for losing lives to defend another country in anticipation of
preventing the problem from spreading to your own territory.
Even though descended from Al Qaeda and therefore Sunni-based,
ISIS is viewed in the Middle East as a terrorist organization.
There is general agreement that it must be stopped and both Saudi
Arabia and Iran (not often on the same side of an issue) are
funding the opposition. Financial support for ISIS is reported to
come from independent sources in Qatar, Saudi Arabia and Russia, as
well as the oil wells in Syria that their troops have captured. The
Syrian rebels are effective but have limited weaponry. Iraqi
military forces are inexperienced and need more training. American
advisers in the region believe it may take as long as two years to
mount a fighting force strong enough to retake territory already
gained by ISIS. The United States could accelerate this process by
sending a fighting force, but President Obama has already ruled
that out.
At this point, nobody expects ISIS to move beyond Syria, Iraq
and possibly Afghanistan. In the places I visited there is concern
but not fear. Observers in the region are disappointed that the
United States has not played a broader role. They believe that the
U.S. is not willing to back up our "red lines" after witnessing our
failure to act when Syria used chemical weapons against its own
people and when Iran moved forward with its nuclear weapons
development program. The foreign nationals and the local citizens
in the Middle East have a fatalistic attitude. They are used to
living in warlike conditions and general adversity is part of the
way of life there. They know that ISIS is a threat, but believe it
is not likely to affect them over the near term. Right now they are
more concerned about the price of oil and the direction of the
financial markets.
Wien is a senior adviser to Blackstone Group, a global private
equity and asset-management firm.
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