So, there I was yesterday morning, standing in a parking garage, dealing with an unprecedented loss.
I had the right mindset for any thirty-something WASP right up until then: Get work done. Make some money. Slowly and quietly prosper.
Apparently that wasn’t meant to be. Instead there was a giant gap down, and the day was ruined.
Specifically, a giant gap down had formed in the seat of my pants. They ripped getting out of my car in a way I only thought possible if there was a sitcom laugh track playing in the background.
I silently hopped back in and went home. (I still worked, lest you doubt the lingering effect of my prototypical Lutheran upbringing.)
There was, of course, that massive 1,000 point Dow Jones drop too. Though one loss is mundane and the other is profound, there are some parallels here.
There is the “be prepared angle.” There is also the “this will become a buying opportunity” one, but my $70 Gap purchase won’t do much to counteract the company’s languishing performance, so that is a bit weaker.
However, this week I’m writing two editorials back-to-back, something I haven’t done in a while, and I shared my version of sage advice regarding those yesterday.
Instead, I’m thinking it is time to step back and turn a critical eye to what is starting to happen as this situation evolves. It ain’t pretty.
Bad Narratives
There is an emerging narrative building up out there that the Chinese meltdown is to blame for this mess we find ourselves in.
As far as I’m concerned, this line of thought only serves to give the U.S. market a whipping boy, and a convenient absolution from the blame it deserves.
Yes, China — if through sheer demographics — is a major part of global economic growth. Something like 16% of the global economy too.
If its GDP growth drops from the always suspect 7% figure it trots out, it will put a large damper on the growth of the global economy.
However, any opinion that doesn’t include the phrase, “the straw that broke the camel’s back” is lacking.
The omnipresent Jeffrey Gundlach didn’t add those words when he stated to Reuters:
“China is supposed to be the engine of global growth. The real key here is if China’s 7% growth rate is weaker than that. What if it’s around 2%, which means global growth could very well be 1%? There is a knock-on effect and every country would have to downgrade their growth projections if China is really that weak.”
That concern is nothing new at all. It has been around for years. It became worse while China papered over a massive surge in loan defaults, many moons ago.
China’s shadow banking sector is particularly exposed, holding what the IMF estimates is $3.2 trillion worth of loans, or 35% of China’s 2014 GDP.
Massaged data and massive interventions that defy belief are par for the course, and have been going on for years.
After all, major U.S. corporations do not have much of a direct link to the Chinese economy. It is estimated at 1% of U.S. economic output, if that.
Unless you’re holding shares of aerospace and large machinery companies (looking at you, Caterpillar), it isn’t enough to warrant a drop of 9.5% five trading days, let alone 11.5% at yesterday morning’s bottom, in any position, let alone the Dow index.
Plus many other indicators look pretty good. In particular, wage growth is around 10%, and the service sector is expanding at over 8%.
The China situation is partly to blame, but it is hardly the worst offender.
The simple fact is, the root cause of what is happening in the U.S. market can be explained by what is happening at U.S. corporations.
Control Freaks
Growth hasn’t justified how expensive stocks have become, and instead of reinvesting in capital growth and revenue expansion in a way that would create a long-legged virtuous cycle, the market demanded, and got, the quick payout.
Share buybacks, which I’ve decried many times (here, here, here, etc.), and the Fed have far more to do with the correction than many can bring themselves to admit.
Back on July 21st, I wrote: “That [buyback] money, in the face of a correction (like in the energy sector) or shrinking earnings, adds an extra layer of consequences for investors.”
Welp, now 80% of companies that bought back shares in the past year have effectively lost money on their investments. Plus, there is still plenty of downside before we get back to normal territory.
Just look at sky-high median enterprise value vs. earnings before interest, tax, depreciation, and amortization, fresh off the presses:
Or, if you prefer, the Shiller price-to-earnings ratio, still far from the 16 median:
So the market that was trained over the course of six years to stay calm and keep buying suddenly realized it has been paying too much for too little.
Then it looked to the Fed and saw no quarter. The threat of a 0.25% (which would put the Fed funds rate at a mere 0.4%) increase looms. At the same time, all of the Fed’s other tools to drive the market are exhausted.
The illusion of control is gone, and the harsh reality of a future without the steady, guiding hand of a central bank and endless QE sets in.
China’s flare up is just coming at the wrong time for us. It is not the cause. U.S. market investors are to blame.
Neatly placing blame on China is the beginning of a narrative flawed by rampant delusions. This is our one chance to collectively relearn that we are vulnerable and the party can’t go on forever.
This bad narrative is coming from control freaks who are trying to keep a tight grasp on the infallibility of this unprecedented American bull market by trying to maintain the belief that the problem is external.
But the U.S. market is deeply flawed, and if we fail to wholeheartedly accept that, this will only be the first time wild panic and rapid selling seem to come from nowhere and hit us hard.
