Letter to Clients.

I want to give you a quick update on what happened last week in the stock market and to give you my thoughts on what may come next.  In the short run it is possible that stocks will experience more volatility.  World markets sold off dramatically again overnight and our markets are going to experience a large sell-off at the open. Probability suggests that markets will take some time now to heal themselves from the damage inflicted in the past few days.  Never the less current economic data still indicates that the US economy is growing, probably in the 2-3% range. We will not change our view that stocks can continue their longer-term advance over the next 6-18 months as long as these economic conditions in the US persist.  We think this is the beginning of a normal correction, made more painful perhaps by the fact we haven’t seen one in about four years.  Because our fundamental view of the markets has not changed we will look to market weakness to add selectively to ETF positions in our universe that we find attractive.  This is the short version of our thoughts.  Read on if you want a longer explanation of what we think.

The immediate cause for last Thursday and Friday’s decline actually began the week before when China staged a surprise devaluation of its currency.  Because this devaluation was unexpected, markets reacted negatively.  The move along with this summer’s decline in Chinese stocks was seen as confirmation that their economy was weaker than had previously been acknowledged.  China’s slowing economy has been putting pressure on emerging market countries that export commodities such as copper and iron ore.  China has for years been a huge buyer of commodities such as these but has now scaled back on these.

The decline of oil is also weighing on the markets.  At first glance this would seem counter-intuitive as lower prices here at home {particularly at the gasoline pump} are seen as a good thing. But the 60% decline in oil has decimated energy company’s balance sheets and the budgets of exporting countries that rely on higher prices to fund their governments.  The implications of this decline have been eating away at markets both here and abroad all year.  US energy company’s earnings declines have impacted S&P 500 estimates while lower oil has the potential for political and economic instability abroad. 

China’s devaluation brought into focus these concerns and gave investors on the fence an excuse to become more bearish.  This is also all coming to a head in August, the peak vacation season when “Wall Streeters” flee to the beach and markets trade thin.  We’ve discussed with you many times in the past that late summer through October is statistically the weakest period of the year for stocks and so this news couldn’t have come at a worse time.  All of this seems to have caught up with investors and gave us the poor trading sessions we saw Thursday, Friday and over the weekend.  With that as a backdrop let’s discuss what we think is likely to happen next and what we are thinking about your investments.

There is a higher possibility that markets will stage some type of advance this week as we are oversold enough in the short-term that a snap-back rally could occur.  However, there is enough evidence now to suggest that markets may have entered a period of heightened volatility and it is also possible that markets will have to move lower in the intermediate time period before a more sustained rally is possible.  Our markets have spent most of this year locked in a relatively tight trading range, capped to the upside by valuation concerns, with a growing American economy providing a floor to each sell off.  However, that trading range was violated to the downside this past week. That technical damage will likely take some time now to be repaired.  While we are starting to see pockets of valuation emerge, money flows, by our work, do not yet show markets or the majority of our ETF universe to be oversold to the point where we historically have seen a longer term rally. 

Investors want to know if we are on the cusp of something worse.  Are we looking at a market that has the potential to see a much more significant decline, something like the two bear markets we experienced in the last decade? While there is no way of knowing what will occur, the current weight of the evidence suggests this is unlikely.  We would become more concerned if current data was showing evidence of a slowing economy.  Instead what the tealeaves indicate is slow but steady growth.   So far the US has avoided the global slowdown and we think there is a strong likelihood that will continue to be the case.  Of course the markets get the ultimate vote and we will change our opinion if the evidence starts to accumulate the need to do so. In regards to long-term growth, I’ll reiterate part of what we said in our last investment letter to you,

“The weight of evidence continues to suggest that the US economy is still in expansion mode.  Strength in the dollar, muted global demand and lower oil prices has put a crimp on growth.  This has hurt the industrial and energy sectors as well as businesses that rely on exports.  However, lower oil and a higher dollar have muted inflation and has been positive for consumers.  That should sustain domestic demand. 

Our longer-term view of the markets remains positive and is roughly the same as it has been for the past few years.  We believe that there is still compelling evidence that the US economy continues to expand. Employment is increasing on average by nearly 200,000 persons per month.  Americans are voting with their wallets. Car sales for example are still showing solid gains and there are no empty seats on airplanes.  We are still of the opinion which we have reiterated in the past that positive demographic trends, revolutionary developments in energy, continued advances in productivity as rooted in the efficiencies of the knowledge based economy and the continuing age of innovation that we have dubbed the “era of miniaturization” are all longer term positives for the economy.”

We have on average made more sales than purchases in accounts this year and now have higher levels of cash depending on our investment strategies and client risk/reward mandates. We have also reviewed portfolios in terms of asset allocation and will make changes if necessary.  As we’ve said in the past, we have the defensive pages of the playbook handy right now.  Absent a change in the underlying fundamentals, we’ll use the current weakness to add to positions that we believe have reached attractive price levels on a risk reward basis.  In particular we are interested in ETFs with attractive dividend yields and ETFs where prices are compelling due to their business fundamentals.  We will unlikely catch the exact bottom in these prices but will make purchases where these ETFs are showing appreciation potential on a 6-18 month time horizon.    

  

Finally I would like to say something about our work with Exchange Traded Funds {ETFs}.  We use ETFs because we believe that their attributes {low costs, exposure to equity markets without single stock risk, diversification, etc} make them compelling investments especially for individual investors.  However, ETFs will go down when markets decline.  We have disciplines that call for us to raise cash under certain circumstances, but client portfolios will never be 100% out of the markets.   When markets decline as they did last week then your account will also experience a decline.  We know of no method that exposes clients to the market’s gains without some exposure to volatility when stocks decline.  If Warren Buffet can’t figure out how to do this out than neither can we.  However ETFs do take the risk of you betting on the wrong stock horse off the table.  CNBC stated last night that currently 66% of the S&P 500 is in correction mode. That means that 66% of these stocks are down over 10%.  Many stocks are down much more than this.  The S&P 500 itself is off 7% from its highs and down something like 2% for the year as of this writing.  Investments based on an index will eventually find some level where valuation, fundamentals and sentiment will lead to a rally.  That is not always the case with an individual stock.  Because we know that these levels exist, we can develop strategies for dealing with markets when they experience a decline.  These strategies have proved valuable to us in the past and we believe we will get that opportunity again in the next few months or perhaps sooner.

*Long ETFs related to the S&P 500 in client and personal accounts.