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Jan 08, 2016

Tough Start to 2016, but Don’t Panic Yet

Bill Miller

Bill Miller, CFA:

Anxiety and fear seem to be the dominant emotions since the financial crisis as they quickly emerge whenever stocks go down, and even 6 years into a bull market with corporate profits at all time highs, margins at all time highs, balance sheets in great shape, dividend yields greater than the 10 year treasury even though dividends grew over 8% last year, household net worth at all time highs and on and on, moderate corrections seem to induce panic. The panic is not confined to the US: every major market in the world is down so far this year.

This sell-off is similar to the one we saw in the summer, and it has similar causes: worries over China and its potential impact on global growth and uncertainty about the continuing collapse of oil and other commodities. Although it has yet to reach the lows seen then (1867 on the S&P), that cannot of course be ruled out, but I think now, as I thought then, the worries are overdone. China has been botching an attempt to both lower its currency and moderate declines in its stock market via circuit breakers. The crawling peg approach to currency management rarely works and is not working now.  Better that they make the currency freely floating and convertible, which would likely lead to a 10-20% drop, a one-time spike in inflation, and a stock market that would go up instead of down. Oil and commodities are suffering the after effects of overcapacity brought on by the belief that China and the emerging markets would be a never ending source of growth. Oil has its own problems apart from that as OPEC no longer exists as a cartel and the market is now trading without a swing producer. I do think oil will be higher in a year or two, but perhaps not enough to satisfy the bulls or prevent a lot more carnage in E&P stocks, especially those that are levered.

The US economy is not great but it is sure not terrible and stocks remain very cheap relative to bonds. High Yield is attractive again, in my opinion, after last year’s sell-off, which you can see in our Income Opportunity Strategy.  I do think the market is not unreasonably worried that the Fed is in a rush to “normalize” rates which may be premature. Every rate increase by central banks since 2008 has been reversed so the idea that the Fed thinks 4 increases this year is about right as Stanley Fischer said the other day seems to a lot of folks a bit much. I agree with Larry Summers about that.

Illustrating how stocks are decoupled from evident fundamentals, ISI noted this week that their housing fieldwork indicates 8  major markets are booming and 20 more are strong. Yet many homebuilders are on the new low list, despite valuations 30 to 40% below the market for the big players and well less than half the market for the smaller ones such as KB and Beazer. All of the builders report solid demand and expect double digit growth. I mention the builders because the reigning fears about China and oil and global growth have no impact on their business, but apparently do on their stock prices.

Finally, it is completely understandable that advisors would be spooked by the worst start to a year since 1928. A week does not a year make. Stocks were up 43% in 1928.

Samantha McLemore, CFA:

What a week! The SPX is down almost 5% so far with the Dow and Nasdaq worse off, along with most major markets in Europe and Asia. The obvious reason being cited is China weakness and their missteps with market interventions (currency and equity). But the selling is broad and indiscriminate. With crude making new lows and generally negative sentiment out of Goldman’s energy conference this week, it’s no wonder there’s selling pressure there. However, Amazon announced a whopping 40% growth on Cyber Monday and has still sold off more than 10% YTD. On KBH’s earnings call today, it mentioned that traffic in Q4 was the highest since 2007 yet the ITB (homebuilder ETF) is off almost 9% YTD. The  global industrial economy is weak and shows no signs of improving. However, the US consumer economy remains strong. Employment continues to gain traction. Inflation is benign. Valuations are ok (and getting cheaper), and offer better values than the alternatives. Sentiment reaches extremes quickly. Typically, this type of environment is one to be bought if you can be patient and long-term. The main risk relates to Fed tightening with the sort of industrial weakness we are seeing. The market may need to convince the Fed to ease up. The notes from the most recent Fed meeting showed that a number of governors expressed concern about tightening with weak inflation so my guess is that they will be slow, but we can’t rule out more weakness before we see improvement. We are always looking at ways to improve the embedded upside in the portfolio (lots of ideas in here!) and we are looking at ways to hedge the risk as well. Birinyi has been the most accurate forecaster on the Street in this market and he remains confident we are in a bull market that will present ample opportunities. That is our base case as well. Interestingly, Opportunity Equity now has an 88% upside to CTV (our assessment of intrinsic value), which it hasn’t had in a few years except for a brief period in the August sell off last year.

The views expressed in this report reflect those of the LMM LLC (LMM) strategy’s portfolio manager(s) as of the date of the report. Any views are subject to change at any time based on market or other conditions, and LMM disclaims any responsibility to update such views. The information presented should not be considered a recommendation to purchase or sell any security and should not be relied upon as investment advice. It should not be assumed that any purchase or sale decisions will be profitable or will equal the performance of any security mentioned. Past performance is no guarantee of future results, and there is no guarantee dividends will be paid or continued.

©2016 LMM LLC. LMM LLC is owned by Bill Miller and Legg Mason, Inc.