We are in the middle of what can be affectionately called a "market correction". Actually, we are most likely way past the middle in my mind since at Thursday’s low point, the TSE was down about 15% from its July high. While many pundits are quick to call it the beginnings of a bear market (defined as a prolonged retrenchment in the index of at least 20%), RBC Dominion Securities (and yours truly) disagree.
We have all been waiting for a market correction (a pullback of at least 10%) for well over a year. Markets have been hospitable for over 4 years and corrections are needed along the way to weed out speculation and excesses. Expecting a correction does not diminish the “sting” when it happens so I thought it would be timely to comment on what has transpired over the last couple of weeks.
There are basically 2 types of bad markets. The first is based on a downturn in economic fundamentals. We don’t interpret this correction as such. The second type of bad market is characterized more by a financial “shock” to the system. By definition, a shock is somewhat unexpected although not a complete surprise. Some examples of financial shocks are The Asian Flu, the collapse of a large and prominent hedge fund (Long Term Capital) and the Savings and Loan crisis. There are others but most can remember those shocks easily. All of these shocks suspended the market’s ability to function normally. Each spawned dreadful investor fear and each time “it was different”. While unfolding, the system looked vulnerable but each time, intervention by global central banks “greased the wheels” and got things flowing again.
The current shock also has the potential to derail the bull market. But more likely we will look back at this time and put it in context with the other financial shocks. This correction will be like all of those with lots of dreadful uncertainty but reasonably short and tolerable. And when all is said and done, the markets will move forward with less speculation in the system.
So what has caused all of this volatility? I have labeled it “Commercial Paper Constipation Crisis”. Not quite as concise as “The Asian Flu” but quite descriptive and accurate. Basically, a part of the short term debt market known as Commercial Paper stopped functioning almost overnight. Buyers stopped buying and holders of maturing issues were stuck with paper as opposed to cash. These paper promises to repay likely still hold all of their value, but when things don’t go as expected, panic ensues.
Suddenly, the US housing slowdown and the suspect sub-prime mortgage lending practices (that have been discussed ad nauseam on CNBC and BNN for the last 18 months) tipped over into a “crisis of confidence”. The market became worried about the true value of any of these baskets of investments referred to as “asset backed commercial paper”.
Whenever an important part of the system suddenly seizes up (referring back to my label) the system malfunctions. In this case, the normal lenders in this massive stop lending, causing a liquidity crunch that has subsequently spilled over into the global stock markets. You may ask what one has to do with the other. Well it seems many of these asset backed investments in question were being used in Hedge Fund portfolios to provide leverage now this leverage is being unwound and stocks are being sold as the need for cash ensues. Stock prices go down quickly and fear creeps back into the system. Buyers of stocks step to the sidelines and those who are forced to sell drive prices down further. It has nothing to do with valuations or fundamentals and everything to do with the need for cash.
Fear trumps fundamentals every time. As you have heard me say before, over the short term, fear and greed drive the markets. As recently as last month, greed was creeping into the system as takeover speculation of every company (right down to the neighborhood convenience store) drove markets to their all time highs. And now the markets have swung back to being driven by fear.
Now over the long term, corporate earnings and interest rates drive the markets. So if we focus on the long term drivers, what do we see at the moment? Corporations are in the best financial health since the 1970’s. Companies have paid down their debt, raised dividends, bought back their shares and are in great shape with huge operating flexibility. The consumer is also in great shape on balance despite what you may hear or read. Household net worth is at an all time high. Everyone has a job and inflation is in check. After raising interest rates consistently for the last several years, rates have pretty much peaked and have plenty of room to go back down and keep the economy moving along. As for the stock market, for the quarter that just ended earnings growth in the S&P500 on average was 8%, almost double what was forecasted. Almost 2/3rds of the companies beat estimates. And even at the market peak last month, valuations were very reasonable (some would say compelling) and now after this correction, valuations are surely attractive.
While there will be much hand wringing about mortgage companies closing their doors, real estate foreclosures having to do with speculative excess in some markets and a few hedge funds winding up because they ended up outsmarting themselves, we will get through this period of turmoil if we keep our seatbelts snug.
Please feel free to call if you would like to discuss any of this further. Otherwise, stay tuned but not too closely!