More Quarterly Investor Letters

See More

The total return of the S&P 500 in the Third Quarter was -6.44%.  From its recent high on May 21, 2015 to the low on August 24, 2015, the index suffered a correction of 12.35%.  This marks the first correction of greater than 10% since 2011.  The catalyst for the correction was a surprise announcement that China was devaluing its currency.  Traders reacted in a typical sell first, ask questions later fashion.  Immediately, market pundits and financial media promulgated theories of economic collapse in the world’s second largest economy.  Doomsday scenarios involving currency wars and emerging market debacles grew in popularity.  China’s action damaged investor confidence, evident in sharply rising volatility.

Adding fuel to the fire of uncertainty, our Federal Reserve opted to remain on hold with respect to interest rate policy changes at its September meeting.  For the past year, the financial media were pre-occupied with the probability of a Fed rate hike in 2015.  There were grave concerns that a tightening of monetary policy would lead to a sharp stock market selloff and economic slowdown.  Citing confidence in the domestic economy but concerns over global market conditions, the Fed decided at its September meeting to defer the first rate increase.  We also suspect the Fed was somewhat concerned about the possibility of a government shutdown.  Ironically, the Fed’s decision to remain on hold contributed to market volatility as investors seemingly inferred that conditions in China must be worse than initially feared.

Crowded out by the focus on China and stock market volatility has been positive news flow on the US economy.  There is compelling evidence that our domestic economy is gathering strength.  The labor market seems healthy; incomes have been rising.  The final revision to Q2 GDP was 3.9%, a large increase from initial estimates of only 2.3%.  Much of the upward revision relates to strong growth in consumer spending. Both residential and non-residential construction activity have been robust.

The stock market has ignored economic data for the past four months.  Instead, it has been correlated with crude oil prices.  When they rise, the stock market rises with it, and vice versa.  The decline in crude oil prices since October of last year has been interpreted as an indication that many emerging market economies are in decline.  Several emerging markets are rich in natural resources, and their principal source of economic growth was to supply China in its decades-long infrastructure boom.  It is now clear that China’s transition from investment led growth to domestic consumption is causing global repercussions.  In many ways, China brought forward years of demand, but its suppliers needed to invest heavily in capacity to fulfill their needs.  Consequently, as China’s demand has waned, the world is now awash in excess capacity in many areas, especially commodities.

The world had adjusted to $100 oil.  High prices encouraged investments in supply, and there was a great deal of global activity associated with energy infrastructure expansion.  For low cost producers, high oil prices also provided large financial windfalls.  The accumulated wealth of oil producing nations, particularly those in the Mideast, facilitated expansion of social programs.  These “petrodollars” were also invested abroad.   With the decline in oil prices, the ability to fund enlarged budgets has become more challenging.  Petrodollars, once used for long term investment, are now being liquidated to support short term fiscal needs.  As oil prices rose over the past decade, there was transference of global wealth from oil consuming nations to oil producing nations.  That process has now reversed.

Many experts have been critical of the economic recovery since 2009 as it has favored Wall Street over Main Street.  With full employment in the US and the collapse in commodity prices, we believe that economic conditions are finally becoming more favorable for the average American household.  For instance, consumers tend to be skeptical of low fuel costs, assuming them to prove transitory.  As low fuel costs persist, that skepticism eventually wanes.  Over time, low energy prices provide a significant boost to the US economy given the high marginal propensity to consume.  We expect that the benefit of low commodity prices will become more apparent as time goes on and as fuel costs remain low.

Distracted by a plethora of negative headlines, we believe that investors are losing sight of the fact that much is going well both in our economy and in the market.  The housing sector is gathering momentum.  Sectors that benefit from low energy prices are performing well, and consumer oriented sectors are providing leadership to the market.  While there are pressures in our manufacturing sector, especially among global industrial conglomerates, the services sector is growing at an impressive rate.  Likewise, in China, there is intense focus on industrial activity, but there has also been rapid growth in its services sector.

We expect that technical forces and momentum will continue to drive short term market activity.  For long term and patient investors that appreciate the benefits of periodic corrections, we consider current conditions an opportunity.  Economic fundamentals remain intact, and the current period is similar to 1998 and 2011.  In both of the prior periods, global economic disruptions contributed to stock market corrections of 20% and 18%, respectively.  However, underlying strength in the US economy was not threatened then, and we have a high degree of confidence in the resilience of the US economy today.