There’s never a good reason to panic in investing, but the 276-point slide in the Dow Jones Industrial Average (DIA) January 4, the worst start to a year since the credit crisis in 2008, reminded us why we hold more than a 30% cash position in both newsletter portfolios at the moment: with a US stock market still near all-time highs, we like having ample capital available to scoop up bargains as stocks inevitably give back some of their gains.
The question for us is not whether the broader US stock market will decline from here but whether such a decline will be 10%, 20% or more. After all, the S&P 500 (SPY) has essentially tripled from the March 2009 panic bottom. What’s a rather “meaningless” 10% or 20% drop? If a move of this magnitude may frighten you, it may be a good time to think about your risk tolerances and talk over your equity allocation with your financial advisor.
The latest reading in Caixin Purchasing Managers’ Index (PMI), a gauge of manufacturing activity in China (FXI), confirmed that a slowdown in the pace of emerging market growth and even greater pressure on commodity prices are key themes to be mindful of in 2016. We believe slowing emerging market demand and corresponding pressure on developing countries’ currencies make for a very troubling situation. Several of the weaker steel mills in China have been under significant pressure for some time, and we posit the Chinese banks have yet to feel the true impact of the commodity price slowdown. We continue to watch prices in residential real estate markets in China very closely, and needless to say, we remain skeptical that China’s housing markets are as healthy as government officials make them out to be, as local stock exchanges in Shanghai and Shenzhen, for example, experience nothing short of crashes.
The Chinese manufacturing PMI fell to 48.2 in December, down from 48.6 in the previous month, marking the tenth straight month of contractionary activity (anything less than 50 represents a slowdown). Despite the weakening activity, however, official government readings of China GDP still indicate a country growing at 6%-7% or more, a figure we simply have trouble believing in earnest. Apple’s (AAPL) iPhone is selling well in the country and Alibaba (BABA) has a long runway of e-commerce growth ahead of it, but it’s likely the dislocations in the local Chinese equity markets we witnessed during the summer months of 2015 are probably only starting to seep through into managerial planning for 2016. Local Chinese equity markets fell at such a rapid pace January 4 that the both the Shanghai and Shenzhen exchanges were halted at declines of 6.95% and 8.25%, respectively.
We noted through the summer months that the local Chinese markets were far from genuine, with activities ranging from indirect government intervention to direct purchasing of stock by the state. The local Chinese markets have not reflected true price discovery for some time, in our view, and our willingness to retain risk in markets we’ve grown more and more uncomfortable with has waned. With much of Chinese political willpower and economic firepower used to prop up local Chinese markets several months ago, we’re starting to think a fallout is becoming more and more likely as government resources have deteriorated. From our perspective, local Chinese equity markets should not be gyrating at near-10% daily ranges, and the spillover effect on equities from Alibaba to Baidu (BIDU) to JD.com (JD) and Sohu (SOHU) has become severe. We plan to remove Alibaba from the Best Ideas Newsletter portfolio, a long-term holding we’ve decided we’ll part with early. Expect an email newsletter alert if we get a sufficiently strong updraft in the markets this week.
Though we can’t possibly read too much into the Chinese manufacturing PMI for December, the data in conjunction with a wide variety of other indicators leaves us less enthused about much of our commodity-dependent universe, not the least of which is iron ore. The collapse of two dams has put BHP’s (BHP) and Vale’s (VALE) backs against the wall, and while we continue to prefer Rio Tinto (RIO) out of the three, it’s time for us to move on from this “valuation” play. The spot price of iron ore plunged to a record low December 11, to $38.30/ton, and the modest bounce into the low- to- mid-$40s is hardly worth getting excited about, in our view. The big three in iron ore have slashed their capital spending plans, much to the dismay of construction equipment makers Caterpillar (CAT) and Joy Global (JOY), but unless overproduction alleviates, and we see increased stability in emerging markets, pressures across the mining space will likely continue. Rio Tinto will no longer be a holding in the Best Ideas Newsletter portfolio if we get a nice bounce in the equity markets this week.
Though tensions between Iran and Saudi Arabia have reached a fever pitch and the export ban on oil in the US has been lifted, with implications still yet to be seen, US commercial supplies in the US remain at 80-year highs and OPEC continues to produce at a breakneck pace. We just got word of the 40th North American E&P entity to file for Chapter 11 in the US, Swift Energy (SFY), and capital spending cuts of another 20%-25% by most of the US oil and gas complex (XLE) can be expected in 2016. The credit rating agencies are expecting defaults to surge, and with half a trillion needed over the next 5 years to keep the domestic oil and gas markets afloat, the outlook appears grim for equity holders. With its integrated business and pristine credit rating, ExxonMobil (XOM) may be the only true safe haven in the space.
Bankruptcies continue to increase and crude oil prices continue to fall, with Brent and West Texas (USO) now converging in the mid-to-high $30s per barrel, but almost haphazardly, midstream equities continue to raise their financially-engineered payouts. Enterprise Products Partners (EPD) raised its quarterly distribution a mere 1.3% January 4 and recommended the board hike the payout another 5% in 2016. The die-hard MLP (AMLP, AMZ) crowd loved it, but we continue to cast a skeptical eye on how long the debt and equity markets will keep fueling the payout. Most midstream MLPs do not cover distributions with free cash flow, and unlike traditional corporations, use external funds to pay the distribution. How long before the external financing markets simply say no? We won’t be sticking around to find out as long as energy resource pricing continues to dive. Executive teams are pulling out all the stops to keep the “distribution” merry-go-round going, it seems.
We’ll have a significant amount of “dry powder” just waiting for the market to come to us, and we’re fairly excited about what bargains might be had. We’re watching Chipotle (CMG) especially close for the Best Ideas Newsletter portfolio and Cracker Barrel (CBRL) for the Dividend Growth Newsletter portfolio, and we’re not against adding incremental utilities (XLU) exposure to both newsletter portfolios in the event markets truly nosedive. These conditions are ripe for the “stock picker” but patience will win the day. There’s no reason to pull the trigger early, if lower prices can be had.