The S&P 500 Index has fallen by more than 8% in the first three weeks of 2016, and international markets such as Japan, China and the U.K. have fallen into bear market territory.
It's natural to fear a repeat of the financial crisis and stock market collapse of 2008, and investors appear fearful of contagion from falling oil prices and slowing growth in China. The search term "market collapse" generates 269 million results, with headlines such as "80% Stock Market Crash to Strike in 2016, Economist Warns," "Here Comes the Biggest Stock Market Crash in a Generation," and "New Crisis Is Coming." The last search result emanates from former congressman and presidential candidate Ron Paul, author of a book titled "End the Fed"!
Our view is that this market correction is an over-reaction to current conditions rather than the start of a financial crisis or a long-lasting bear market. Here's why:
Bear Markets and Recessions
Bear markets, defined as a market decline of 20% or more, typically are associated with recessions.There have been bear markets that haven't coincided with recessions, such as in 1987 and 2011, but those bear markets reversed course relatively quickly.
Recessions Since 1970
| Primary Cause(s) | Economic and Market Impact | |
| 1973-75 | Arab oil embargo, "stagflation" | Inflation rises to critical levels |
| 1980-82 | Inflation, real estate bubble, financial deregulation | Volcker Fed tightens monetary policy; significant rise in interest rates |
| 1990 | Saddam invades Kuwait | Oil price shock |
| 2001 | Technology bubble | Stock market plunge |
| 2007-08 | Real estate bubble, over-leveraged economy | Real estate collapse, financial crisis |
We don't see signs of the imbalances that frequently cause recessions and severe market downturns, for these five reasons especially:
- Collapse of energy and commodity prices Energy and other commodity prices are severely distressed, with no turnaround in sight. However, energy is a relatively small contributor to the U.S. economy – with U.S. energy companies accounting for about 6% of the S&P 500, and oil and gas extraction employment less than one-eighth of 1% of total non-farm employment. We don't see the downturn in oil and other commodity prices as a catalyst for another crisis for the U.S. economy. Falling oil prices are an economic nightmare for the governments of Russia, Venezuela and Saudi Arabia, but are good news for oil consumers throughout the world. In the words of Oaktree's Howard Marks, "I think low energy prices today will contribute to better economic growth tomorrow."
- Slowdown in China The symbolic impact of China's slowdown is taking on outsized importance relative to the actual impact on the global economy. We expect the industrial slowdown in China to continue, creating challenges not only for China but for commodity exporters throughout the world who previously benefited from China's seemingly insatiable appetite. The Chinese government has substantial financial resources and powerful motivation to keep their economy from falling into too steep a slowdown. Thinking in very basic terms – when Americans are unhappy, leaders are voted out of office, but when the Chinese or Russian people are unhappy, more extreme events may happen. The Chinese leadership is very aware of the need to maintain social harmony, and we think they will do whatever is possible to smooth the transition to more of a consumer-led economy.
- Bank health. U.S. banks are stronger than was the case in the prelude to the financial crisis, more than doubling equity capital since 2009 while significantly improving credit standards. European banks have made less progress, but are still stronger than they were at the depths of the European sovereign debt crisis. We are, however, monitoring the troubling buildup of debt in the developing world.
- Residential real estate. Real estate, according to BCA Research, represents half the share of GDP that it had in 2005.
My wife and I went to the movies to see "The Big Short" last weekend, and I was reminded of the credit excesses that jeopardized the global financial system. I'd almost forgotten about "NINJA loans (no income, no job, no assets)," pay option loans (loans that gave borrowers the choice of payments each month), and the abundance of derivative structures (CDO, CLO, CDS) that created enormous systemic leverage. We've come a long way since 2007! There is considerably less real estate-related leverage in the system, and delinquencies are not signaling a return to the systemic stress experienced in 2007-09. Although there may be some pockets of excess, real estate doesn't seem to be a threat to the health of the U.S. or global economy. - High yield. The high yield market has been under pressure alongside falling oil prices since 2014, pressure that increased since the closing of Third Avenue Management's distressed debt fund. Delinquencies and defaults are rapidly increasing among energy and commodities companies, but the rest of the high yield market is experiencing much lower levels of financial stress. In stark contrast to the collapse of the housing market in 2007, most high-yield debt is owned by non-leveraged investors and the derivatives structure that served as an accelerant to the financial crisis in largely absent from the high yield market.
Liquidity factors may be magnifying market movements. Sovereign wealth funds pressured by falling oil prices have reportedly been selling equities. Corporate stock buybacks, which have been a meaningful source of support for markets in recent years, are precluded in the month before earnings are released. Resumption of buybacks may provide some support to markets.
