Monday, August 24, 2015

August 24 2015 Special: Volatility + Fear is a good combination for long term investors

What exactly happened today? Near the open, the futures were pointing to a negative start to the day but nothing too extreme. The S&P 500 was down 2-3% but the decline accelerated to near 5% at the opening bell. Stocks rallied heavily until losses were less than 1%. However, by the closing bell, stocks began to show losses again with major indices closing about 4% lower. A ride of down 5%, up 4% and then down 3% in a matter of 6.5 hours is not normal. It's no wonder that the CBOE VIX Index, nicknamed the "fear gauge", soared to levels not seen since spring of 2009 (even higher than the U.S. debt ceiling crisis in 2011). Fear was evident in the market.

Potential Explanations:
Most market commentators and analysts would point to China, which set the stage for today's turbulence. The Shanghai Composite lost another 8.5%, erasing most of the gains it made this year. The fact that the government was unable to stop the market from declining, even with hundreds of billions of dollars pumped into the system, made investors extremely nervous. With the recent Yuan (RMB) devaluation and a slowing PMI number that came out late-last week, investors worry that a Chinese economic slowdown would significantly impact global growth. 

Investor's fear about China also leads them to evaluate some of the other potential negatives in the market such as weak earnings growth and the negative effects from oil's rapid decline from $60 (late June) to below $40. The large capital expenditure reductions by many energy companies have been impacting growth numbers in Canada and as well as United States. The high yield market has also been hurt by the increased distress in energy names and we just saw the bankruptcy of Samson Resources last week. 

Investor's confidence was pretty shaky to begin with. After a 8.5% decline in Chinese markets and the continued decline in oil, many investors would prefer to sit this one out and run for cover. 

A Lehman Moment:
Some analysts argued this could a Lehman moment brewing. I think that's an overstatement. 

First, the fact that the Dow dropped 588 points - more than the 508 point it lost on September 15,2008 after Lehman was bankrupt - doesn't mean we're in a crisis. The index was at a much lower level back then and in percentage terms, today's 3.6% decline was much lower than the 5% decline on September 15, 2008. 

Second, it's important to understand that the Lehman failure caused a credit crisis, not a stock market panic. The credit crisis stopped the credit market from functioning properly, a key criteria for a prosperous economy. When money markets, which are suppose to guarantee your principal, lose money (due to Lehman debt), that's when credit/bond investors get really nervous and essentially refused to re-finance the money market, which eliminated liquidity of many corporations. With no liquidity to pay bills, even corporate giants like GE and Honeywell faced bankruptcy even with enormous assets and future cash flow generation ability.  

It is worth noting that a credit crisis is less likely now because:
  • Better Bank Balance Sheets: Due to the new Basel III banking regulations, the need to deleverage balance sheet became important. Many banks already got ahead of regulator's time schedule of the Leverage Ratio (basically an asset to capital multiple) implementation and sold off risky assets to meet that new rule. Because banks are important credit and liquidity providers to the financial system, healthier banks means lower chances of a credit crisis. 
  • More liquidity at the banks: This point is very important. Before the financial crisis, many banks borrow extremely short funds in the repo market. When the credit markets froze, they couldn't refinance and faced a cash crunch. However due to new Basel III rules on the Liquidity Coverage Ratio, banks are holding liquid assets enough to fund cash outflows for a minimum of 30 days to a maximum of 1 year. This new rule reduces the risk of bank failures and decreases of credit in the economy. 
  • High Yield Spreads Looks Reasonable: High Yield spread provides a good signal to credit distress. Before the Lehman failure, the BoAML High Yield Masters II's OAS was about 850 basis points. Today, it was only 586 basis points before the big drop today. After factoring the credit distress of certain energy names, the overall high yield spreads looks reasonable.  
  • Libor-OIS spread also OK: The Libor-OIS is one of the best indicator of credit conditions. Libor is the interbank interest rate paid by banks while OIS is the Overnight Index Swap that is based on risk free instruments like the Federal Funds Rate. Despite the recent controversy with Libor, it still showed the cracks of the financial crisis of 2008 way before Lehman's failure. The spread was well over 150 basis points before Lehman failed. It's now at 30 basis points. While that figure is slightly high, it is not high enough for a credit crisis. 
While there is spillover risk from China, I think the Chinese government can be more effective stabilizing the economy than the stock market. It'a command economy and the government controls major credit sources like the banks. The reason that it failed to stop the stock market decline was because it was simply too hard to stop emotional retail investors (90% of the market participants) from rushing out at once. Chinese retail investors are clearly panicking but investors in developed market should be more mature and not let the panic in China cloud their judgement. 

A Logical Course of Action:
"Be fearful when others are greedy; be greedy when others are fearful"                    Warren Buffett 
After seeing the markets down over 5% with some names down more than 10%, my first reaction was to pull out cash to buy. Crazy? I don't think so.

My contrarian reaction was built over time. I was quite scared during the financial crisis seeing stocks dropping more than 10% in one day.  However, as I observe the market fluctuations over time and understand a company's fundamentals more, I have more reason to believe that investors should listen to Buffett's famous quote.

The illogical course of action would be to sell during these large market panics, provided that your holdings are of good quality. The illogical course of action was actually a result of our primitive senses.  Back in the caveman days, when one person sees a crowd running for whatever reason, that person would assume that the crowd is right. For the person that ran with crowd, he or she could have avoided being someone else's dinner. Even in present day, this social proof effect is still powerful as shown by Robert Cialdini (highly recommend his book "Influence"). Thus in the financial markets, when an investor sees everyone selling, the most logical sense is to sell as well. But that's exact the wrong course of action.

The reason is a stock is not a ticker that trades on an exchange. A stock is a fractional ownership in a business that produces cash flow and profit. Most of the time, a major stock decline does little to impact company's future earnings power in the long run.

It's also worthwhile to review my favourite paragraph from Ben Graham's The Intelligent Investor about "Mr.Market":

Imagine that in some private business you own a small share that cost you $1000. One of your partner, named Mr. Market is a very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly. If you are a prudent investor or a sensible businessman, will you let Mr. Market's daily communication determine your view of the value of a $1,000 interest in the enterprise. Only in case you agree with him, or in case you want to trade with him... the rest of the time you will be wiser to form your own ideas of the value of your holdings on full reports from the company about its operations and financial position (p.204-205)
Today, Mr. Market decided that some of the stocks I like are suddenly valued 10% lower because he was a bit moody. Most of time I do nothing but I did what Ben Graham said an Intelligent Investor should do when there is high market volatility such as a day like today's:
Basically, price fluctuations have only one significant meaning for the true investor. They provide him with an opportunity to buy wisely when prices fall sharply and to sell wisely when they advance a great deal. At other times he will do better if he forgets about the stock market and pays attention to his dividend returns and to the operation results of his companies. . (P.205) 

In sum: Volatility + Fear  = Opportunity

As Ben Graham stated many years ago, price fluctuations' main purpose is for investor to buy cheap and sell dear. It is not a negative thing as many investor think. In fact, if you are not close to retirement and in your accumulation stage, you should prefer declines over advances. If you love a 10% sale in the mall, why is that feeling different in the stock market? 

Of course, not all stock is a buy but today's selling was pretty wide spread, even in high quality stocks. Selected buying based on fundamental and patience will reward investors in the long run. Instead of viewing the high volatility as a negative thing, I think investors should change their prospective and think that Volatility + Fear = Opportunity. Of course, the volatility won't end that quickly and declines may continue but patience will be key riding out the storm.  

I'll end with an excerpt from Buffett's 1997 letter in a section called "How We Think About Market Fluctuation":

A short quiz: If you plan to eat hamburgers throughout your life and are not a cattle producer, should you wish for higher or lower prices for beef? Likewise, if you are going to buy a car from time to time but are not an auto manufacturer, should you prefer higher or lower car prices? These questions, of course, answer themselves.  
But now for the final exam: If you expect to be a net saver during the next five years, should you hope for a higher or lower stock market during that period? Many investors get this one wrong. Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall. In effect, they rejoice because prices have risen for the "hamburgers" they will soon be buying. This reaction makes no sense. Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices