The Start of 2016
The financial media is abuzz with the soundbite that the stock market is off to “the worst start in history” in 2016. That is both absolutely true, and completely misleading. The fact is, corrections similar in size to the one we saw the first few weeks of the year happen on average once a year, they just haven’t happened to coincide with the first few weeks of the year in the past. So the fact that this is the worst start ever is an interesting anecdote, but is also fairly meaningless for our Thrift Savings Plan investing. (See also, Debunking the January Myth in case you were concerned by the annual beginning of February onslaught of click-bait headlines suggesting that a poor market performance in January portends of a bad year.)
The sell-off appears to largely be a panicked reaction to downbeat economic news from China and the continued fall of oil prices. But while stock markets have tumbled, there is no indication of similar problems in the overall economy. Now it is entirely possible that a recession is on the way, but the fact is that the economic data is not behaving in a pre-recessionary manner. Job and wage growth continue, and consumer and industry sentiment remain reasonably strong. With the exception of manufacturing (which is in a global recession), the US economy is performing well. In fact, the only indicator pointing in the direction of recession is the stock market, which has rather famously predicted nine recessions during a period in which we have seen five. And in the Business Cycle investing strategy, there is never going to be a time when I am not invested in the stock market during a non-recessionary period.
The Stock Market in 2016
The stock market goes up two years out of three. Pull out the years when the US is in recession and it gets even better than that. All indications are that the US can avoid recession in 2016.
I believe the stock market will in all likelihood end the year higher than where it started. I think large cap stocks (the TSP C Fund) will outperform small and medium cap stocks (the TSP S Fund). I believe developed international markets (the TSP I Fund) have the potential to outperform the US markets (because they are still in the recovery phase of their business cycle), but are also in a more fragile position and have the potential to fall apart more easily than our domestic markets.
As at the beginning of every year, I will confidently predict we will see four or five 5% corrections, and probably a 10% correction at some point (because that happens pretty much every year). With history as a guide, I am convinced the timing of those corrections isn’t predictable, and that the market will recover and move higher in each case within a matter of weeks.
I think we will see a lot of volatility in 2016. That isn’t necessarily a bad thing if the overall direction of the market is up, but those big down days have a strong psychological effect on many investors. The moves in either direction may be caused by any number of external events, but the big moves during periods like this are caused by a trading strategy called Risk On, Risk Off. The nutshell is that when news comes out which points towards inflation (which you will remember is a good thing in small amounts), traders pile into stocks. And when news comes out pointing towards deflation, everyone goes the opposite direction. As a result, individual stocks and market sectors aren’t valued based on their, well, value. Instead, everything goes in the same direction, which causes the overall market to move in that direction more than it otherwise would in a typical trading pattern.
Thrift Savings Plan Allocation
At this point, my best guess is that I will continue to move the bulk of my TSP investments to the TSP C Fund over the next few months, and that I will maintain a small investment in the TSP I Fund. I don’t make many changes, so odds are good that I will also finish the year at 85% C Fund, 15% I Fund. Each month I will take a hard look at the indicators for both the US economy as well as the developed markets which dominate the I Fund and try to make a determination as to where in the respective business cycles those indicators put us.
Please don’t ever forget that these allocations are based on my circumstances and the strategy which I have chosen to employ. Your circumstances may be very different and my strategy may not work, so I encourage everyone to read widely and consider a range of different viewpoints before making investing decisions for themselves.
The Risks in 2016
The risks to the slow but reasonably steady US economic recovery and corresponding stock market gains are China and Oil:
The China Risk
In A Look Forward at TSP Investing in 2015 I wrote about the risk posed to the global economy by the potential for a Chinese financial crisis. What we saw this year in the Chinese stock market certainly had some negative effects on our market, but was not the crisis which I was writing about.
So let’s talk about what we are seeing right now. It’s true that a collapse in China’s economy would be a game changer, an event which could tip the globe into recession. But there is no evidence that we are seeing such a collapse. China’s growth has slowed, to a 25-year low of 6.9%. But that is almost exactly the target which the Chinese government was aiming for as they try to modernize their economy and create a greater balance between manufacturing and services. (And yes, I know that we can’t trust the numbers the Chinese put out, but independent analysts put their estimates in the same ballpark).
China’s immature stock markets have exaggerated the slowdown in the country’s economy. The Chinese stock market is only 25 years old, and didn’t require significant downside management during 24 of those years because their economy was growing at a double digit clip. As a result, inexperienced Chinese regulators have been experimenting with techniques intended to quell volatility (such as circuit breakers which stop trading in a stock after a modest decline), but which have exacerbated the problem. And extremely ill-educated retail investors in China have proven prone to irrational euphorias and panics.
I think the Chinese market will continue to jump around, sometimes in response to economic news, sometimes randomly (just like our own). At this point, I don’t think the Chinese economy and stock market will be as much of a factor as it was last year, as they have started to adjust to a new normal and are learning to manage their markets a bit more cleanly.
The big China risk comes from their debt market. Nothing has changed from last year, so I’m going to reprint that section here:
At some point in the next few years, China is likely going to undergo a financial crisis which will make the 2008/2009 US meltdown look like a relative blip. China’s development has been funded by very low interest, cheap loans. These loans were never repaid though; instead they were simply rolled over into new loans again and again. The money doesn’t exist to pay these loans off, and with interest rates rising and tighter lending requirements in place it will become increasingly difficult to roll them over.
As a result, the Chinese financial system is in a precarious position. The Chinese certainly realize the predicament they are in and they are trying to create a way for these loans to transition to a sustainable model, but I don’t believe it will be possible without a severe restructuring of their financial system with companies bankrupted, banks failing, and a collapse of the Chinese real estate market. When this takes place, it will send shock waves through markets throughout the world, and it will likely more damaging to the Thrift Savings Plan stock funds than the European debt crisis in 2011. When and if this occurs, I will certainly be scrambling for the safety of either the TSP G or F Fund.
So the question is whether or not we will be able to see that coming in time to make a move in our TSP. I don’t know. Knowing that it is a real possibility certainly helps, but also makes it possible that confirmation bias will have me pulling the trigger much too soon. Either way, there will be nothing precise about it and it will be messy.
The Impact of Oil Prices on the World’s Economy
First, let’s disabuse the notion that falling oil prices have been caused by weakening demand which shows weakness in the global economy. That just isn’t the case – while demand growth has slumped in some places, overall demand has continued to grow and the fall in prices has been caused by a glut in supply.
The relationship between oil prices and the world economy has been fairly simple in modern times. Sharply rising oil prices have some sort of correlation with recession – this was true in 1973-74, 1979-80, 1990, and 2008. In contrast, when oil prices fall (the mid-80s and late-90s), the world economy has surged.
It is overly simplistic to say that low oil prices will necessarily result in a boom in the world economy, but it doesn’t hurt. When oil prices are high, oil producers (both companies and countries) receive a disproportionate bonus which (1) they invest in expanding oil production, and (2) they tend to save a reasonably large percentage of because (being dependent on oil prices) they know darned well that prices are going to fall. When oil prices are low, in contrast, the wealth is spread much wider – basically every consumer in the world benefits, and like most consumers they spend that small windfall rather than saving it.
But I have talked before about dislocations, and most of the world’s economies are not so evenly balanced. For a number of countries, their economies are based on expectations that oil will trade at a certain price, a price that is roughly three times that where it is now. It isn’t just Saudi Arabia, Kuwait and the countries you think of which are being pummeled by low oil prices – the list stretches across much of the world and includes major emerging economies such as Russia and Brazil.
Now, none of those countries are particularly important trading partners of the US, and trouble in any of their economies has limited impact on our own. But if enough of those countries can’t weather the low oil price storm, that will ripple across the global economy. They are staring down three barrels – widening trade deficits (the oil they are exporting is worth a lot less than it once was), weaker currencies (which means that they can’t buy as much as they once could), and debts which typically must be repaid in dollars (and of course the dollar is strong, and keeps getting stronger, so it costs more of their weak currency to buy dollars to make loan payments.
All that said, after these dislocations are sorted out, low oil prices should eventually provide a stimulus. It puts money in the pockets of individuals as well as businesses (airlines suddenly become quite profitable for example), and that has the same stimulating effect as a tax cut or lower interest rates.
I am a long-term investor. There are two reasons I don’t lose any sleep over what the market has done over the past 12 months:
(1) The market can do just about anything in the short term based on sentiment, but long term its performance is based on fundamentals such as earnings per share and expected growth.
(2) Whether you realize it or not, what we are doing when the Thrift Savings Plan pulls money out of our paycheck and invests it for us every two weeks is dollar-cost averaging. That simply means investing a set amount of money on a fixed schedule no matter what the stock market does. One of the benefits to that strategy is that during down markets you are able to buy more shares for the same amount of money. As counterintuitive as it might sound, in an ideal world the market would stay depressed for your entire investing career until just before you were ready to sell, so that during that entire period the shares you were buying were on sale.
In my next post I will talk about non-TSP investing in 2016 and how I am approaching the various opportunities which the market appears to be presenting me over the next few months. Hopefully I will get that out in the next few days.
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