"Kee" Points with Jim Kee, Ph.D.

Stocks are about flat for the year after last week’s sell-off, and that’s pretty typical of what stock markets do. It could be up 17% one year, and then flat or down 3% the next, etc. In fact, if you look at a 90-year chart of year-to-year stock market returns you would see what essentially looks like an unchanged process, regardless of the various narratives that crop up to explain it. Last week’s sell-off appears to have been prompted by the liquidation of a high-yield (i.e. “junk”) bond fund by Third Avenue Management (and as investors were barred from withdrawals during the process). This is just the latest in a string of bad outcomes for bond funds in general, and it is one of reasons that we at STMM prefer investing in individual bonds rather than funds. Junk bonds are experiencing what is being described in the press as an “bloodbath,”(WSJ) but the important insight for investors is that high yield bonds are not an effective hedge to stocks, which is where the risk in your portfolio should reside. That’s a point we made in the first quarter webcast, but it is always worth a reminder, particularly in times like these. The sell-off in high yield bonds has resulted in a decline in their price and a rise in their yields. This means that the spread between the yields on junk bonds and the yields on safer bonds has increased, which is known as an “increase in quality spreads.” That, in turn, tends to forecast economic downturns, as high yield bonds tend to sell-off when the risk of default increases, and the risk of default tends to increase during recessions. It isn’t a perfect indicator, and current research at the Federal Reserve suggests that spreads would have to widen a lot more based upon prior episodes that signaled recession. But it is a key variable that I watch. Right now the data (consumer spending/retail sales, housing, etc.) still looks ok, consistent with 1.5%-2% GDP growth for the fourth quarter.

 

But does growth matter? My experience as a professional economist working with professional forecasting firms is similar to that of other economists…you talk a lot about growth, all the while cognizant of the fact that even if you had perfect foresight as to how each of the world’s economies would grow in the year ahead, it isn’t at all clear that you could put together an investment strategy that would take advantage of it. This year is a great example, as the major economy with the best performing stock market has been Japan, even though Japan slipped back into recession this year! But the insight here is about the dubious nature of market timing, particularly applied to different countries, not the apparent disconnect between economic growth and stock market performance.

 

Here’s the way to think about it: Growth does matter in the long run. Over the past several decades the best growing developed economy has been the United States, followed by Europe, and then Japan. And if you look at stock market performance over that period, the best performer has been the US, followed by Europe, and then Japan. As for emerging markets, most analysts will tell you that it appears to be the opposite….you historically make more money investing in the slow growers than the fast growers, depending upon the specific time frame. I’ve noticed that too, and the main reasons are that companies in emerging economies have much weaker governance structures and are far more subject to state intervention and less subject to market discipline. Plus, the “rules” are evolving.

 

Consequently, there has been a much weaker connection between the stocks of publicly traded companies in emerging markets and the economies in those markets. Emerging markets are of course not a homogeneous group, but the above, I think, explains a lot with a little. And remember that, while stocks here in the US have produced very impressive results since the March 2009 bottom, a lot of that surge has been a rebound from a prior collapse. The rebound actually took twice as long as normal (4 years instead of 2), as the economic growth was half as strong as normal (2% instead of 4%). We are only up about 20%-25% from the 2007 peak. Growth does matter!

 

I’m working on the outlook for 2016. In Japan, I’m hoping that indeed Abe’s first two arrows (monetary and spending policies) were just buying time to get the third arrow, corporate governance reform, in place. In Europe, you have the tailwinds of pent-up demand, a weak euro, and the promise of accommodative monetary policy facing the headwind of the uncertainties surrounding a growing refugee crisis. China faces extreme long-term challenges as the country’s export-oriented coastal regions differ from the poor interior, which makes the transition to a more consumer-oriented economy challenging to say the least. In the US, the election is the big issue for 2016, and I would like to share with you some recent research (peer-reviewed) that showed that people’s spending is not influenced by whether or not they think their particular candidate is doing well or not doing well during an election year. That’s important, because knowing what not to pay attention to can be as important as knowing what to pay attention to. I will be reporting on political forecasting models that have good prior track records once they get enough data to be up and running, but we are a few months away from that.