"Kee" Points with Jim Kee, PhD.

Markets declined by nearly 2.5% on Friday, triggered perhaps by Boston Fed President Eric Rosengren’s advocacy of the Federal Reserve resuming rate hikes (Rosengren was one of the few remaining “doves,” or advocates of continued low rates). This combined with the European Central Bank’s (ECB) decision last week to keep rates on hold (though continuing asset purchase programs) seems to have left markets evaluating the possibility of higher rates in the future. The ECB downgraded its growth assumptions somewhat, which was consistent with US ISM PMI manufacturing and non-manufacturing purchasing manager index declines. Both indicate moderate growth, but the non-manufacturing PMI, though indicating expansion for the 79th consecutive month, dropped 4.1 percentage points to 51.4% in August from July’s 55.5%. Taken on balance with Leading Indicator Indices, Nowcasting models, job growth, and other data, I expect a stronger second half for 2016, but not robust growth by any measure.

Most analysts expect more volatility as we head into the fall, due primarily to uncertainty regarding fed actions, US elections, and weak capital spending. There are of course longer-term bulls (e.g. Morgan Stanley) and bears (e.g. Deutsche Bank), with the bear case being a 10 percent or more decline or “correction,” and bulls seeing similar upside, mostly upon expectations of stronger growth in 2017. Bears always come out of the woods, so to speak, following a sell-off, as do bulls. But this is all too short-term thinking for investors, as decades and decades of data confirm. A broader view of the global economy is best if one wishes to reach long-term investment goals, and here’s mine:

Shareholders gain when companies earn a return on investment (ROI) that exceeds the costs of that investment (whether capital is borrowed or whether equity or shares are issued). It’s a complex topic, but the bottom line is that ROIs are driven by operating margins or profitability, and asset turns or “asset efficiency." You can earn a high ROI by selling a product or service at a high mark up (i.e. high operating margins), like Rolex watches, or by selling a lot of product or service at lower operating margins, like Timex watches. Looking at aggregated company data in the United States (and much of the world), ROIs are flat to down slightly near 20-year highs. The flat to slightly down ROIs are being supported by operating margins that are at 20-year highs. But those operating margins are not due to the ability to charge high prices for products and services (i.e. pricing power), but because costs have been driven down. That’s operating costs, which includes materials, sales, administrative costs etc., think “variable costs.” But asset efficiency or “asset turns”, which measures how well a company is using its assets to generate income, measured by total sales over total (long-term) investment, think “fixed costs”, are at 20-year lows (hence flat overall ROIs). That’s not because investment has been great, but rather because sales relative to investment have fallen. This is clear in aggregate data across the world. Some attribute it to an output glut, which is another controversial subject in economic history. But others attribute it to a lack of investment. Believe it or not, it is not clear among the brightest economic minds of the past century whether profits drive investment, or investment drives profits!

Investment implications: I won’t try to resolve that here and don’t have to. A strategy based upon owning both growth stocks and value stocks, domestic and international, can address the problem. Even in a global environment where sales and GDP growth are low, there are many companies that are increasing sales well above average, which are growth stocks. And any time market volatility increases, the market tends to leave many companies undervalued even with low (albeit consistent) expected sales growth, which are value stocks. At STMM we are always investing in both growth stocks and value stocks, 65 or so in total, which is a much more manageable strategy than relying on indices with hundreds or even thousands of stocks. But there is another advantage to owning individuals securities over “funds” of thousands of securities, particularly in environments characterized by a lot of uncertainty. If concerns in any region (like China) or sector (like Healthcare or Energy) rise, owning individual securities allows you to know your exact exposure down to the business unit level, and minimize that exposure if necessary. With a broad index, you can just “guesstimate” your exposure to unexpected risks but you cannot do anything about it.