The correction is finally here; well overdue. The stock market seems to be quickly correcting with the Dow having dropped over 1000 points in the last ten days (about 6%) and the other major indexes following in similar fashion. This is, after a two year run without any corrections, an unusually long stretch without a pullback in the market. Technically, we haven’t quite reached correction stage yet, which is loosely defined as a market pullback of 10% or more, but the quick switch in market mentality from greed to fear is obvious and I think we are finally in for an old fashioned valuation adjustment. What finally started the correction? After all, Congress passed a budget agreement in mid-January that will keep government running, at least until September 30th, 2014. Janet Yellen starts her term as the first female Federal Reserve chairman today, taking over for Ben Bernanke. The market expected, and wanted, this smooth transition at the Fed as Yellen is expected to continue the policies put in place by Bernanke. Bernanke’s last action as chairman was to continue the “tapering” of the government bond-buying stimulus program by a couple of billion more dollars per month, a completely expected event. The economy is stronger than it has been for many years, corporate earnings are very strong, interest rates are still low, housing is strong, unemployment has come down, and businesses are taking risks and spending money again. In short, things are humming along nicely, so why is the market going down?
The answer, valuation, valuation, valuation. Markets are self-correcting mechanisms and will always overshoot and undershoot true economic value. Just as markets overreacted somewhat to the credit crisis (undershooting), markets have overreacted to the world-wide recovery from the crisis (overshooting) and will settle in around a more sober view of economic value. Conditions are actually very, very good compared to the grim outlook just five short years ago. But two years without any correction built up a mini-bubble in prices that needs to have some air let out – which we seem to be at the start of now. You could see the cracks developing the last six months or so in spite of slightly higher highs every couple of months. The market was treading water (known as consolidating) and without a correction in the last two years there was a much greater likelihood of the next move being down versus up. But greed is a powerful motivator and many investors have put fresh money in at the top. Value investors like myself are hoping that those investors will now turn around and sell, sell, sell, providing undershooting to the downside that opens up some good buying opportunities. Investors that have waited for the buying opportunities will drive the next “up” leg of the market – a healthy correction weeds out the weak hands and puts assets in the strong hands that are in for the long-term. With a healthy backdrop as we have now, a valuation correction is a huge flashing “buy” signal to investors with cash as nothing about the rosy economic conditions has changed and it is an easy investment decision to buy assets at 15-20% sale prices when greed turns to fear but the economic backdrop remains the same.
Portfolio Strategy - I spent all of 2013 writing about economic conditions, a rising market, and detailing long-term positions that were harvested. Now that I anticipate beginning a new cycle of heavy buying starting this month, we can turn our attention to what kinds of companies that I am looking to own that will fare well in the coming economic cycle. What is the coming economic cycle? The Fed has taken its foot off the gas pedal (stimulus), and the next step will be eventually applying the brake (interest rate hikes). We have been in a period of artificially low interest rates for six years now, but with a strong economy eventually higher rates and higher inflation become primary concerns, and are something the Fed is steering us towards now even as we still enjoy low inflation and low interest rates. In the coming cycle, we will want large multinational dividend paying companies that can pass along higher prices quickly if the cost of their inputs rise (technology, energy, utilities). We also want companies whose profits are tied to hard assets, such as real estate, commodities and agriculture. Last, companies tied more to demographics than the economy, (such as medical or services etc.) will be mostly unaffected by higher rates. They will do well in an inflationary environment and in a world of higher growth and higher rates. Conversely, we want to stay away from fixed income, retail products, consumer products, consumer electronics and transportation.