In my conversations with investors, it’s clear that the market volatility with which we have begun 2016 is unsettling. And that is understandable. It never feels good when stock prices are falling. But the key to long-term investing is resisting the pull of pure emotion, taking a deep breath, stepping back and reviewing the facts.
In this case, the facts clearly show that market corrections of this magnitude happen both regularly and often. In 33 out of the past 35 years we have seen market corrections of 6% or more.1 The only thing unusual about this one is it began in January.
The timing of this correction does not mean that “it’s different this time.” Nor does it mean, as some are saying, that we are entering a self-perpetuating bear market because the system is choked with leverage. The world has been deleveraging over the past few years.
In my opinion, the volatility we are seeing is caused by the transitions investors are making as they adjust to the shift in growth drivers in the world economy. Since the early 2000s, one of the major growth drivers has been the rapid industrialization of China. It raised prices for energy and commodities, bringing them to the top of their typical 30-year cycle. It raised the boats of most emerging market economies indiscriminately since so many of these countries are major suppliers of those commodities, are linked to China’s manufacturing supply chain, or both.
China as Catalyst
Now the picture is changing and, again, the catalyst is China. That economy is now growing more slowly, and the composition of its growth is changing. China’s demand for raw industrial commodities has declined. And that has happened at the same time as all of the natural results of high commodity prices—conservation, substitution, new supply — have taken hold as well. The old saying that “Nothing cures high commodity prices like high commodity prices” is being proven true once again. The prices for most commodities are sliding down the post-peak side of their mountain charts. The implications of this vary across countries and industries.
Countries that are major commodity suppliers, and have relied on this source of “easy money,” will now have to develop other areas of their economies. On the other hand, cheaper oil is a welcome relief for countries such as India and Japan, who are huge importers of it. In industries, capital goods makers are adjusting to slower demand. Many are adjusting to rising competition from China, as China is turning from a buyer to an exporter of many of their products. By contrast, refiners and many chemical producers are benefitting from lower input prices.
As investors evaluate the implications and alter their expectations, prices will be in flux; not only for those areas and industries directly affected, but in the market as a whole. We will have periods of volatility, such as the one we are experiencing now.
What’s important to remember is that there are many industries whose secular demand drivers are impervious to “the China shift” I’ve described. People are not slowing their mobile search and social networking activity. Concerns about cybersecurity and the demand for safety systems to address it have not subsided. Consumers who are buying cars have not decided that they want them to have less connectivity, fewer safety systems and slower acceleration times. Satellites are still necessary to transmit sports to those that want to watch them. Borrowing money still requires someone to do a credit check. I could go on, but you can see the point here.
As we have so often said, it is the growth WITHIN the economy that matters to us, not the growth OF the economy. Industries catering to the demands I have described may have strong growth prospects. We focus on finding companies within them that have durable pricing power and can deliver a solid return on the capital invested in them. When negative sentiment pushes down all share prices indiscriminately, these companies that we want to own can sometimes be bought at prices we are happy to pay.
1Source: Bloomberg, as of 2/9/16.
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