History is Repeating Itself

As you are no doubt aware, the stock market was a bloodbath yesterday. And with the NYSE shutdown midday due to a “technical glitch”, China’s capital markets in shambles, jitters remain.  Everyone from novice investors to investment pros is on edge.

In response, we just published a special report:

Conspiracy, Cover-up, Cyberterrorism And Capital Markets Chaos

In this special report, we highlight how and why stocks will move in the near term, and what you should do now. Moreover, after seeing some interesting data, you will see why we have seen this movie before and U.S. investors should be jumping for joy rather than shaking in their boots. 

Investment and Company Research
Select Research
SPECIAL REPORT
 
Rob Goldman
rob@goldmanresearch.com
July 9, 2015

Conspiracy, Cover-up, Cyberterrorism
And Capital Markets Chaos

Important Disclaimer: I am not short the market. Hell, I am barely long stocks. The patriotism imbued in this blog does not infer that I am a xenophobe or a racist or a conspiracy theorist. I am merely a proud, foul-mouthed American capitalist/opportunist/infidel.

Conspiracy

Midday on Wednesday, July 8, 2015 I put two and two together. Whether the government or organizations wish to admit it or not, I was pretty sure that the United States was hit by a coordinated cyberattack. There were just too many coincidences. It seems unlikely that United Continental Airlines (NYSE – UAL - NR), the New York Stock Exchange, The Wall Street Journal and perhaps another popular financial news website (Zerohedge.com) all experienced technical difficulties on the same day that subsequently knocked out service for hours.  The net results were a crippling of UAL service early in the day but due to the new distribution trading infrastructure (i.e., other exchanges) the prolonged NYSE incident may have been unnerving as hell but at least it was not paralyzing.

Has it occurred to anyone that the day and month of yesterday’s date, (7.8.15, or 8.7.15 for non-Americans), when added together come to 15, which is the current year? We know that some groups have had a history of engaging in these types of ironies in their attacks.  Again, it seems unlikely that this is a coincidence. 

If it was an attack, I am not smart enough to even hazard a guess as to who is behind this…some have proffered that it could be China (the government or other parties/hackers/a-holes) in order to deflect attention on their own capital markets calamity.  Frankly, I do not know and it really does not matter if the incidents are related or not. This blog is about the U.S. market and securities traded here so let’s get on with the show.

While a lot of individual investors cowered in fear, especially during the NYSE shutdown, I was seeking people with whom to high-five.   It seems like we have been writing for about two months that the summer was going to be rough but present us with buying opportunities later. In Sunday’s edition of The Goldman Guide we talked a lot about Greece due to its timeliness but very little about China and Puerto Rico. So, here we go.

Capital Markets Chaos

It is no secret that the heavy down days of late have been prompted by the Greek financial crisis only to be exacerbated by a downright calamity in China, where stocks have been hammered, the government has intervened, most stocks are halted, and there does not appear to be an end in sight.  To put it in perspective, the iShares China Large Cap ETF (NYSE – FXI –NR) dropped by nearly 8% on Wednesday and is down 26% since its April 2015 high—and that’s nothing! The largest U.S.-listed exchange-traded fund tracking yuan-denominated equities dove more than 11% as the $3.6 trillion sell-off in China continued in earnest, even after the Asian markets closed. 

The biggest ETF winner of the year is now down 50%+ in a month and even the emerging market ETF standard bearer, iShares Emerging Markets MSCI ETF (NYSE – EEM – NR), has declined 15% in recent months, since nearly a quarter of its holdings are in China.

This was bound to happen. Too much money going to the wrong places for too long. For months we have been tracking fund flows in the Guide and while domestic funds have been hit with outflows, foreign fund flows (especially emerging market funds) have consistently experienced big inflows. We never really bought into this idea and therefore never recommending chasing these investments, thank goodness.  

So here we are today and the Greek situation has not been rectified which could smack the rest of Europe. That gives investors the shivers. However, that is a walk in the park because this collapse in China is surely keeping some investors up at night. They fear that this is the start of a global economic crisis with Greece as the secondary issue. Also, with a debt default potentially in the cards in Puerto Rico, won’t that really and directly hurt an already anxious group of U.S. investors?  Might prolonged financial turmoil there put pressure on Florida and its economy?  These are real issues.

Before the recent Grina crisis (our new term combining Greece and China) it seemed that investors were stuck in neutral while fretting about low earnings growth, weak GDP, and future interest rate rises, etc. which put a cap on market upside.  How interesting that the DJIA and S&P 500 index are now down for the year and have declined by more than 4% in the past few weeks. For their part, NASDAQ and the Russell 2000, while still up for 2015, have had declines of roughly 5% in the past 2 weeks alone.

The Past Tells Us the Future

We do not purport to predict what will actually happen with Grina, or Puerto Rico for that matter. Clearly, more volatility and big down and up days are in the offing while the mess gets sorted out, at least to some degree. Yes, the big picture may be scary if Grina could sink the global economy. However, I believe that all this concern should actually be music to American investors’ ears.

Recent history has demonstrated that when economic crises occur on a regional basis abroad, they quickly crush stocks for a time only to be followed by a huge run once lows are recorded.  We point to the most recent Greece crisis (2011/2012) and the Asian contagion in 1997.  In 1997, high debt/GDP ratios, currency devaluation and IMF default fears crushed many Asian countries and eventually prompted a 7% drop in one day in the U.S. market. As quickly as things fell apart, however, they recovered strongly mid-month and stocks rose by an average of 29% for the years 1997 and 1998.

Truth be told, from the economic perspective, it was scary, since the problems were largely driven by currency policy. Oil prices plunged, major economies were crushed, currencies devalued, policies mocked and changed. Still, they had no real adverse effect on U.S. stocks.

The Intermediate Future

We believe that after enduring billions and billions in outflows, U.S. stocks will be the beneficiary of fund inflows before the start of the third quarter. Interest rates will remain low in response to the current and pending Asian and European situations.  These factors signal (to us, at least) sharply higher stock prices once Grina stabilizes.

We note that even with the recent declines, all four indices are up 10-19% since their October 2014 lows, which represent solid returns. At present, they all trade below their 100-day moving averages and are nearly halfway to the correction (10% decline from high) territory.  To be certain, these trends portend more down days are to come, but we do not believe that will last long.

The current 12-month forward P/E’s for the S&P 500 and the Russell 2000 are 17x and 19x, respectively.  Even if we endure a total 10% plunge (correction), that would take stocks to very favorable valuations and yet still be above the lows of October 2014.  Moreover, P/Es would be 16x and 18x for these indices and that does not take into account the EPS for the full year 2016—which is an election year. Folks, election years are historically good for stocks, which is another plus for the bullish perspective.  

In the meantime…

For the near term speculative traders with big cojones can trade VelocityShares Daily 2x VIX ST ETN (NYSE – TVIX - $10.51 – NR) or even Direxion Shares ETF Trust- Direxion Daily CSI 300 China A Share Bear 1X Shares (NYSE – CHAD - $59.31 - NR), which is a bear bet on China.  There is big risk with both because there will be up days too but TVIX counterpart VelocityShares Daily Inverse VIX ST ETN (NYSE – XIV) would factor in as an alternative. 

Since we are talking about China, we would be remiss if we did not mention that there is a “YINN” and a “YANG” for bull and bear investments on China.  Direxion Daily FTSE China Bull 3X ETF (NYSE-YINN) dropped 21% while Direxion Shares ETF Trust - Direxion Daily FTSE China Bear 3X Shares (NYSE – YANG) rose 21%.

Volatility, big swings in both directions, a whole lot of confusing proposed and executed resolutions mean uncertainty for a while. The good news is that is exactly what we needed to drive above average, sustainable gains beginning later this year.

Senior Analyst: Robert Goldman

Rob Goldman founded Goldman Small Cap Research in 2009 and has over 20 years of investment and company research experience as a senior research analyst and as a portfolio and mutual fund manager. During his tenure as a sell side analyst, Rob was a senior member of Piper Jaffray's Technology and Communications teams. Prior to joining Piper, Rob led Josephthal & Co.'s Washington-based Emerging Growth Research Group. In addition to his sell-side experience Rob served as Chief Investment Officer of a boutique investment management firm and Blue and White Investment Management, where he managed Small Cap Growth portfolios and The Blue and White Fund.

Analyst Certification

I, Robert Goldman, hereby certify that the view expressed in this research report accurately reflect my personal views about the subject securities and issuers. I also certify that no part of my compensation was, is, or will be, directly or indirectly, related to the recommendations or views expressed in this research report.

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