3 Reasons To Invest In January’s Bear Market

I left for Asia on January 4 — to lead a Babson College MBA course on startups in Hong Kong and Singapore – and returned on the 15th to a “bear market.”

Is this an opportunity to invest or a signal to get out before things get much worse? I think buying is a better bet.

Before getting into that, let’s examine the evidence of a bear market and the unpersuasive reasons that aspire to explain why stocks have fallen.

We are in a bear market because the CEO of the world’s largest money manager said so – according to Laurence D. Fink, “Technically we are in a bear market. There is just a broad reassessment of risk right now,” reported the New York Times.

Having fallen 23%, the Russell 2,000 — a small cap stock index — has beaten the official definition of a bear market — stocks falling 20% from their high. But the S&P 500 is not there yet, having dropped 12% from its July 2015 high.

The most popular explanations for January’s stock market plunge make me think that reporters are confusing coincidence with causation. That is, just because two events occur at the same time (e.g., coincidence), it does not mean that one has caused the other (causation).

Here are three of the most common explanations offered for why stocks crashed and why I think they are unpersuasive:

Oil price plunge.

18 months ago, oil traded at $100 a barrel — now it’s below $30. This does not explain why stocks plunged in January. After all, oil was at $35 at the end of 2015. Could the loss of $5 more per barrel explain the S&P’s 10% loss since then? 

To be sure, the part of the economy dependent on oil is hurting — but that represents a mere 2.5% of U.S. GDP, according to Capital Economics. And for every penny drop in the price of gasoline, $1 billion is supposed to be added to GDP, according to Amherst Pierpont.

If that’s right, the 40 cents a gallon drop in gas prices in the last year, according to the EIA, should add $40 billion to GDP – mostly offsetting the economic damage of lower prices to oil and gas suppliers.

China implosion.

It’s true that the Shanghai index has fallen more than 20% from its December high. U.S. stocks have behaved as if the two market were inter-changeable. But this stock market behavior suggests that investors believe that the two economies — whose prospects those markets are supposed to predict — are in exactly the same condition.

About 7% of U.S. exports go to China, according to Wells Fargo Securities, which is officially forecast to grow at 6.5%.

To be sure, that official statistic is too high. But is China really imploding? And if it does, that 7% represents a mere 0.9% — I estimate 2015 U.S. exports to China totaled $164 billion – of the U.S.’s 2015 GDP of about $18 trillion, according to the IMF.

In short, the two economies are very different and the U.S.’s economy is not as tightly linked to China’s as the hype would suggest.

Economic collapse. 

The U.S. economy is expected to grow 2.5% in 2016 according to a recent Reuters survey of economists. About a year ago, economists expected that the U.S. economy would grow at 2.8% in 2016. It does not make sense that such a small drop in the 2016 economic forecast would explain the drop in stocks.

If these explanations for the stock plunge don’t make sense, maybe markets are offering bargains to investors who are not persuaded by these weak explanations. Here are three reasons stocks should be worth more.

Lower price/earnings ratio.

Stocks have gotten cheaper — with their P/E dropping from about 22 in December to 19.8 now. A quick look at the Shiller P/E ratio suggests that we are way short of the 65 P/E that presaged the 2008 economic collapse.

In short, there is no way to justify the January sell-off on the notion that stocks here are grossly over-valued.

Solid earnings growth.

Earnings per share are forecast to rise in 2016, according to Factset. Its January 15 report noted that while analysts expect a slight 0.6% decline in first quarter 2016 EPS, it sees a big boost in growth for the subsequent quarters.

Specifically, Factset expects second quarter 2016 earnings to rise 5.1%, third quarter EPS to be up 7%, and fourth quarter EPS to soar 14.7% over 2015′s reported EPS.

U.S. economy is a safe haven.

While Europe appears to growing at less than 2% – with bouts of panic regarding Greek debt and the economic impact of Syrian refugees – and China in a state of significant uncertainty, the U.S. economy has been steadily growing and is creating a steady flow of new jobs.

I do not have a compelling explanation for the January plunge in stock prices.

Could it be — as a CEO I met in Singapore suggested — that hedge funds have been dumping U.S. stocks and will get together and decide to buy them after the recent selling has been exhausted?

If so, I believe that they will be able to back up their buying with a reasonable case that with P/Es lower and earnings expected to grow later in 2016, U.S. stocks look compelling after January’s correction.

Peter Cohan

(Source: Forbes)