Corrections and Drawdowns

While always painful. corrections; i.e. sudden drops, in the prices of stocks have always been a very real part of investors’ lives. They typically come with very little warning, and the reasons given by market pundits are always presented to us after the market drops, not before. This time it was the drop and the volatility in the Chinese market, and the price of oil.

The Shanghai Stock Market has always been subject to extreme moves, and the first week of this year has been no exception. They introduced circuit breakers which they hoped would stem sudden declines in prices. Simply stated, they halt trading for the day when prices decline 7%. This idea was only introduced and took effect about a week ago, and it tended to intensify fears rather than calm them. Investors raced to exit when it appeared prices were approaching that limit. Twice, this past week, the trigger was affected and trading was halted. Thursday, trading on the Shanghai Market only lasted 29 minutes, the shortest day in the history of that stock exchange. This sent a shock wave around the world, starting with the European markets and finally hitting us.  US stock markets also use circuit breakers, but they are far more flexible, with trading halted for 15 minutes at various levels of decline, and only halted for the day if prices drop by 20%. China has now suspended its automated stock-trading halt just four days after its introduction.

With respect to oil, it is still probably our most important commodity, and its price not only affects the prices of almost all other commodities, it is an important part of our GDP. Over the last year and a half, the price has dropped from roughly $114 per barrel to the current price of around $33. This is a price drop of more than 70%. This has precipitated a price drop in many other products, including grains, edible oils, industrial metals, and even lumber products. Price drops always create a fear of depression-type values. Oil below

$40 puts pressure on the OPEC countries.  It puts extreme pressure on Russia, the world’s largest oil producer, who derives a great deal of their foreign exchange by selling oil. The trackers of Texas and North Dakota are also feeling the pain. There is no question that the crude oil drop is worrisome; however, there is another (edge to this sword) side to this equation. The huge price drop represents a major reduction in the cost of our energy. The costs to transport goods, whether by water, air, rail, or truck, are much cheaper. Lower costs will mean more discretionary spending in other areas. As lower prices filter through our economy, there are some major positives to cheap energy.

What about corrections?

There is a term with which every person in our business is familiar. That term is drawdown, and it refers to pullbacks, drops, corrections, etc. They have occurred in every market, whether strong or weak, for as long as markets have been in existence. It is not uncommon for a major average, the S & P 500, to experience a drop of 10% to 20% every two to three years or so. One of the tough ones was in the fall of 1987. The market was on an 18 year upward run from 1982 to 2000, which ultimately took that big average up tenfold. The worst correction I can remember occurred that year. Over a period of two weeks, starting on October 6, the S&P dropped from 328 to 225, a sudden drop of just over 30%. People were shaken to their bones. Fear was the word of the day . . . and October 20th of that year turns out to have been the best time to buy for the next three decades.

Naturally, drawdown occurs in individual stocks, but frequently to a greater extent than with market averages. Netflix was $9 a share in 2005. In 2015 the stock was over $800. This doesn’t tell the whole story, however. Over the years the stock went from 9 to 41, down to 18, up to 305, down to 53, up to 457, down to 316, up to over 800. Given all the corrections, how many of us could have stayed with that great company for the terrific 10 year move. The stock split 7 for 1 in 2015.

As mentioned above, corrections in the stock market almost always come without warning. The drops are sudden and scary, and we always seem to be unable to find the reason why the selling should cease. The fact is that it does cease, and when once again prices begin to rise, we ask ourselves why we didn’t step in and pick up some shares when prices were at such bargains. I have a friend, Bob, who has been an investment advisor for fifty years. He once said to me, “Do you know what happens after the stock market goes down? It turns around and goes up, and eventually makes a new all-time high.” Bob is right!  We are still one of the most innovative countries on earth, and we are convinced that the United States is still the best country in the world to start and operate a business.

We will continue to buy stocks that meet the criteria we have established with regard to earnings, cash flow, long-term debt, etc. If we decide to sell two or three of our positions, it will be to have opportunity money to search for bargains. It is our job to keep absolutely focused on the quest for the long-term growth of your capital.