Moneybeat - On the brink of a bear market

MARY REICHARD, HOST: Next up on The World and Everything in It: the Monday Moneybeat.

NICK EICHER, HOST: Time now for our regular conversation on business, markets, and the economy. Financial analyst and adviser David Bahnsen is on the line. Good morning.

DAVID BAHNSEN, GUEST: Good morning, Nick, good to be with you.

EICHER: I want to pick up on a topic we started last week, David, because the markets really dropped again with the Standard & Poor’s 500 careening toward bear-market territory and I want to read a headline from The Wall Street Journal. “The Market Is Melting Down and People Are Feeling It.” Then the headline adds a spicy quote from a market advisor: “My Stomach Is Churning All Day.” David, can you relate? How’s your stomach?

BAHNSEN: My stomach is fine, that person who said that may want to find a different line of work if they find this market to be turning their stomach, it's a very volatile market. And this last week it had downside. For about six months the NASDAQ has had a lot of downside. But I'm not sure what this adviser’s experience is with financial markets that would make him think it is abnormal. The reason markets have delivered, you know, the 10% return per year going back 100 years is because markets are subject to various bouts of volatility and uncertainty. And what that does is generate what we call a risk premium. To be willing to go through moments like this, we require a higher expected rate of return. And that's sort of the point of being a stock market investor.

So what you've seen is the market have to kind of deal with two things at once. The first has been playing out for as I said, six months, it's not a new story. And that is companies that made stationary bicycles with an iPad on top that were worth more than some of the largest companies in the world have had to drop 95% in value because they were in a bubble, and the whole world lost its mind. And companies that made video camera technology—with no revenue—to talk to each other on a computer that were worth 14 times as much as the largest oil and gas company in the world - and America - had to reprice, because they were 70-80% overvalued. That kind of a thing started six months ago and has continued to play out and there's been a lot of carnage there.

And so I shouldn't be overly glib. If somebody is in that space, I can see where their stomach’s turning, but their stomach should be churning in repentance, of of the absurdity of the way they were managing capital.

I guess it doesn't mean people have to like it all the time. The Dow is right now down between 13 and 14% on the year. The average drawdown going back 50 years, meaning at some point from a high level to a low level in the middle of the year, every year for 50 years on average has been somewhere around 11%. So it isn't particularly abnormal. It's definitely worse for those that are heavy in growth. But that's different than saying ‘the market.’ I get very excited during periods of market volatility because I believe that it rationalizes the risk premium we hope to capture over long periods of time.

EICHER: Well, given that this is the big story everyone’s talking about, I would like for you to spend our remaining few minutes explaining, fundamentally, why is the market so volatile right now?

BAHNSEN: Yeah, the market is going down because risk assets are getting repriced in a different monetary environment. And so all risk assets are priced against a ‘risk free rate’ - the amount of return that you want and expect relative to giving up your money for a period of time. And when you get rid of your money for a period of time, you are getting rid of a risk free rate that you could have gotten on that money by holding on to it. So when that risk free rate is zero, it makes risky assets worth more. And when that risk free rate is 2%, it makes risky assets worth somewhat less. The more money one can get without risk, the less risk they're willing to take. But when you talk about the more diversified market that reflects the diversified nature of the American economy, that would include technology but would include the consumer, it would include industrials, it would include materials, it would include health care, which by the way, is doing very well in this period; it would include energy, which is done extremely well in this period up about 40% on the year.

Now, why do most investors not feel that? Because energy 10 years ago was 17% of the S&P 500 and six months ago, it was 2%. And so a lot of the anti-fossil fuel people that were successful in getting people out of their energy investments, they took an entire part of the population out of what has been the top performing area all of last year, and the first almost six months of this year.

So fundamentally, it is right now all markets that are down, but not all down equally, and not all sectors are down.

And so I believe that this transition in the market, Nick from growth into value—from overpriced speculative things to more rational and fair-valued type of investments, that's the theme that we're seeing. But then, right now, with the Fed tightening, it does exacerbate uncertainty, even in the quote unquote, “safer” and more rational parts of the market. And so you have to kind of take on a little more volatility there, as well. And I'm very confident that this will play out over time in a way that reprices assets as they ought to be repriced; that things that were excessively valued need to come down and that's good for markets. You want capital allocated towards its most rational use, and there was nothing rational about calling a bicycle company with an iPad on top a $50 billion company.

EICHER: All right, David Bahnsen, financial analyst and advisor, head of the financial planning firm The Bahnsen Group. He writes daily at DividendCafe.com. David, thanks.

BAHNSEN: Thanks so much, Nick.

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