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2015 was not a good year compared to prior years since the 2007-2008 financial crisis. The Dow was up 0.21%, the S&P 500 was up 1.38% and the NASDAQ was up 6.96% led by technology stocks. Energy was the big loser with the S&P Energy Index down 21.12%.
2016 has not started well. The Dow is down 8.73%, the S&P 500 is down 8.07%, and the NASDAQ is down 9.74% through January 25. The catalyst for this global turmoil in financial markets is confusion over China, the price of oil and other commodities, and uncertainty about what the Federal Reserve will do about interest rates. All of these affect the global economy and whether it slows down, and by how much.
Among the fear of the last few weeks, there is a positive and comforting consensus. Bear markets never inflict much damage on investors’ wealth, unless they are accompanied by a recession. Few people now expect a U.S. recession. So the chances are that the fall for U.S. stocks should end around the 20% mark and then present a buying opportunity. As stated in a January 17, 2016 Financial Times article titled “What goes down comes up, but how long will that take?” by John Authers, “This argument has some history on its side. In the past 30 years there have been only three 20% falls in the S&P 500 that did not overlap with a recession. All involved financial accidents.”
“The first came with the Black Monday crash of October 1987, when the S&P fell 33 per cent and regained its prior high in just under two years.
The second came in the autumn of 1998, when the Russian default crisis, followed by the meltdown of the Long-Term Capital Management hedge fund, forced the S&P down 22.5 per cent. It recovered all its lost ground within six weeks of hitting bottom.
Finally, in 2011 the S&P fell 21.6 per cent during the political standoff over raising the U.S. federal debt ceiling; the decision by Standard & Poor’s to downgrade U.S. sovereign debt; and the eurozone crisis. It regained all its losses within five months of hitting bottom.
So the argument that the damage should not be bad if we avoid a recession is reasonable. But why exactly did markets rebound?
In all three cases, the Federal Reserve eased monetary policy, when it had intended to tighten. In 1987, there were three rate cuts, not reversed for almost a year. Rates ended that cycle two percentage points higher than they were on the eve of Black Monday. LTCM also triggered three rate cuts. In 2011, with rates already at zero, the Fed responded with “Operation Twist” to try to push down bond yields.
So a bet that the market will rebound once it has fallen a few more percentage points is also – history suggests – a bet that it will successfully prompt the Fed into changing course and cutting rates.
That is quite possible. But it would be a very big deal for this Federal Reserve, having only just started to raise rates, to admit a mistake and head back.
Then we should check the confidence that the U.S. can avoid a recession. Outside of manufacturing, which is in global recession, the economy does look robust. But signals such as poor retail sales growth, tightening loan standards or rising spreads on high-yield credit all suggest at least some concern about a weakening economy.
Brokers have been writing down their earnings forecasts for the fourth quarter of last year. This creates an easier bar for companies to clear, and positive earnings surprises have often in the past led to a rally. This happened most clearly in October of last year, when stocks rebounded impressively on the back of earnings that were slightly down on a year earlier, but better than expected.
But judging by the reception for the few companies to have reported so far, investors are so rattled that this trick will not work. Companies that have beaten their earnings estimates for the fourth quarter include Alcoa, Intel, Citigroup and Wells Fargo. In all cases, they accompanied their earnings announcement with less than rosily optimistic forecasts for the year ahead – and were immediately punished with sharp falls in their share price. Without assurance that revenues will stay robust for the rest of the year, investors want out.
Where does this leave us? If the U.S. tips into recession, a serious bear market is possible. Assuming it does not, then we need to wait until investors lose their faith that a recession will be avoided, and push down stocks enough (probably by about 20 per cent) to force the Fed into backtracking.”
“There are times to make money, and times not to lose money.
This is a time not to lose money.”
– Oscar Schafer
Each year Barron’s publicizes the thoughts of a Roundtable of experts about the markets and the global economy. The participants this year were: Scott Black of Delphi Management; Abby Joseph Cohen of Goldman Sachs; Mario Gabelli of GAMCO Investors; Jeffrey Gundlach of DoubleLine Capital; Brian Rogers of T. Rowe Price; Oscar Schafer of Rivulet Capital; Meryl Witmer of Eagle Capital Partners and Felix Zulauf of Zulauf Asset Management. All of these people are very experienced and successful investors. The full article was published in the January 18, 2016 issue.
In this group optimism about the markets was in short supply. They see more stock market turmoil, junk bond mayhem, and global strife in the year ahead. Some expect U.S. stocks to end the year flat or down, while other see modest gains on the order of 7%. Nearly all agree that judiciously buying undervalued equities will yield for greater returns than sticking with index funds. They expect the U.S. economy to expand only modestly this year, by a bit more than 2%, while China’s economy will continue to struggle, leading to further devaluation of the Chinese currency and continued pressure on commodities and energy markets. They think the Federal Reserve, which finally lifted interest rates in December 2015 for the first time in seven years, won’t hike four more times during 2016 because market conditions will not allow it. Fed Chair Janet Yellen might even be forced to ease again after lifting rates one more time.
Comments from the Roundtable that I find interesting are:
Priest: There are only three drivers of stock market returns: earnings, price/earnings multiples, and dividends. The S&P 500 index was up 72% from 2012 through 2014, and 56% of that gain came from P/E multiple expansion. P/Es should be flat from here. Earnings are problematic. Dividend yields will rise. Markets will struggle this year to appreciate both globally and in the U.S.
Rogers: Growth is challenged, and it all goes back to the global financial crisis. Carmen Reinbart and Kenneth Rogoff called it in their book “This Time Is Different”: When you work your way out of a global financial crisis with a lot of leverage, growth is difficult to achieve.
Black: We’ve had three demographic waves propelling the world economy: the baby boomers went to work; Eastern Europe joined the world economy; and China joined the world economy. That’s all over now. Another issue is debt. The world economy has levered up since the early 1980s and economic subjects have hit their borrowing-capacity limits. By definition that means lower demand.
Zulouf: China’s currency is heading south. The only way to prop it up is to restrict capital flows, but that would create another bubble inside China, leading to even bigger problems. China eventually will let the currency fall in value. But a decline of 15% to 30% from here in value of the yuan has negative implication not just for China’s trading partners but its competitors around the world. China is the world’s largest exporter, and one of the largest importers. Imports will be cut if the currency falls sharply, and prices of exported goods also will go down. We are talking about a major deflationary hit to the world economy. That leads to lower corporate revenue and profits outside China, forcing companies to cut costs. Then you have a global recession. That’s what the whole situation is leading to.
Cohen: With the S&P 500 trading at roughly 16 times this year’s expected earnings, it might not be sensible to argue for additional multiple expansion. Thus, it becomes critical to look at earnings, profit margins and returns on equity.
Gundlach: It is unprecedented for the Fed to be raising interest rates with nominal GDP at or near 2%. Things will get worse now. Raising interest rates can’t make things better. If conditions were too rocky to raise rates on September 17, 2015, why are we talking about raising interest rates four times this year? Retail sales are up simply because of auto sales. Ex-autos, the number is negative.
Black: There is no earnings momentum. One reason retail spending isn’t as high as expected is because people have to pay down their debt.
Gundlach: While I don’t have nearly the conviction that I had in 2014, I’d say the yield on the 10-year is going up. One reason rates could rise in this environment is because of liquidation of Treasury bonds by foreign holders. Liquidation by central banks and sovereign wealth funds seems to be overwhelming the flight-to-quality demand for Treasuries.
Zulouf: Some foreign central banks are selling large quantities of Treasuries to support their currencies. These sales are felt in the Treasury market; that’s why bond yields didn’t fall as much as you might expect, given what has happened to commodity prices. It tells you the down-side potential in yields is probably limited.
Black: The mid-cap Russell 2500 index is trading at about 21 times expected earnings, and the small-cap Russell 2000 is at roughly 22 times. It is hard to find great values in individual stocks, and hard to be bullish on the U.S. stock market as a whole.
Schafer: 70% of the stocks in the Russell 2000 are down more than 20% from their 52-week highs. That is also true of 49% of the S&P 500, and 68% of the NASDAQ Composite. A lot of stocks are down 30% or 40% and are buys now. We are in a bear market now. There are times to make money, and times not to lose money. This is a time not to lose money.
Gundlach: I agree and that’s not even a prediction. It’s an observation.
Schafer: There have rarely been times in my career when there have been so many uncertainties; whether it’s interest rates or terrorism or China or the economy, or all the other things we have been discussing.
Hoisington (from the Quarterly Review and Outlook Fourth Quarter 2015)
A Weak Finish to a Disappointing Year
The economy was supposed to fire on all cylinders in 2015. Sufficient time had passed for the often-mentioned lags in monetary and fiscal policy to finally work their way through the system according to many pundits inside and outside the Fed. Surely the economy would be kick-started by: three rounds of quantitative easing and forward guidance; a record Federal Reserve balance sheet; and an unprecedented increase in federal debt from $9.99 trillion in 2008 to $18.63 trillion in 2015, a jump of 86%. Further, stock prices had gained sufficiently over the past several years, thus the so-called wealth effect would boost consumer spending.
The economic facts of 2015 displayed no impact from these massive government experiments. The broadest and most reliable measure of economic performance – nominal GDP – decelerated. The 3% estimated gain registered in 2015, measured by the year ending quarter, was down from 3.9% and 4.1%, respectively, in 2014 and 2013. In fact the gain in nominal GDP in 2015 was less than the gain for any year since the recession. The two components of nominal GDP also decelerated in 2015. Real GDP slowed to 2%, down from 2.5% in the prior two years, and the implicit price deflator rose by 1% compared with a 1.4% and 1.6% rise in 2014 and 2013, respectively. All of the above economic measures were expanding at, or near, their weakest yearly growth rates in the final quarter of 2015, indicating that the economy possessed little forward momentum moving into 2016.
The 2015 global picture was just as disappointing. By some measures, worldwide economic growth was the poorest since the last recession. As in the United States, economic growth was ebbing in Japan, China, Canada, Australia, Europe and virtually all of Latin America as the books closed on 2015. As an indication of the Chinese problem, the Yuan has recently dropped to the lowest level since 2011. Thus, the global economy confirms that the entry point for 2016 is fragile.
Quantitative easing and zero interest rates shifted capital from the real domestic economy to financial assets at home and abroad due to four considerations:
First, financial assets can be short-lived, in the sense that share buybacks and other financial transactions can be curtailed easily and at any time. CEOs cannot be certain about the consequences of unwinding QE on the real economy. The resulting risk aversion translates to a preference for shorter-term commitments, such as financial assets.
Second, financial assets are more liquid. In a financial crisis, capital equipment and other real assets are extremely illiquid. Financial assets can be sold if survivability is at stake, and as is often said, “illiquidity can be fatal.”
Third, QE “in effect if not by design” reduces volatility of financial markets but not the volatility of real asset prices. Like 2007, actual macro risk may be the highest when market measures of volatility are the lowest. “Thus financial assets tend to outperform real assets because market volatility is lower than real economic volatility.”
Fourth, QE works by a “signaling effect” rather than by any actual policy operations. Event studies show QE is viewed positively, while the removal of QE is viewed negatively. Thus, market participants believe QE puts a floor under financial asset prices. Central bankers might not intend to be providing downside insurance to the securities markets, but that is the widely held judgment of market participants. But, “No such protection is offered for real assets, never mind the real economy.” Thus, the central bank operations boost financial asset returns relative to real asset returns and induce the shift away from real investment.
Inadequate real investment means demand for labor is weak. Productivity is poor, which in turn, diminishes returns to labor. According to a Spence and Warsh op-ed article in the Wall Street Journal (Oct. 26, 2015), “… only about half of the profit improvement in the current period is from business operation; the balance of earnings-per-share gains arose from record levels of share buybacks. So the quality of earnings is as deficient as its quantity.”
The firm dollar will remain a restraining force on economic activity and should cause the year-over-year increase in the CPI to reverse later in the year. Under such circumstances, lower, rather than higher, inflation remains the greater risk. Such conditions are ultimately consistent with an environment conducive to declining long-term U.S. Treasury bond yields. In short, we believe that the long awaited secular low in long-term Treasury bond yields remains ahead
There is a lot of information in this letter. The bottom line is that we expect 2016 to not be a good year for stocks; volatility will continue; oil prices will remain low; China will continue to devalue its currency, as will emerging market countries; the Federal Reserve will not raise rates four times this year and may have to drop rates at some point; and the U.S. may or may not go into recession. If the U.S. does not then the stock market may fall by 20% and then rebound. If the U.S. does go into recession then the stock market could drop 50% from its high based on past history. We are in the midst of a global “currency war”. These wars have happened before. One of the weapons countries use is devaluing their currencies in order to increase exports.
At Monroe Vos we do not try to time the market and predict what direction it will go. No one is smart enough to do that and be consistently right. We do have an asset allocation process that shows the projected effects of changes in asset allocation to lower or raise volatility of the portfolio. This quarter we will be taking all of our clients through this process to revisit their asset allocation with the exception of 401(k)/403(b) plans. Each client will have the opportunity to reduce volatility in their portfolio if they wish to do so. We look forward to seeing you this quarter.
Chairman & CEO
Director of Consulting
Released: January 29th, 2016 12:00 PM