January marked one of the worst starts to a year ever; one that I’m happy to quickly put behind me. If the market climbs a wall of worry, then there are bloodied fingernails from trying to hang on.
If there was any hint of over-optimism on the part of investors heading into the New Year, that by now is gone. It was a horrible month; one that will make viewing January brokerage statements painful to do. Unfortunately, February, so far, hasn’t offered firm footing for investors.
The market’s pullback was violent and caught many investors by surprise. Nobody could really escape it. It’s now about finding a bottom and digging out from the mounting losses to get back to even.
This was the worst January for stocks since 2009 in a selloff that erased $7 trillion from the market value worldwide, and $2.5 trillion in American shares at its worst point. The graphic below shows the MSCI All-Country World Index which slid 5.3% for the month, with the S&P 500 being off 5.1% for all of January.
I suppose if there is any solace to the month it had to be January 20th – the day of capitulation. The S&P tumbled 12% to start the year, then turned up 7.4% from the lows of that day through February 1st.
MSCI All-Country World Stock Market Index (Dec. 28, 2015 – Jan. 29, 2016)
Source: Bloomberg, January 29, 2016 (ECB=European Central Bank, BOJ=Bank of Japan)
By the end of January, global markets appeared to be stabilizing with the Standard & Poor’s 500 Index trimming its worst monthly drop since August.
|2016 Returns||3-Yr Annualized Returns|
|S&P 500 Index||-5.07||+8.77|
|Dow Jones Industrial Average||-5.50||+5.67|
|Russell 2000 Index||-8.85||+4.50|
|MSCI World ex-USA**||-6.94||-2.67|
|MSCI Emerging Markets**||-6.52||-11.44|
Source: Wall Street Journal, MSCI.com; 2016 returns (month of January): December 31, 2015 through January 29, 2016; *Annualized; ** U.S. Dollar Returns
Much like last year (particularly in the second half), the culprits weren’t a surprise – plunging oil prices, concern that China’s slowing growth will create contagion, and rising stress in credit/debt markets. Collectively, these concerns could be signaling an end to the bull market run or an impending recession.
The biggest story this year is oil, especially the interesting and inextricable link to all things financial (be it stocks, the U.S. dollar, other commodities or credit markets). Given the swift drop in oil prices, it’s creating a negative feedback loop.
While oil has been slippery to the downside, let’s touch upon some positive lubricants to the economy. Fortunately, there a good number of them that should help to offset investors’ dour tone. The US economy is resilient, particularly in the services sector which comprises nearly 80% of our overall GDP.
Consumer balance sheets have been shored up after being strained from the Great Recession. Given low interest rates, U.S. consumers are in a better position to service their debt. The strength of the labor market has also contributed to healthy household balance sheets, helped along by higher home values and lower energy costs. These tailwinds have helped buttress spending in the face of a slump in stock prices. All in all, there is plenty of evidence to suggest a disconnect between Wall Street and Main Street, where there’s a lack of signs pointing to a looming recession.
Even January’s job report released last Friday (February 5th) reiterated that the job market is on solid footing with decent wage growth, thus confirming companies continue to be confident in their outlook, at least domestically.
As for the Federal Reserve, I’m sure they now regret initiating an ill-timed tightening in mid-December. At their policy meeting on January 27th they admitted that they’re “closely monitoring global economic and financial developments” and their impact on the U.S. economy. Given that the Fed is raising rates during a deflationary expansion puts great onus on corporate earnings to support security prices this year.
We are in the thick of 4th quarter 2015 earnings season, with results of ~ 63% of the S&P 500 members already out (as of February 5th). Growth is turning out to be even more challenging relative to other recent reporting periods, but that is hardly surprising given the well-known headwinds of a slowing global economy, the strong U.S. dollar, and problems in the energy/commodity sector.
The problematic part on the earnings front is that the growth challenge isn’t something that’s quickly going to anniversary itself away; it is very much an issue for the current and coming quarters as well. All of the earnings growth for 2016 is now entirely expected to come in the back half of the year, with growth (or lack thereof) in the first half of the year now expected to be down year-over-year.
Analyst expected in December that S&P 500 companies’ earnings would grow 7.1% this year but that’s quickly falling to the wayside. The take-away from the reporting season so far is that there is a dearth of revenue and earnings growth. Estimates for the first quarter are coming down quickly as companies offer a lackluster outlook for the first quarter. Earnings for the S&P 500 are expected to fall -5.3% in the first quarter, year-over-year, according to FactSet Research, with the energy sector weighing heavily on earnings once again. However, as is often the case, overly optimistic analysts are still predicting significant increases in earnings and revenue growth in the 2nd half of the year; estimates that often get more realistic as the period draws nearer.
Although investors are fearing a global downturn that has the bear pawing the bull, debt leverage should be the least of investors’ worries. Given historical levels, corporate leverage is modest today, and it has not been the driver of deteriorating corporate quality in recent downturns.
On the other hand, profitability has been known to collapse and earnings volatility to spike when the going gets tough, and the U.S. in particular is due for a cyclical earnings correction – one that seems well under way (the past 3 quarters and the upcoming first quarter all show negative earnings growth). It’s best to keep a close eye on profitability and not to get distracted by corporate debt; healthy and stable earnings are key to better days ahead.
The market is now pricing in one hike for the rest of the year in overnight borrowing rates, not four as the Fed’s median forecast predicted. The Fed will most likely hold off on hiking in March, but we could see them use that meeting to increase the probability of a hike at a subsequent meeting, if market volatility subsides by then.
Bond investors this year have benefited from rising demand for safe haven assets lately, with Treasuries rising for a third straight January. The benchmark 10-year Treasury note closed at 1.83% (Feb. 5th), the lowest since last April.
The return outlook for fixed income remains positive, yet muted. My fair value estimate for the 10-year U.S. Treasury yield this year is near 2.5%, as I don’t see a big snap-back in yields anytime soon. Given investors’ response to the initial rate hike and other central banks’ intervention, the Fed will be hard-pressed to raise rates this year. Treasuries bonds should be less volatile than other segments of the bond market.
However, we’re not at the bottom for riskier securities. The U.S. corporate default rate is expected to rise, possibly significantly this year, with Moody’s predicting it will reach a six-year high of 4.4% this year. Speculative-grade/junk debt will likely remain under pressure, with yields on some bonds rising even more (particularly commodity producers). Beware of emerging market sovereign and corporate debt as well.
While January’s markets offered up plenty of worry, the traditional signs that a bull market is over weren’t visible – excessive valuations, irrational exuberance nor outright signs of a looming recession. However, there are market segments nearing 20% correction.
After several years of suggesting that low economic growth doesn’t necessarily equate with poor stock returns, my outlook for U.S. and developed country stocks remains guarded. That said, my long-term outlook is not bearish and can even be viewed as constructive when adjusted for the secular low-rate environment we find ourselves.
Where are the Markets Headed?
Until recently, most Wall Street strategists didn’t expect we’d witness a bear market (stocks dropping 20%) in 2016, but now there’s a growing chorus of pessimists. In the near-term, markets will most likely find a bottom and trade sideways, providing break-even returns at best. I can’t be overly optimistic about the S&P 500 running higher right now as the markets are in dire need of growth catalysts.
Whether there’s truth in the adage “as goes January, so goes the year” depends on whom you ask. Since 1927, the remaining 11 months have moved in sync with January 68% of the time, suggesting a weak month could portend a weak 2016. Taking the signal from January’s 6.1% retreat in 2008 spared you a 34% plunge during the rest of the year. However, bailing after the 8.6% tumble in 2009 would’ve cost you a 35% rebound.
Then there’s also the Super Bowl indicator that claims the stock market’s performance can be predicted by the outcome of the game. If the AFC team (Denver) wins, then it will be a bear market. If the NFC team (Carolina) wins, then it will be a bull market for the rest of the year. Its success rate is ~ 80% so is it pure coincidence?
Given the Super Bowl indicator, investors appeared to put sell orders in ahead of Monday’s open as the Denver Broncos won the game convincingly, 24-10.
Regardless of the game’s outcome, if investors learn to tackle China’s issues and the energy slump, 2016 may turn out all right. If we look back to 2014, the markets witnessed the initiation of the slump in crude prices along with geopolitical troubles.
However, that did not restrict the S&P 500 from hitting multiple highs. 2016 should include similar strong domestic data. The energy price slump should then be seen as a blessing. Lower crude prices eventually boost purchasing power and disposable income, helping consumer confidence to soar especially since consumer spending accounts for 70% of GDP.
I firmly believe that the principles of portfolio construction remain unchanged. Investors with an appropriate level of discipline, diversification, and patience are likely to be rewarded over the next decade with fair inflation-adjusted returns. While a long-term approach requires discipline for one to best achieve their financial goals, it also involves fortitude – sole-searching, restless nights and queasy stomachs.
Even though we are off to a turbulent start to the year, it’s usually best to remain calm and stay the course. We will always have geopolitical crises of one stripe or another, but history has shown that the majority of these crises have little to no impact on the long-term performance of the markets.
Over the course of my career, I have witnessed numerous bear markets, corrections, tech and housing bubbles and flash crashes. Interestingly enough, each bear market was followed by an even longer bull run. There have always been many reasons not to invest in stocks. The only reason to invest in stocks is that, over the long term, stocks have always gone up, outpacing the rate of inflation.
In 1960, the Standard & Poor’s 500 was 60. Today, it’s closer to 1,900. While many international economies are weak, the U.S. economy is in good shape and has been getting stronger – unemployment is down and wages are (finally) starting to increase; mergers and acquisitions (M&A) activity is at a record high; and interest rates are near historic lows and will most likely remain fairly low over the next few years.
Over the past year, low oil prices have devastated the profits of energy companies and related service companies, which has impacted the markets. But on the flipside, that’s means energy savings for consumers and energy-intensive businesses that will deploy these savings elsewhere. Some economists predict $3 trillion a year will be transferred from oil producers to global consumers, setting off one of the largest wealth transfers in history.
While I’m in the camp that says a recession should be avoided this year, an aging bull market means rising risks and increasingly volatile trading days will most likely continue. Only time will tell if this is just a nauseating correction in the midst of a bull market or a hibernating bear awakening.
Looking forward to better days ahead,
Eric J. Linser, CFA