Part I - Bad News Bears
As I watch the talking heads on CNBC, Fox and Bloomberg parade the permabears each time the market looks to correct, I react firstly with anger at this open-ended script which quickly vaporizes at a market reversal. But, as an economist/market strategist it is an embarrassment to watch these Doomers; Marc Faber, Peter Shiff and David Rosenberg, all of whom somehow gain credibility for being consistently wrong. They are pawns in the game of “down markets sell media.” Currently, the S&P 500 has once again corrected as the average as of last Friday’s close was 11.9% below the May record high. The S&P 500 closed on Friday at 1,880.33 slightly above the double bottom of August and September. Technicians will scramble to set lower boundaries determining whether it will be only a 10% correction or a 20% bear market. So much for the first few innings of the bull and bear’s game.
No doubt problems exist both domestically and globally affecting US stock values. Slow growth in China, the strong US dollar, oversupply of oil, and deflation in industrial commodities are cited as major culprits in a global slowdown. Investors cannot discount the deleveraging associated with alternative and commodity traders. This is, in part, an unintended consequence of the 25 basis point rise by the Fed. To conclude that a full-blown recession, or even worse a repeat of 2008-2009 is on the horizon does not equate with the current domestic economic situation. Much of the 4Q2015 slowdown is most likely already reflected in stock prices along with a weak beginning to 2016. That being said, the current environment necessitates a more cautious investment policy.
China has embarked on a policy to lower the value of the yuan against the dollar and other major currencies. The policy is gradual and will not be an immediate devaluation, as rumored recently. At this time, China has decided to intervene to protect the value of the yuan, a losing battle costing China billions in US dollars and other major currency reserves. Briefly stated, China is holding on as the transition to a consumer economy moves forward. In 4Q2015 consumer spending rose 11.1%. Longer-term this will be beneficial to US companies. The dollar pain is well-advertised and reflected in earnings and revenues and will continue until the “de facto” devaluation of other weaker currencies is replaced by economic growth. This is particularly true for developing countries with excess capacity experiencing raw material liquidation. Oil is a unique problem as more crude is coming to market. Supply outstrips demand by more than most experts have estimated and it is unlikely that prices will firm until costs prohibit further extraction. We would expect bankruptcies of highly leveraged oil drillers before a sustainable supply/demand level is reached, with the peak in bankruptcies confirming the bottom. It is widely believed that this price will be around $20 a barrel. The uniqueness of the supply equation is that a number of the major oil producing countries; Brazil, Russia, Libya, Venezuela, and now Iran, will export at maximum levels no matter what losses are incurred. While predicting a bottom has proven futile, falling oil prices have led stocks down.
Oversupply is not unique to the emerging countries. For the US, where final sales have averaged about 2% annually for over the past five years, changes in inventory and trade volume play a larger than normal role on overall economic growth. Burdened with overcapacity, US industries, both manufacturing and retailing, have been liquidating inventory since late-2015. Absent capital spending, these net liquidations have a larger negative effect on real GDP growth. According to Federal Reserve Bank of Atlanta’s “GDP Now,” as of January 15 the 4Q2015 real growth rate is estimated 0.6% with consumer spending only 1.7%. This is well-below the nearly 3.0% GDP increase estimated by the Bank in early November 2015. This is a potential negative for a market selloff should these below average estimates hold when GDP data are released on January 29, 2016.
With all the negatives revolving around weak quarterly earnings, stock valuations have declined to levels where a better-than-expected 4Q2015 earnings may set a floor under stock prices. According to FactSet, as of January 15 the blended (combined actual and estimated) earnings decline in 4Q2015 for the S&P is 5.7%. Excluding the Energy sector (-70.7%) the estimated earnings decline would be 0.1%. Also troublesome is the continued weakness in revenues. The blended revenue decline is 3.3%. Excluding the Energy sector, S&P revenues rise only to 1.0%. Just how much of these negative estimates are reflected in stock prices will be known shortly. There will be earnings shocks, particularly from Large Cap companies selling abroad and for technology companies affected by international considerations in China and developing countries.
Our Reports over the past year have discussed at length the lack of transparency for large segments of the equities markets. This is particularly true for “flash or algorithmic traders.” Classified as hedge funds, these computerized firms rely on instantaneous transactions, which according to the SEC add liquidity to the markets. Under normal conditions this is defensible as concluded by academic studies. In periods of high or increasing volatility these momentum trades, in the absence of the Uptick Rule abolished in 2007, create a clear path to lower stock prices. As momentum builds, legitimate bids are either withdrawn or withheld, giving a distinct advantage to these short sellers. After the flash crashes in 2010 a partial reinstatement of the Uptick Rule requires a price increase prior to shorting after a stock has fallen 10% for the remainder of that day’s session, not much of a deterrent.
Our investment policy has become more cautious. In our January 4 Compass, we wrote that the August-September lows may be tested, we did not think it would happen in nine days. With all the pessimism in the markets there appears to be opportunity. However, good news is bad news and bad news is just that. The problems we foresee are cyclical and not systemic but, they may continue further into 2016 than in previous post-2008 selloffs. Since late-December, there have been no meaningful rallies and buyers are reluctant to commit to new positions, instead raising cash on any up moves, even if intraday. Earnings season will add clarification but chances are results will not push equities above the November highs. What is going on today is more of a mid-cycle adjustment. The 2H2016 should reward caution and patience. I reiterate our strategy expressed in early January, “sit back and wait.”
The US economy continues to grow, but below trend for 1H2016. For the stock market the problems are well-documented but solutions will take time. Lower earnings will carry through the second quarter as corporations work through a strong dollar, tighter margins, and inventory liquidation. Expect higher volatility during early-2016 as companies shift to satisfy increased consumer demand in an environment of geopolitical uncertainty and an impending presidential election. The transition to a more consumer-oriented economy is in its early stages and not fully reflected in corporate aggregate earnings. Longer term we believe that consumer-led economic growth, accompanied by slow rising real interest rates and low inflation, will result in increased earnings and multiple expansion with continued upside for select Large-Cap Consumer Discretionary and Technology companies.