A Rally to Nowhere
After a five week rally, as of Friday’s close the S&P 500 and Dow Jones Industrials were positive for the year, but are below the May 2015 all-time highs. The NASDAQ Composite and the Russell 2000 remained in the red. The Volatility Index (VIX) steadily declined from mid-20’s to a more moderate level of 14. Since the selloff began in January there has been a shift away from growth into value. Large-Cap stocks continue to outperform Small-Caps, and without earnings growth equities are bumping into a valuation ceiling. Leadership has shifted away from Healthcare (-7.1%) and Financials (-4.6%) into the more income-oriented Consumer Staples (+4.2%) and Utilities (+12.4%). Energy (+5.6%) and Materials (+4.2%) have outperformed in reaction to rising oil and raw industrial commodity prices. The S&P 500 now stands where it began the year.
Much of the volatility experienced in 1Q2016 underscores the sharp selloff in the role of hedge funds and algorithmic firms trading on short-term indicators. These market participants, which add no economic value to investing, distort the fundamentals on the long and short side of the trade. At its mid-January lows, only 10.6% of the S&P 500 stocks were above their 50-day MA, and last Friday this number rose to 92.3%. The same trend is apparent with the 200-day MA, which fell to 9.6% and was 57.5% last week. Earnings for 4Q2015 were near forecasted levels and the economy, despite perma-bear recession forecasts, grew at a 2% level. In fact, improvements in employment, consumer spending and housing were better than forecast. Stocks traded on short-term technicals, reacting to oil price movements and to a lesser extent fluctuations in the US dollar. The issues continue to be oil prices and the US dollar with an eye to volatility. Until there is a clear reversal in the energy and dollar trend, corporate earnings will remain under pressure.
A barrel of WTI crude oil rose over this five week period from a low of $26.10 to over $40.00. This over 50% retracement of crude prices had short-term significance for the stock market, but in the context of the decline from $110 a barrel, the reversal is minimal. The oil surplus continues, and with the increase in demand only slowing, an equilibrium price remains elusive. The dramatic 76% decline in US rig count brought the number down to 386, levels not seen since December 2009. Lost production has been more than offset by Iran’s increase to 3 million barrels a day, up from 1.5 million with intentions to reach 4 million by year-end. In reality, the decline in oil rigs has had a more negative impact on US energy company earnings and employment than on overall supply. The shift in refinery blend for summer driving normally leads to a temporary rise in inventories. Should the reaction to the seasonal shift lower oil prices, it would be only temporary but reestablish focus on oversupply.
Emerging Markets (EM) currencies were weakened by the Fed rate hike in December. The EM economies are saddled with excess capacity from the over-investment during the 2013-2014 commodity bubble and have been plagued by tightening financial conditions from reduced exports and increased funding costs. Many of these countries issued US dollar-dominated sovereign debt and are now faced with repayment or refinancing at much higher costs due to their currency’s depreciation against the US dollar and the Fed rate increase. (The estimate for this debt runs as high as $3 trillion.) It is too early to tell if the recent rise in commodity prices will alleviate pressure on these countries, but the adjustment will be longer than initially anticipated. China, the main driver of Asian-Pacific commodity demand, continues to rebalance but at a pace more gradual. Downward revisions to GDP will be the barometer for estimating a timetable for EM return to growth. Investors should be aware of EM problems, but for now there are no meaningful consequences for US equities.
China’s economy appears to have stabilized. Real GDP growth is forecast at 6.5% for 2016 and 2017. Monetary policy should remain accommodative, although continued easing weighs on the currency and accelerates capital outflows. The transition to a consumer-oriented economy continues apace as infrastructure growth, manufacturing, and exports decline as consumer spending, including housing, accelerates. The net effect of this shift is a slow deliberate yuan depreciation. This weakening of the currency leads to further outflows and may result in strong capital controls. What happens in China will continue to have a short-term impact on US markets beyond reality as only earnings translations and its effect on US multinationals matter.
In our last Report we discussed the housing sector and its potential as a driver of a longer-than- anticipated economic growth. This conclusion is based on a financially healthy consumer in an era of rising employment opportunity and wage gains. However, this 2016 consumer is more cautious. Conditioned by high unemployment, lower real income, a housing depression, foreclosure and personal bankruptcies, the current consumer is more defensive and weary of a repetition of 2008-2009. US households increased spending 3.1% in 2015, the largest annual increase since 2005. But unlike other high-spending cycles, it is estimated that only 70% of disposable income (including gas price savings) was used in purchases. The savings rate reached 5.2% last year, up from 4.8% in 2014. Strong employment gains at the lower-end of the pay scale, not wage increases, have been a major contributor to spending. The lower fuel costs are reflected in increased spending for motorcycles, pickup trucks, SUV’s, tobacco, and eating out. Middle to upper income spending has recovered but is more dependent on wage and salary increases, which only recently are showing signs of acceleration. A risk to luxury spending is volatility in the stock market similar to 1Q2106 resulting in a negative wealth affect.
Our investment policy remains cautious. The recent rally has not changed our outlook as it is short-term technicals (triple bottom) coinciding with a bounce from the mid-$20’s in crude oil. The problems we foresee are cyclical and not systemic, but they may continue further into 2016. Unless earnings surprise to the upside, the dismal outlook for 2Q2016 and beyond could negatively affect current stock prices. 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 some multiple expansion with further upside for select Large-Cap Consumer Discretionary and Technology companies. Portfolios should move to include value companies exhibiting sustainable earnings growth and dividends. We reiterate our strategy expressed in early January, “sit back and wait.”