I’ve Got Some Bad News For You Sunshine

In case you hadn’t heard, January 2016 is the stock market’s worst yearly start in history.  Every index, large and small (except for the Dow Jones Utility Index’s less than 1% gain), is down over 7% in just two weeks of trading.  Many averages are down over 10%.  And the carnage extends beyond U.S. equities and includes foreign stocks, commodities, bonds, and currencies.
Markets began deteriorating in November.  Stocks then regained losses later that month but retreated again in December.  There was a Santa Claus rally although it was not nearly as strong as expected.  Despite the market’s sloppiness, there was no indication of what was to happen.
As 2016 trading got under way, the markets encountered problems starting in Asia as China’s Shanghai index collapsed 7% on the first trading day.  Weaker than forecast Chinese economic data was one of the reasons, however an unexpected devaluation of China’s currency played a bigger role.  In the past the People’s Bank of China (PBOC) controlled the value of the renminbi (vs. other currencies primarily the U.S. dollar) to a very narrow range.
Last August the PBOC first loosened the renminbi peg and the markets revalued it to around 6.5 renminbi to the dollar from 6.2.  The PBOC provided little guidance with this announcement which, as expected, lead to confusion and questions.  That uncertainty rippled through the global capital markets and contributed to the August/September  selloff.
Apparently the PBOC didn’t learn from that debacle as they repeated the decision during the first week of January.  Once again Chinese officials allowed their currency to decline against the dollar, and once again turmoil ensued.  The questions started – was China encouraging currency depreciation to boost growth?  Others worried that the Chinese officials had lost control of the financial system and that there was a run on the currency.  Of course, rumors were that the economy was imploding.  Whatever the real reason, the capital markets were confused and uncertain. This resulting in selling which spread globally.
China’s markets has remained the focal point during this two week sell off.  This is a function of being the world’s 2nd largest economy as well as it’s where the trouble started.   The attention intensified as the authorities and officials made so many missteps it resembled a Three Stooges episode.  This climaxed when the Chinese stock market opened with another plunge in the first 15 minutes and then closed trading for the rest of the day.
As we know, the damage wasn’t contained to Asia.  The U.S. markets were under pressure from the first trading day as well.  Stocks declined, commodities fell, and bond yields were lower.  As mentioned, it was the stock market’s worst start of a year.
Here are the major averages for the first two weeks. 
2016 YTD: 
  Dow Jones Industrial Average  -8.2%                  
  S&P 500                                           -8.0%  
  Nasdaq Composite                      -10.4%
  Russell 2000                                  -11.3%                                 
Indices are unmanaged, do not incur fees or expenses, and cannot be invested into directly. These returns do not include dividends
While the China’s issues have not helped the markets, U.S. equities appear to be more tied to crude oil prices.  This has been a recent development and appears to be related to the large amounts of debt that the energy sector accumulated over the past 5 – 6 years.  This capital helped finance the U.S. drilling boom.  A significant amount of this debt was raised by smaller companies as high yield bonds.  Crude’s implosion has increased the risk that the debt can’t be serviced.
It’s intuitive to think that lower energy prices are a huge economic benefit.  However Wall Street is worried that widespread default on fixed income could have a much larger negative impact on the financial system.  As a consequence, for the time being, lower crude means lower stock prices.
As pessimism over the stock markets increases, it’s helpful to look back at previous weakness to start the year.  2016 is the worst start in history.  Using a sample of the 15 worst 5 days to begin a year, the declines range from 5.96% (2016) to 1.79% (2000).  Of these past examples, January ended up being higher 36% of the time with an average increase of 1.34% (there were some large recoveries such as 14% in 1934 and 9.5% in 1985).  Looking to the rest of the year, the S&P 500 ended the year up 43% with an average return of 0.85%.
Given the size of the declines in 2016, it’s hard to see a recovery during in the month’s final two weeks.  Another important indicator is flashing a more troubling signal.  The December Low Indicator measures the Dow Jones Industrial Average’s low point in December as a tipping point.  If the Dow trades below the December low in the New Year’s first quarter, it signals a warning.  For the record, the Dow’s low last month was 17,128 on December 18 and we have sliced through that on January 6th.
There have 33 occurrences of the December low being violated.  The Dow has averaged a 10% further decline in those instances.  The index closed higher from that lower “low” in 19 of those 33 examples.  Applying this to 2016, there is risk that we have not seen the bottom for this sell off.
On the positive side, there are several things pointing to somewhat of a bottom.  Two option related statistics are that the equity put/call ratio closed above 1 which has only happened 5 times since 2011 and usually signals at least a short-term bottom. Also the 5-day average of this ratio reached .93 which is the highest since 2009.
The American Association of Individual Investors (AAII) bullish sentiment reading was the lowest in 10 years (this is viewed as a contrary indicator – low bullish numbers can be market bottoms).  Also, the second half of January is seasonally positive.  Last week’s Barron’s cover featured the headline “Bear Scare”.  Clearly there is a good amount of pessimism which is often associated with bottoms.
Whether the problems in the capital markets spill over to the economy is far from certain.  Indicators are still pointing to growth however slower than previous years.  Nevertheless, it would be naïve to think that the headlines and news reports about the global markets won’t have an impact.  Moreover, when these type of avalanches take place, there is usually a sideways period rather than a “V” shaped move as the market adjust and rebalance.
It would be natural for equities, commodities, and bonds to retrace a portion of January’s move.  Assuming this takes place, metrics like market breadth, the number of new 52-week highs vs. 52-week lows, volume (both absolute and up volume vs. down volume) and credit spreads will be important signs of bounce’s health.
It’s a long shot that we repeat the market’s 2008-2009 path.  The banks are not as heavily exposed to energy as they were to the mortgage market.  Further, such things as job growth and corporate earnings remain supportive.  Currently, however, Mr. Market’s focus is on the visible negatives we face.  If that changes together with some further positive signs for the economy, we may find a bottom.

There is Nothing Permanent Except Change

Three weeks ago the Federal Reserve raised the federal fund rate and Disney Studios released Star Wars – The Force Awakens.  Both have been among 2015’s most anticipated events.  Also, both are notable because they’re the start of many more to come – more Star Wars sequels and more Federal Reserve interest rate increases.  While the Star Wars movies will be a continuation of its storyline, the financial markets are in a process of adjusting to a new landscape.
The Federal Reserve Open Market Committee raised its overnight lending rate to 0.25% – it was the first increase in 9 years.  It’s been so long that many have probably forgotten how markets act when interest rates are moving higher.  Of course, the amount of future increases as well as their timing is a hot financial topic.  There is a growing contingent that believes that the Fed should have waited in December.  On the other hand, it seems that the consensus is for up to 4 rate increases in 2016.
Those in the ‘wait’ camp point to some softening economic statistics.  Industrial production in the U.S. contracted on a year-over-year basis.  It’s the first time that this has happened since the recession.  And while it’s important that production is still positive, a decline in industrial production usually coincides with a recession.
Furthermore, the Institute of Supply Management (ISM) survey remained below the important 50 level for the second month in December.  The index fell to 48.2 which is the lowest level since June 2009.  Unfortunately, most components (employment, new orders, etc.) show little signs of recovery.
Another cautionary sign is that corporate profits as measured by the S&P 500’s 3rd quarter’s earnings declined year-over-year. It was the second consecutive quarter of an earnings decline.
Margins are being pressured by wages and higher interest costs.  Labor expenses are starting to rise.  Employee compensation as a percentage of total corporate expenses has risen recently from a cyclical low of 57% to 58.5% in the 3rd quarter.  The normal long term level is in the low 60%.  A move back toward this level would be a headwind to earnings growth.
Revenues are obviously another important component of the equation.  Unfortunately, there are some challenges in this area as well.  The U.S. dollar has been on a steady rise and has broken above its long term trend line and moving averages.  The higher value of the greenback means that when U.S. companies translate their foreign sales from euro, yen, or rupee back into dollars, it is a lower number (all things being equal).  And as we know, international business has become an important part of the U.S. economy.  Lower sales together with higher labor costs are a troubling combination for profit growth.
Another notable market development has been the turmoil in the corporate bond market especially in the high yield sector.  As we know, the collapse in crude oil and commodities has hurt any company that drills, mines, transports, services, or is involved in any way to these industries.  This hit has increased the risk that some of the entities can’t repay the interest and principle on their borrowings.  Within the fixed income market, these company’s bonds were sold (lower bond prices and higher yields).  While a lower bond price doesn’t immediately hurt the company that issued the bonds, it essentially closes them from selling new bonds to rollover the debt when the older issues mature.  If new debt can be sold to the market, it will be at a substantially higher interest rate (cost to the borrower) at the same time that the borrower is experiencing lower revenues.  A double whammy.  These factors probably had an impact on stocks prices.
Here are the major averages returns for 2015. 
2015 YTD
Dow Jones Industrial Average  -2.2%                     
S&P 500                                    -0.7% 
Nasdaq Composite                   +5.7%
Russell 2000                             -5.7% 
Indices are unmanaged, do not incur fees or expenses, and cannot be invested into directly. These returns do not include dividends
Before readers begin reaching for the hemlock, there are positives.  Staying with the fixed income markets, high yield bonds have never had two consecutive down years.  Perhaps 2015’s carnage has priced in all of the bad news surrounding the commodity and energy industries.  If that is the case, 2016 could turn out to be a year of stabilization and recovery.
Another reason for optimism is that there is too much pessimism.  Investor sentiment is typically thought of as a contrary indicator.  In other words, if there is too much bullishness, it is viewed negatively as investors have already acted on this and have done their buying.  The current landscape, as measured by traditional surveys, is far from upbeat.  The AAII (American Association of Individual Investors) weekly report stood at just 25.1% bullish respondents.  This is a low number.  There were only 8 weeks of 40% and above during 2015 which was the lowest number in 25 years!  By far the largest group is neutral or perhaps “confused”.  51.3% of the survey were in this neutral position which is a 12-year high.  Strategists and professionals are similarly situated – a strong statement given that the economy is growing albeit at lower levels.
The capital markets are dealing with some large cross currents.  The Fed will be raising rates while the ECB (Europe Central Bank) is cutting rates.  In fact they are expanding their monetary stimulus as their bond buying program will be to one of the largest ever.  U.S. corporate profits are forecasted to grow but are facing new obstacles such as increasing costs and a slower global economy.  This will likely result in growth but at a lower level than recent years.  Toss in terrorism, geopolitical tensions, and emerging markets problems, it is easy to be confused.
The markets are always facing uncertainty.  It is reflected in such things as earnings multiples and interest rate spreads.  It will be the same in 2016 as the markets digest the news flow and then adjust to new uncertainties.  Unless one of those ‘new uncertainties’ is a recession, investors can expect to find some opportunities amongst the market ebbs and flows.