It’s Darkness Before the Dawn

After the worst start to a year, the stock market has amazingly recovered.  The nightmare that began 2016 was a tortuous six week drop.  The widespread damage to the global equity markets was relentless.  The panic and fear increased to a point where the Chinese closed their markets for a couple of days to try to combat the selling.
In mid-February, as pessimism was everywhere, something completely unexpected happened – the global markets stabilized and U.S. stocks went on a five week rally that erased all of the losses.   So after the first three months of the year, we’ve had a lot of price movement but little change from where we started.  More importantly, the markets’ emotional state is back to its normal neurotic condition.
Despite ending the quarter with just a small gain, it was a historic three months.  It was the first time in 82 years where the S&P 500 was down over 10% during a quarter and then recovered and closed up at the end of that same quarter.  It last happened in the 4th quarter of 1933.
It was a remarkable shift in investor emotions during 2016’s first three months.  Conventional wisdom during the decline was that the emerging markets were imploding, commodities were dropping, and the world was plunging into recession.  Sentiment switched during the second half of the quarter to a calmer view of the global economy and re-established confidence that the central banks would be able to navigate through the challenges.
The trading action in these three months reflect the decline and then the recovery.  In 2016’s first 48 trading days the S&P 500 moved 1% over half of the time (26 times).  In contrast, March only had 4 days of 1% moves.  That is a lot of motion without much movement (the S&P closed the quarter less than 1% higher than where it began the year).  Of course, inquiring minds want to know if that volatility and recovery signaled a sustainable low.  In other words, did February’s reversal represent a panic point that priced in all of the bad news and none of the good news?
Here are the major averages returns for through April 1st.
Dow Jones Industrial Average        -2.1%
S&P 500                                            +1.4%
Nasdaq Composite                           -1.9%
Russell 2000                                      -1.6%                       
Indices are unmanaged, do not incur fees or expenses, and cannot be invested into directly. These returns do not include dividends
As referenced above, recession worries and the Fed have been two of the biggest market influences.  This likely remains the background although at any given time Mr. Market will also focus on the potential terrorist threats, BREXIT (Great Britain’s possible exit from the EU), presidential polls, and polar cap ice cover.
While economic reports have improved, progress remains challenged.  For example, the unemployment rate has dropped to 5% but job growth is frustratingly below historic standards and wages are stagnant.  Secondly, automobile sales are at record levels but it’s been assisted by cheap financing.  Finally real GDP, while still positive, is lower on a year-over-year basis.
As the markets digest these reports, their eyes remain on the Fed.  After their December interest rate increase, investors have been on edge over how many more increases will take place in 2016.  Last week Janet Yellen gave a very dovish speech.  While she didn’t provide details on the future monetary policy, she was clearly in no hurry to raise rates again. Some market strategists were looking for up to four fed funds rate hikes in 2016.  Those expectations have been severely reduced post speech to the point where several commentators are forecasting only one more move this year.  Some are predicting no hikes in 2016.
In addition to the economic cycle and monetary policy, stock valuations is another important variable.  As measured by the S&P 500, stocks are trading at a price-to-earnings (P/E) ratio of just under 20 times.  The long-term average for this index is 15.42.  According to Bespoke Investment Group (April 1, 2016, The Bespoke Report), this P/E level is higher than 82% of all daily readings since 1929.  That’s far from an “all clear” sign and unfortunately the recent trend has seen the denominator (earnings) decline.  High valuations are not always the catalyst for falling stock prices but they will not be helpful if markets retreat again.
The S&P 500 has averaged a gain of 2.7% in April during the past 10 years.  Given a recently confirmed supportive Federal Reserve, this trend might continue.  However, there are substantial headwinds to a sustained rally.  Reestablishing corporate earnings growth would be an important development to continuing the stock market’s advance.  First quarter earnings and management’s guidance for the rest of 2016 should be a helpful sign in determining if this is developing.  Otherwise 2016 might turn into a “sell in May and go away” year.

Mr. Kerr is an Investment Advisor Representative of advisory services offered through Kildare Asset Management, a Registered Investment Advisor.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Past performance is not indicative of future results. Investing involves risks, including the risk of principal loss. The strategies discussed do not ensure success or guarantee against loss. This information should not be construed as investment, tax or legal advice and may not be relied on for the purpose of avoiding any Federal tax penalty. The Dow Jones Industrial Average is a price-weighted index of 30 actively traded blue-chip stocks.  The Standard & Poor’s 500 (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general. It is not possible to invest directly in an index.  Trading of derivative products such as options, futures or exchange traded funds involves significant risks and it is important to fully understand the risks and consequences involved before investing in these products. All information is believed to be from reliable sources; however we make no representation as to its completeness or accuracy. All economic and performance data is historical and not indicative of future results. Market indices discussed are unmanaged. Investors cannot invest in unmanaged indices. If assistance is needed, the reader is advised to engage the services of a competent professional.
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