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.
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