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.

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.