In 2014, when I first broadcast the notion of this year being a “Transition Year”, I probably understated what we’re actually seeing today. We have seen some wild moves that are far beyond the forecasts calling for slightly higher volatility. But from the wreckage, we find opportunity and I’m beginning to see some nice set ups for bold investors who know where to look. I’m going to force myself to take a stab at likely outcomes for 2016, purely for your entertainment, while we wait for the market’s reaction to the Fed’s rate hike tomorrow.
Current Market Conditions
I can describe them easily – UGLY. We have pockets of things that are not as bad as others, but that’s probably the most positive thing I can say. Last week was a bone crusher as the markets broke decisively below long term averages (again) fleshing out what now looks like a larger market top in stocks. The waterfall decline in August is also now looking like a brief acceleration period among sellers within a larger developing peak for many sectors and investment styles. As I said two weeks ago, the set up in late November was WORSE looking from a sentiment perspective, as bullishness was much HIGHER than in July before the summer slam. High bullishness is a negative factor for stocks and contrarian by nature. There was a lot of Red ink on the board last week. For those who have some lingering notion that 2015 is an up year, take a look at this matrix provided by Bespoke Investment Group. Hard to find any love this year, in any country, any sector, any asset class.
Over the last couple weeks, we have been selling and cutting our net exposure to the markets as evidence began to mount that our short-term recovery was fading quickly. Cash levels are back up to nearly 30% (or more) in our tactical equity models. Blended asset strategies have cash of 25-45% and Income models are still 60-75% in cash. Remaining holdings are still those trading above their long term moving averages but we’re losing positions regularly as stops are broken. Again, this is our process at work, making incremental changes and adjustments as market conditions unfold. In hindsight everyone is a genius and of course, we could have guessed at this outcome. Then again, we could have guessed that the market would put in a top every year since 2011 – except it didn’t. We try not to use guessing as a market strategy. So is this time different? I’m going to answer that question by tearing it apart looking at the broad US stock market first and then focusing on select internal pieces of the market.
Is This The Top for the US Stock Market?
All things considered, I think there is growing evidence that 2016 could be tough for the US stock market in aggregate, at least into the summer. Investech Research did a nice job of summarizing the state of things offering “6 More-Compelling Reasons to be Cautious in 2016”. I’ll list them here and am happy to provide more details upon request:
-
- 1. This bull market is now the second longest in duration since 1932.
- 2. Gains have been the 4th largest since 1932 (now behind us)
- 3. Margin Debt still looks like it’s putting in a top – typical at market peaks
- 4. Speculation in a few names is high (Facebook, Amazon, Netflix, Google), the FANG trade has been carrying the market – masking weakness
- 5. Corporate profits have peaked – leads a final price peak by a few months.
- 6. Long-term momentum indicators have negative bear market patterns.
Also, regular readers might remember the status of Lowry’s Buying and Selling pressure index which flipped negative in July and never returned to positive (sadly). So the weight of evidence points to lower prices in early 2016, perhaps with some follow through basing price patterns into the summer. This is just the way things sit now, subject to change at any time. But here’s the good news;
I don’t currently see the potential for a global stock market decline that will be anything other than a garden variety bear market (15-20%). We’ve all heard the doomsayers proclaim the END is upon us and to expect another bear market that is worse than anything we have seen in modern history. I don’t think so. There are three reasons why we could expect a just as shallow bear market.
First, I still see a tremendous pile of cash sitting on the sidelines, both in households, bank deposits and corporate cash. Cash is fuel for investments and it will jump at virtually anything offering a reasonable return opportunity. I call this Cash Anxiety. We’ve been in this environment for nearly four years and I will openly blame the Fed’s extended stay at zero interest rates as the root cause. In fact, we are seeing the fallout from this anxiety played out in the high yield bond market now as people have reached way out on that brittle limb to find yield. Now the limb has broken and high yield corporate bonds are crashing to the ground – more on this “opportunity” in a minute. So cash hates to earn nothing and investors are actively looking for places to put it. Remember most investors don’t know much more than to buy market index funds, so any price decline in the corresponding market indices will be bought offering some support to limit the magnitude of bear market declines.
Second, I see a rotation of investment capital rather than exit from global stock markets. Circle back to the Bespoke matrix above and focus on the internationals for a second. Wow! Brazil down -38% YTD, China down -17% YTD, India down -14% YTD, Canada down -25% YTD. 2014 wasn’t much better for internationals in a lot of cases. Europe suffered badly in 2014 but seems to be recovering, at least from a stock market perspective, as they are only down -6% YTD now. The US has been the best looking horse in the glue factory for the last 12-18 months but common sense says we could see a great deal of money rotate to internationals in 2016. One could argue this will drive prices even lower in the US but you have to remember that the investing world is much more linked globally in terms of price action, revenue and economics than anytime in recent history. Remember, more than 50% of the S&P 500 company revenues are derived from overseas now. A healthy resurgence in international economies and indices should also provide a limit to any downside in our domestic markets.
Finally, like internationals, we are already seeing deep discounts at the sector and asset class level in our own markets. These are in obvious places like commodities, energy, materials, industrials, high yield bonds, small caps and classic Value funds (like Berkshire Hathaway!). Bubbles in the credit markets are popping and they look to be contained to the junk bond space. We exited all junk bonds in June and July – FYI. The energy sector is having a generational moment of pain as the industry adjusts to the ramifications of unchecked supply and production. Drill Baby Drill ? remember that? History is full of painful stories surrounding supply-side disasters. If one does not read history, one is doomed to repeat it. Required reading for anyone in the oil and gas business – Niall Ferguson’s “Ascent of Money”. Nevertheless, it is extremely difficult for a major sector to work its way all the way down to making a 5-6 year new low in prices. The energy sector (stock averages) has just done that while the price of crude itself is close to a 12 year new low – also very rare! I expect we’ll see some massive M and A activity in the energy space in 2016, like the airlines did in 2009. We will not have more than 2-3 major integrated oil and gas companies in the end. We will only have 1-2 coal companies left in the end. We have not seen the end of this story yet but we should be alert to generational investment opportunities in the energy sector as early as next year.
High yield bonds are also angling toward another incredible buying zone although I think we’ll have to see 2-3 rate hikes in the rear view mirror before high yield bonds will actually move higher in price sustainably. Already, we are seeing corporate bond yields push up to 8% (from 4%) and prices are down 12-15% from the highs. Ultimately, junk bond yields will reach 10-12% and that should be the time to consider reloading. Both of our High Income strategies are capable of getting aggressively invested in high yield corporate bonds and both strategies have generated some of their best double digit returns in years following these set ups. I am openly recommending that all of our clients review their exposure to our High Income strategies and consider an allocation if you are underweight or have none – maybe for some sideline cash (wink).
Again, investment opportunities have been developing for the last couple years and these will keep investor capital engaged. If money just sloshes from one sector to another, rather than leaving the market altogether, we don’t have to see declines like those of 2001 or 2008. One more reason why we might expect a more tepid broad market decline in the broad market averages.
In summary, the weight of evidence for the US stock market is still down and the intermediate term price pattern is no longer constructive. We do expect a short term bounce in prices starting almost immediately, perhaps a relief rally with the Fed Decision tomorrow. The set up is not favorable anymore and still points down; we must remember that we are now in a new secular bull market that will be interrupted by cyclical, “garden variety” bear markets. We saw this condition last from 1982 to the year 2000. We saw it happen from 1948 to 1966. It can happen again. With our twenty year goggles firmly in place, we want to use deep corrections and even mild bear markets, as opportunities to add cash, to invest in deep discounts, to find value and make some long term investments. In the meantime, we’ll continue to play defense with the primary intent of having our emotional and physical capital intact when we need it. Buy discounts in a primary bull market!
That’s it for now. We’ll be watching for the market’s reaction to the Fed tomorrow along with the rest of the world
Cheers
Sam Jones
