After spending thousands of hours working to make money unproductively, we’re more than happy to close up 2015 and are looking forward to the next year of investing. This update will begin a series that focuses on developing opportunities as we see them in 2016. Thankfully, as we complete our analysis, we find that our view is comfortably on the contrarian side to what we’re seeing in the mass financial media. Part I will take a very high level view of the larger market and economic cycle in the US, including the risks of recession, historical probabilities, key drivers of returns and timing considerations. On with the show!
The Bigger Cycle – Buying Into End of Q1?
As I write this first edition, global financial markets are having one of their worst starts of the year since 2001 (down 2-4%). As such, it seems almost silly to say that we expect more weakness and continuation of the correction that began in July of last year. As I mentioned a couple of weeks ago, the markets seem to be pricing in a higher risk of a global recession. For instance, Treasury bonds are up, Gold is up, Short sellers are getting excited, defensive sectors like healthcare and consumer staples are doing the best, etc. While recession risk is certainly on the rise, looking out over the course of 2016, the evidence does NOT support that outcome – at least not yet. Beyond the nastiness in the energy and high yield credit market (which are highly related issues) as well some very weak manufacturing reports; we just don’t see leading indicators supporting the recessionary theme. Auto sales, strong employment, housing, spending, household debt, a rising US dollar, strong service sector, the shape of the yield curve and other leading indicators are still pointing to a tepid but healthy economic recovery here in the US. We see this as a mid to late cycle expansion in the US and the Fed supports that view with their most recent rate hike. The bond market is pricing in additional rate hikes totaling 0.75 though 2016, probably .15-.20 at a time.
Issues that will be the key drivers of returns for 2016 are the Federal Reserve policy changes (obviously), trends in the energy sector (can we find stability?), and valuations. I’ll focus for a moment on the last one. Valuations for most of the developed world stock markets are no longer attractive and this remains a concern. Select foreign and developing markets are far more attractive now and will be the subject of a pending “2016 Best Bets” report as we build out our optimal international investment guidelines. According to our trusted research sources, the S&P 500 would need to pull back to around 1884 to return to the average post WWII valuation of 15 times earnings. The index is now trading at 19 x earnings on a trailing 12-month basis, which is in the 80-90thpercentile of all market conditions for high valuations. The 1884 level represents a loss of 8% from the 2015 year end close and coincidentally brings us back to the August lows. Remember, this is just to get back to an average stock market valuation. Downside risk is therefore a minimum 8%, but likely more. Now for some upside good news. The US market has been here before and done remarkable well at least until valuations have pushed into the 90-100th percentile. Take a look at this chart provided by Bespoke Research.
The left chart shows forward one year returns for various percentile ranks based on valuations. Remember, we are in the column second to the right (80-90th percentile). Average returns have been lower at these levels but still positive (~5%). Now look at the right chart. Strangely, the “percent of time positive” shows that when the markets are at this HIGH valuation, the odds of a positive year are actually also one of the highest (74.5%). Obviously, we need to be watchful for the condition when valuations truly hit historic extremes and push us in that zone of serious risk of loss. Along those lines, we also have not seen that bull ending frenzy of euphoria and bullishness among investors. Some would argue that we did see it in concentrated form with significant gains in names like Facebook, Amazon, Netflix and Google (FANG). We don’t think strong moves in a select few names are enough to create a frenzy of mass investor bullishness, quite the opposite in fact from analysis of Sentiment trader.com. 2016 could be the year where we see a surprising exhaustive move that blows out valuations and witnesses that bull ending euphoria in investor sentiment.
Timing is everything so let’s spend some ink on that. The first quarter of 2016 could be tough as I said and the basis of that comment is year over year comparisons in earnings from Q4, 2015 (weak) to Q4, 2014 (strong). Estimates from earnings from last quarter are still strongly negative especially compared to the same period 2014. But beyond the pending earnings reporting period starting next week, things look better again. We should not be surprised to see the market trade lower in the first 3-4 months of 2016 but ultimately finding an attractive bottom that takes prices higher all the way into elections. This is guesswork at best but the technical pattern would also confirm an end to the market correction cycle that began in July of 2014 (yes 2014!). July of 2014 marked the end of the three-year strong uptrend in a MAJORITY of market indices. Yes, most indices made very marginal new highs in June of 2015 but those proved to be just part of a larger topping process and unsustainable. From a timing perspective, I am reminded of 2009 which saw an exhaustive move lower into March following one of the worst 18 months in stock market history. That low, in March of 2009, was the generational low!
I’ll finish with some quick commentary on historical odds regarding percentage moves for the broad US stock market. The average of all big brokerage shops says the US stock market will finish 2016 with a gain of 7%. They are punting. They have no idea, so they went with the long long long term average for the US stock market. Using volatility measures, valuations, election cycles and stage of the Federal Reserve interest rate policy, there is a 76% chance that we’ll see the US market finish the year at greater, or less than, 10% in 2016. We have little doubt we’ll see both during the year. With that said, I’ll reiterate our gratitude and commitment to our process which remains focused on dynamically allocated assets according to market conditions. Our net exposure, selectivity and position size daily analysis should do their job in mitigating risk of significant loss while taking advantage of buying opportunities when they come. Frankly, I would not want to be a passive investor of any type in 2016 despite the relatively poor performance of most active managers in 2015.
Happy New Year to everyone and we look forward to serving you again in 2016.