Looking Ahead to 2016

“Chaos isn’t a pit. Chaos is a ladder. Many who try to climb it fail and never get to try again. The fall breaks them. And some are given a chance to climb, they cling to the realm or the gods or love. Only the ladder is real. The climb is all there is.” – Littlefinger, Game of Thrones

On May 21st, the S&P 500 index hit an all-time high, 3.5% above December 31st close, only to drop 12.35% in the following three months.

A similar and even deeper fall occurred during the summer of 2011, a loss of 17.6% in the same index.

But between these two incidents, 2011 and 2015, there hasn’t been a correction over 10%. This uptrend with no breaks had brought valuations to a stretched territory and susceptible to a correction.

Looking at other major indexes and Exchange Traded Funds, the recent 12.35% drop in the S&P 500, was 14.44% in Dow Jones, 13.65% in Nasdaq, 28.98% in Emerging Markets ETF (EEM), 17% in Gold ETF (GLD), 17.78% International Developed Markets ETF (EFA).

In bonds, the loss was 3.4% in 20 Year Treasury Bonds ETF (TLT) and 3.7% in Aggregate Bond ETF (AGG).

Commodities have been in a straight downtrend since June 2014 and the drop is 53.65% from top to bottom.

It has been a difficult market to find positive returns…as stocks, bonds, precious metals and commodities all have been hit hard lately.

Why?

The main culprits have been widely viewed as: the FED fears, global and more so Chinese economic slowdown, oil glut, stretched valuations and strong US dollar.

So looking ahead globally and in the US, what to expect and what should be one’s investment strategy in 2016?

Valuations

The recent drop in equity prices cooled off valuations a bit. Absolute valuation (stand-alone) matrices have been showing stocks as mostly expensive, relatively (to bond yields) fairly valued and cash adjusted within historical averages.

Cash adjusted valuation adjusts the valuation of your stock investment for the cash the company has at its disposal. US large corporations have piled 2.5 trillion dollars of cash and when you invest in them, you get to own a portion of this asset as a shareholder, hence the reason why cash adjusted valuation makes equity prices seem more reasonable.

Where will this cash be spent in 2016? Most likely the past trend will be repeated and it will be allocated to stock buy backs and dividends.

When a company buys its own stock, it lowers the number of available shares. This improves earnings per share without increasing earnings. So even though company earnings don’t improve, its stock valuation gets a boost.

In aggregate, when these funds aren’t invested in capital expenditures or research and development, the economy doesn’t reap their benefits, but investors are rewarded through dividends and buy backs.

Global Stock Markets

The weakness we’ve been seeing in the US equities is a global phenomenon, in some cases even more seriously. But more recently, breadth (percentage of the world stock indices with rising moving averages) is improving and signs of a recovery may already be here.

Japan and Emerging Markets, specifically India and China has more room to the upside as unlike the US stock market with shallow corrections, they have been hit hard. But again, they also carry higher risk, so think twice before you overweight.

US Dollar

A strong US dollar is one of the reasons for headwinds, as it makes US exports more expensive and puts pressure on foreign earnings. Has dollar reached a peak? I doubt it.

Knowing that we are probably only about a month or two away from the next FED rate hike, historical US dollar movement around past rate hikes can be a guide here. Considering the weakness in the global economy, European and Asian central bankers’ rate hike decision is a low probability event. So relatively, the dollar may seem more attractive and continue its strength. Given that the rate hike pace is expected to be slow; the trend in dollar strength may be sustained.

Commodities

If you’re wondering whether or not the bear market since 2014 has created a buying opportunity in commodities, think again. Technical support levels have been broken and there is no reason to think the reversal is near. This is good news for consumers, but bad news for commodity driven industries.

Bubble Economy?

Are we in a bubble, closer to the end of the growth cycle?

It is understandable to look at historical averages and wonder if a recession is here, knowing that historically about every 5-7 years, the US economy finds itself in one.

According to this approach since the growth cycle started in 2009, next year we should start feeling the heat. According to National Bureau of Economic Research, since the Great Depression in 1929-1933, the longest growth cycle was for 10 years (1991-2001) and the shortest was for 1 year (1980-1981). So it may still take a few more years for the US economy to reach that point.

There is also the camp that argues FED’s next to zero interest rate policy has been artificially boosting asset values and once the tightening cycle starts, the bubble will burst.

Before I get to FED, I will say this: growth cycles don’t die because of old age and bubbles form mainly as a result of excessive debt. We live in a fiat currency and debt driven economy. In a usual business cycle, the borrowing goes to the roof and the debt payments become a burden on spending. As one’s spending is another’s income, falling incomes put pressure on growth and the economy goes in to a recession.

So the better question here is the level of debt, especially consumer debt. The answer is, nowhere near peak, in fact consumer debt to consumer financial assets ratio has been falling since 2009.

Also, other signs of an end of a growth cycle usually include high inflation, high interest rates and extreme optimism, none of which are present at current time. In short, a recession in 2016 is a low probability.

The FED

Leaving the best to last, let’s talk about the FED. The most important player and its actions have been so closely followed; that it is hard to report news here. Most likely in December or January the rate hike will be resumed, and will continue through 2016. How will this affect the markets?

As mentioned previously, it really depends on the pace of the rate hike and most likely a slow pace is in the cards in which case, based on historical records, the market may actually continue the uptrend with some volatility for adjustment.

I hope you find this summary of global capital markets and my projections as helpful. Please feel free to send your questions or comments to bbakan@shieldwm.com.

Also, have a pleasant Thanks Giving!