So, the market is off to a less-than-stellar start to the year, to put it mildly. In fact, stocks endured the worst first week ever, with the S&P down 6% last week. Naturally, everyone wants to know what it means for the rest of the year, so here it is, the good, bad, and ugly.
- The good: of the other 9 years in the top 10 worst starts to the year, 4 recorded a gain for the year, with 2 well into double-digits (+15% and +26%).
- The bad: 5 of the 9 years were negative.
- The ugly: the previous worst first week was 2008.
The average return for these 9 years is -3.7% (which includes 2008’s -38.5% loss), but this number does not include dividends.
Clearly, this is not the company you want to keep. But the glass is half full! If the S&P hit its low this morning at 1,879, that -8% loss to start the year means that we should see a +4.3% gain the rest of the year, plus dividends. Obviously, we not only hope for, but anticipate, much better returns than that in 2016. It is very rare to have 2 negative years without coinciding with a recession.
So was last year a negative year? Depends how you look at it. The S&P lost 0.7% last year, but including dividends, it was +1.4%. The Dow lost 2.2%, but eked out a 0.2% gain with dividends. However, U.S. large-cap stocks were the exception last year. Total return for U.S. mid-caps was -2.2%, and for small-caps it was -4.4%. European stocks were -3.6%. Emerging markets were -14.8%. Even bonds failed to provide respite, with the Barclays Aggregate Index only +0.5%. High-yield bonds lost 5%. Recall that the 3rd year of the presidential cycle is typically the best, with no down years since 1939….but years where a horse won the Triple Crown haven’t been good. So the horse got the better of the president.
From its high last summer, the S&P is now -12% to the low this morning, firmly in correction territory. But if all you own are U.S. large-caps, consider yourself lucky. U.S. small-caps are down 23% from their high! Dow Transports are down even more: 28%!? The Value Line Arithmetic Index is not a benchmark we often quote, but it does a good job of capturing the performance of the average stock, as it’s not market-cap weighted like most other indices. This index was down 22% as of this morning. Other markets around the world are also in bear market territory, including stalwarts Germany and Canada, while emerging markets like Brazil are down 40%.
By now you can see the double entendre of the title of this piece. Almost nothing is up this year, with the exceptions being treasury bonds, muni bonds, and Wal-Mart. Who is selling? And why?
When you distill everything that affects markets into a fermentation tank, what remains is OIL. After enduring a 70% drop from the mid-2014 highs into the end of last year, spot crude oil has taken a further 15% hit to start the year from $35 to $30 per barrel. Throughout this oil saga, the market has routinely switched from “risk-off” to “risk-on” mentality. “Risk-off” simply means that investors choose to take less risk by selling risky assets and buying riskless assets. The vacillation between these two mentalities utterly coincides with shifting beliefs on whether the U.S. economy will make it through the oil shock unscathed, or whether it will succumb to it. You can throw in a whole mess of exogenous variables from the last 1 ½ years (the rise of ISIS, ebola, the surging US $, China’s stock market boom and bust, Donald Trump). But they inevitably take a back seat to oil’s persistent collapses. The bottom line is that when the price of oil is falling, stocks are typically falling. When it stabilizes, stocks recover. On the chart below, oil is the yellow line:
So if you’re worried about stocks falling, the implicit belief is that oil will keep falling. We view sub-$30 oil as totally unsustainable…maybe for a short time as inventories remain high, but not beyond the short-term. If you haven’t read Dave’s end-of-year newsletter, check it out.
So how much has the economic outlook changed in the last 14 days, as oil fell from $35 to $30 per barrel (it is now back up to $31)? We would argue very little, and we’ll get more into that shortly. Here’s how the last 12 days have played out:
- Death by a thousand cuts to oil. The latest swoon in oil is the 7th big swoon since prices started falling in mid-2014, and it comes after prices had stabilized in the latter half of December. Investors had come to grips with oil in the $35-$40 range. As soon as they did, oil took another dump and forced them to reassess just how much damage will be done to oil producers, their bonds, the banks that loaned them money, foreign economies which depend on oil, and capital spending declines by the oil sector.
- Investors have pulled money out of junk bond funds and ETFs, requiring fund managers to sell bonds just to meet redemptions, only to have buyers vanish. The outflows have totaled roughly $90 billion since mid-2014.
- Similarly, investors have been selling stock mutual funds throughout 2015, to the tune of $172 billion, prompting fund managers to sell stocks to meet redemptions.
- Reports that oil-dependent countries are raiding their reserves and sovereign wealth funds by the tens of billions in order to plug holes in their budget, to make up for lost oil revenues. These funds own a whole gamut of assets like real estate and Premier League soccer teams, which aren’t readily sellable, so they must sell liquid assets like stocks.
- Once a correction gets going, individual investors panic and sell.
- Buyers who lack conviction become gun-shy and back away from buying “until the smoke clears.”
That’s the who, why, when, where, and what of the deal. Does it tell us whether the market has found a bottom today? Not at all. Does that mean you should be scared that stocks could fall further? Prepared, yes, but scared, no. If you’re scared of stocks falling, you probably own too much in stocks. Stocks are almost always volatile. They can go a year or two with low volatility, like U.S. stocks did from mid-2012 to mid-2014. But the average range for the stock market from its low to its high in a year is 20%. Put the 12% drop into that perspective.
During this correction, safe stocks have dramatically outperformed risky stocks. Our core stocks have outperformed the S&P 500 by almost 2% year-to-date in just 9 trading days. In the market swoon last August, there was no distinction whatsoever; everything fell pretty much as much as the market. When the pinnacle of defensive safety, Johnson & Johnson, falls 10% in 3 days, you know the baby just got thrown out with the bath water.
What does it mean when quality outperforms? It means investors have genuine concerns about the economy. As commodities continue to crash, they dent the growth prospects of many countries. These countries will buy less stuff from American companies, a problem exacerbated by the strong U.S. dollar. This is why corporate profits were flat in 2015.
But, on balance, any country which is a net importer of commodities is a net winner these days. This would include almost every developed economy in the world (think U.S., Japan, most of Europe) and even some emerging economies (China, India, Korea, many other Asian and eastern European countries). In these countries, consumers have a major tailwind from lower gas and heating prices. Companies in these countries see their costs drop too, which helps profits grow.
With consumer spending rising at a healthy clip now, companies are continuing to hire new workers at a healthy clip, and these are the major reasons why we don’t see a recession in the U.S. anytime soon. U.S. recessions are almost always preceded by a bubble in the economy (real estate, tech spending), a sharp increase in oil prices (never a decrease), rising labor cost inflation, and an inverted yield curve (where short-term interest rates are higher than long-term rates). The current economy has none of these. The most recent occasion when commodities endured such a crash was 1997-98, which caused many emerging markets to go into recession and devalue their currencies. The U.S. didn’t enter recession until 2001, and it was caused by the bubble in tech capital spending which burst, the Fed raising rates many times, and sharply rising labor costs. Even oil prices were rising into 2000 and 2001. The result was a shallow U.S. recession. Meanwhile, the rest of the world did not share these woes, and there was no global recession.
We might prove overly optimistic on the economy, but we still see no cause for concern whatsoever. In fact, the more hits the global economy takes, the slower growth remains in the U.S., the slower the Fed will move to normalize interest rates higher, and the longer this economic expansion could go. We still think it will take higher wages and higher interest rates to end this cycle, and anything to stave off both should be welcomed by investors.
“Is it a good time to buy?”
This is the question we are most often asked now. It’s a good question, and it’s a sign of how seasoned our clients are that their #1 question isn’t, “Should we sell?” The answer largely depends on the client’s liquidity, time horizon, and our understanding of his/her risk tolerance. That said, if there’s room to buy some more stocks, there are a lot of stocks we wouldn’t hesitate to buy right now. It is not necessary to buy at the absolute bottom. Even after today’s rally, you have a “20% off” coupon for the average stock. We see a lot of reasonable valuations that can be sustained for the long-term, for companies who can grow earnings, and with dividend yields now into the 4s, even on high quality growth companies like Emerson and Abbvie, and over 3% for Wal-Mart, P&G, 3M, Exxon, Coke, Cisco, Intel, J&J, Merck, Sysco, United Tech, and McDonald’s. Yes, even MCD, trading at an all-time high after a +30% total return last year.
Does there need to be a bull case for stocks? We expect earnings to grow in 2016, which would be an improvement over 2015. The pause in cyclical capital spending will continue into the year, but we see other headwinds starting to dissipate, notably the U.S. dollar, which actually peaked last March. Consumer spending will accelerate, led by improving wage growth. The real catalyst will be evidence that the U.S. economy is not a sinking ship. But the fuel for a rally would be provided by any thawing of the rampant pessimism that exists among investors today. That $172 billion that came out of U.S. equity mutual funds and ETFs last year? More than came out in 2008, 2009, 2010, and 2011 combined! There is no greater contrarian indicator than mutual fund flows. Or if you prefer, how about the II Bull/Bear ratio? More survey respondents are bears than bulls, to a level as low as all past corrections and bear markets.
There are genuine concerns out there, such as the junk bond market, which continues to look uglier, and probably presages a tick up in bank loan loss reserves. The crash in commodities hasn’t yet taken out any major producer, and it seems like investors are waiting for the first one to fall before they consider buying stocks. While this might give you pause for buying a copper producer, it really shouldn’t compel you to avoid buying J&J.