2015 has come to an end and it will be printed in the record books that the S&P 500 declined 0.7%, excluding dividends. That broke a string of three straight years of double-digit gains and it was the weakest showing since 2011 when the S&P declined a mere 0.04 points. The final standing for 2015, however, belies the fact that it was an extraordinary year for the market even if it didn’t produce any extraordinary returns.
Restraints & Fed Fear
The Dow Jones Industrial Average, Nasdaq Composite, S&P 500, and Russell 2000 all established new record highs before August. They did so climbing the proverbial wall of worry, which included the stepping stones of contentious negotiations between Greece and its creditors, an uneasy ceasefire between Russia and Ukraine, a strengthening dollar that cut into the earnings prospects of multinational companies, slowing global growth, and falling commodity prices.
It was not an easy climb. If anything, it was an arduous climb, which was reflected in the fact that the indices hit new record highs but couldn’t break out with any convincing flair.
Stretched valuations were a restraint along with a narrowing level of participation in the advance, which was being spearheaded by a handful of heavily-weighted stocks like Apple (AAPL) and Nike (NKE) and the so-called “FANG” contingent — Facebook (FB), Amazon.com (AMZN), Netflix (NFLX), and Google, which was eventually renamed Alphabet (GOOG).
The biggest restraint, however, was the fear of Fed tightening in the second half of the year.
Apple for its part lost its momentum in the latter half of the year, slipping 21.6% from its all-time high in April and closing the year down 4.4%. Apple’s weakness proved to be a big restraint for the market in the second half of the year due to its market weight and how widely-held it is.
In effect, 2015 was really a tale of two halves of the year.
The first half action was steady and unspectacular while the second half was a roller-coaster ride with some spectacular twists and turns that could leave some market participants feeling relieved that the ride ended with S&P 500 down only 0.7% for the year. Last year reminds me of the scene from the movie Apollo 13 where astronauts Jim Lovell (Tom Hanks), Fred Haise (Bill Paxton) and Jack Swigert (Kevin Bacon) are forced to fire their remaining booster rocket to put them back on the correct course to get them back home safely. The resulting wild ride, up, down, left, right is ended when Lovell (Hanks) locks their guidance system back in the middle on the course that will bring them back to earth safely. The astronauts then collapse in a collective sigh of relief. So long, 2015!
Notwithstanding the narrow trading ranges in the first half of the year, it was not a period devoid of meaningful developments.
The Swiss National Bank got things started with a surprise announcement in January that it was scrapping its policy of capping the franc against the euro. In hindsight, that marked the start of a crazy year in the currency markets, which featured the US Dollar Index hitting a 13-year high, the euro toying with a move toward parity with the dollar, and the Chinese yuan hitting a five-year low.
The Swiss move came just in front of the European Central Bank (ECB) joining the quantitative easing (QE) party with an announcement that it will buy EUR 60 billion per month of private and public securities until September 2016. Like other QE programs, the first round didn’t exactly get the job done, so the ECB came back in December with an announcement that it will extend that program until March 2017 (or beyond if necessary).
Europe was a focal point in the first half for other reasons, too, not the least of which was Greece’s bailout standoff with its creditors and the tremendous first quarter rally seen in the European bourses, which rode the QE announcement for all it was worth. Greece and the troika would continue their back and forth until a EUR 85 billion bailout agreement was ultimately reached in August.
Believe it or not, oil prices were not the bugaboo in the first half of the year that they were in the second half of the year.
By the end of June, oil prices had climbed to just shy of $60.00 per barrel from $53.27 at the end of 2014. However, they have been scaling lower ever since, taking earnings estimates and capital spending budgets along with them. At the same time, they have led to a noticeable widening in high-yield spreads, striking budget cutbacks in Saudi Arabia, and infighting among OPEC members.
As you know, we have been completely out of the energy sector since mid-2014 after we wrote a negative review oil prices in our April 1, 2014 client newsletter (“$75 Oil & Putin’s Peril” – oil was trading at $105/barrel at the time). Energy has been a great place NOT to be since that writing and we continue to have a negative outlook on the sector as the Saudis and other oil producing nations continue to pump new oil at near record pace which is at odds with a continuing weakness in new demand as the global economy slows. I believe there will be another leg down this year with a catalyst being a major bankruptcy or major default by one of the larger oil producers, (say, Chesapeake Energy (CHK) or Continental Resources, etc.) would be a likely catalyst to a complete market capitulation for hopes of a speedy rebound in the energy sector. When investors give up hope, then bargains based on solid research can be found, as the baby gets thrown out with the bath water during periods of market capitulation in a sector.
Crazy is as Crazy Does
The roller coaster really got rolling for the stock market in August when China’s stock market went into a freefall and the yuan was devalued. Those particular events, along with plummeting oil and copper prices, precipitated a widespread selloff that would culminate in the first correction for the S&P 500 in four years.
From its peak in June to its trough in August, the Shanghai Composite dropped 44.9%. In other words, the Chinese stock market crashed and it triggered a wave of concerns about global growth and earnings prospects that fueled a risk-off move that hit momentum stocks, like the biotech issues, extremely hard.
August 24 in particular is one of those days that will live in market infamy as it produced an unbelievable and nearly inexplicable loss of 1089 points for the Dow Jones Industrial Average in the first few minutes of trading, a loss of as many as 104 points, or 5.3%, for the S&P 500, and a loss of as many as 414 points, or 8.8%, for the Nasdaq Composite. Only three sessions later, all of those losses were made up and then some. Crazy is as crazy does.
The SEC would later release an 88-page report discussing the volatility seen that day.
While things weren’t nearly as crazy the rest of the year, they were still zany as market participants alternated between a fear of Fed tightening, the hopeful implications of a Fed tightening, and the expectation of further stimulus from the People’s Bank of China (PBOC), the Bank of Japan (BOJ), and the ECB.
The zaniness was embodied in the performance of the market itself. The S&P 500 declined 6.3% in August and another 2.6% in September before ultimately surging 8.3% in October, which represented its best month in four years.
There was a bouncing ball of Fed rate hike expectations in the latter half of the year.
The disappointing September employment report seen in early October left many with the impression that the fed funds rate would enter 2016 at the zero bound. A strong employment report for October seen in early November and another solid employment report for November seen in early December helped change the course of things for both the Fed and the market.
On December 16, 2015 — exactly seven years to the day that the Fed moved policy rates to the zero bound — the Federal Open Market Committee agreed to raise the target range for the federal funds rate by 25 basis points to 0.25% to 0.50%.
It was a seminal move, not only because there hadn’t been an actual rate hike in more than 10 years, but because it marked a key divergence in central bank policies that may very well lead to some more zaniness in 2016. That is, the Fed is now in a mode of aiming to raise its policy rate while the ECB, BOJ, and PBOC are still working to provide accommodation and the Bank of England is still sitting tight with its easy money policy.
Those divergences are expected to be at the root of many trading decisions in 2016
What It All Means
2015 was a huge year of M&A activity. In fact, it was a record year, according to Dealogic, which said activity topped $5 trillion for the first time ever. Pfizer (PFE) and Allergan (AGN) topped the list with their $160 billion merger plan, followed by the $117 billion Anheuser-Busch InBev (BUD) and SABMiller deal.
IPO activity, on the other hand, was not too stellar. In many ways, it was the worst year for IPOs since 2011 as worries the bull market may be coming to an end and an over-saturation of deals in the previous two years helped keep IPO activity at bay.
Despite the headlines these activities generated, we’d argue that the lead actor in 2015 was the central banks and that the plunge in commodity prices was the supporting character.
Those two factors were a prominent part of the market discourse just about every day.
China had a constant headline presence, too, but everything that happened there with its stock market and economy still flowed right back into what it presumably implied for commodity prices and further policy stimulus from the PBOC and the potential action (or inaction) of other central banks.
The same can be said about inflation readings, stock market volatility, credit spreads, the flattening yield curve, economic data, commodity prices, currency moves, and weak earnings (S&P 500 operating earnings are projected to decline 0.9% in 2015, according to S&P Capital IQ).
What does it all mean for the Federal Reserve in particular and other central banks in general?
That will remain the question as 2016 unfolds (and probably 2017 and 2018), just as it was in 2015, which saw little return and a lot of craziness.
|Market||Price Return 2015|
|S&P Mid Cap 400||-3.7%|
|S&P Small Cap 600||-3.4%|
|Dow Jones Industrial Average||-2.2%|
(Data Source: FactSet; Yahoo! Finance)
|Sector||Price Return 2015|
(Data Source: FactSet)
2016 Market View
We didn’t expect much out of 2015 from a price return standpoint. Unfortunately, we’re not all that enthused right now by the return outlook for 2016 either.
Valuation is stretched, interest rates are moving up, earnings growth estimates are falling, and, frankly, we’re not altogether confident in the Federal Reserve’s more hopeful view of how things might unfold.
Throw in some increasing geopolitical stress, divergent monetary policies, widening credit spreads, narrow market leadership, and presidential politics, and you have some grey clouds hanging over the market as we enter 2016.
Those clouds could rain, they could pour, or they could pass by to give way to sunnier skies. We don’t know for certain. Nobody does, because the future is inherently uncertain. That’s why our forecast will be subject to change as 2016 unfolds.
What we see in the weather pattern today though leads us to think the barometric pressure is falling, and not rising, for the stock market. For those who may not know, falling barometric pressure is generally a harbinger of an approaching storm.
At recent closing prices, the S&P 500 was trading at 16.5x forward twelve-month earnings, according to FactSet. That’s not an exorbitant valuation, but it is stretched relative to the 15-year average of 15.3x.
Others who follow Robert Shiller’s cyclically adjusted price-to-earnings ratio, or CAPE ratio, will be quick to point out that it’s more than stretched at 26x current earnings, which is a 56% premium to the long-term mean.
Whatever PE path one follows, the overarching point is that the stock market at current levels is fully valued at best and very overvalued at worst.
The forward price/earnings multiple contracted over the course of the last tightening cycle which began in 2004. We may not see the same type of multiple contraction we did in the last cycle if the Fed is able to follow a gradual path of tightening, but a faster pace of tightening would be more problematic.
Nevertheless, with profit margins near record highs, the dollar remaining strong, and global economic growth weak, the market is unlikely to be as willing as years past to pay up for each dollar of earnings with interest rates just starting to rise.
Said another way, we don’t think investors will be willing to pay any price for growth in 2016 as they did with a number of market darlings in 2015.
Growth stocks may still be the preferred option if economic growth remains sub-par, yet we suspect the market will be more discerning with an approach of buying growth at a reasonable price (i.e. GARP investing).
If economic growth was to accelerate in a stronger-than-expected fashion, value investing could become — and probably should become — a more popular strategy. For now, we will continue to focus on larger capitalization firms with superior cash flow return on investment well in excess of their firm’s cost of capital that are selling at attractive prices relative to our view on these firm’s intrinsic value. We’ll also want these firms to have a demonstrative history of above average dividend yields and growth.
The Big Risk
The issue of economic growth will be a key driver of things in 2016 given the related association with managing monetary policy. We know from the accommodative stance of the world’s major central banks that the growth outlook isn’t too stellar.
According to the Federal Reserve — the world’s most influential central bank — the US outlook is looking better, so much so that the Fed moved the target range for the fed funds rate off the zero bound for the first time in exactly seven years this month.
It was a so-called “dovish hike,” because it was accompanied by a contention that future rate hikes are likely to happen only gradually. If there is a key risk to the market in 2016, it is the Fed’s approach to managing monetary policy.
If subsequent data show a marked deterioration in growth and/or inflation, the Fed will be accused of choking off the recovery effort by raising rates too soon.
If subsequent data show a much quicker pace of acceleration, the Fed will be accused of being behind the curve and will prompt concerns that it will have to raise rates faster than it (and the market) expected.
The latter is the bigger risk, because the market is not buckled in to handle a faster pace of rate hikes. Having to take back the rate hike would be an initial disappointment, yet a move back to the zero bound we think would ultimately be viewed as a source of support — but from what level is the real question.
This goes to show how the Fed really needs to thread the needle with its policy approach to keep the market on a relatively even keel. That won’t be an easy task with other central banks maintaining the status quo with their accommodative policy stances or making them even more accommodative.
This divergence in central bank policies carries the potential to cause a storm in the currency markets if it leads to a continued strengthening in the dollar. That would rain further on commodity prices, emerging markets, and the earnings prospects for multinational companies — the combined impact of which would have a boomerang effect on the US stock market and severely challenge the Fed’s assumptions.
There has been a lot of chatter in recent years about currency wars, yet there is latent potential in the depreciating yuan, the depreciating euro, and the depreciating yen to cause some currency and policy storms in 2016.
A Trend That Is Not One’s Friend
We saw in 2015 how the strong dollar crimped the earnings prospects of multinational companies. A bullish view toward 2016 is predicated in part on a rebound in earnings growth that flows partly from a relaxation of the dollar’s strength and a recovery in oil prices.
We struggle to see the dollar weakening to any great degree if other central banks keep their foot on the policy stimulus pedal while the Fed starts applying the brakes.
We know today that the consensus earnings per share (EPS) growth estimate for calendar 2016 is 7.9%, according to S&P Capital IQ. That sounds good relative to the 0.8% decline currently projected for calendar 2015. Then again, at the end of 2014 calendar EPS growth for 2015 was projected to be 8.8%.
The relentless slide in energy prices, and the hit to earnings for the energy sector, drove the downward revision for 2015.
At the moment, every sector, with the exception of the energy sector, is projected to deliver EPS growth in 2016, yet every sector has seen growth estimates come in since the start of the third quarter reporting period.
|Sector||CY 16 EPS Growth Estimate Oct. 1||CY16 EPS Growth Estimate Today|
(Source: S&P Capital IQ)
We’re not convinced given the weak global growth, the dollar’s persistent strength, the consumer’s newfound propensity to save more than he/she spends, and the ongoing decline in commodity prices that 2016 EPS growth estimates won’t be subject to further downward revision.
This consideration is a main reason why we’re not as enthused by 2016 return prospects as EPS growth estimates suggest we should be.
We could become more enthused with a reversal in earnings growth estimate trends and will watch that as a potential driver of an upgraded market view in coming months.
What It All Means
It is set up right now to be a tough investing environment in 2016.
The chatter heard today that it will be a stock picker’s market is probably right. It sets up as such with the broader market’s valuation already stretched and monetary policy moving from a coordinated approach to a less coordinated approach.
The volatility seen in the second half of 2015 is expected to carry over into 2016, with the movement in commodity prices, credit spreads, and incoming economic data playing a key part there since they will all influence the market’s thinking with respect to the Fed’s monetary policy approach.
It’s a year that investors won’t be criticized for starting in observation mode considering 2015 has been drawing to a close with more of a whimper in the stock market amid bangs heard elsewhere, which have included the Fed’s first rate hike in more than 10 years, OPEC’s recalcitrant stance and infighting on production levels, emerging signs of distress in the junk bond market, and a terrorist act in France.
Based on less accommodating fundamental factors, our view is that investors with a time horizon that doesn’t stretch past 2016 should have a more conservative mindset when it comes to investing in the stock market.
That doesn’t mean one should simply favor defensive-oriented sectors. It really means to be careful about picking and choosing your stocks in all sectors, and remembering that cash is an appropriate investment alternative at times to stocks and bonds. It also means the US stock market as a whole may not be the best place to look for excess returns in 2016.
Investors with a longer-term orientation have the implicit benefit of additional time on their side. That key element might allow for a more opportunistic approach that includes starting to build long-term positions in beaten-down areas like energy, materials, retail, and transportation. Still, the focus there should be on companies with the best balance sheets because the sledding could still be tough over the near term for these groups.
There are grey clouds lurking above, so don’t forget an umbrella to protect you from any rain that might fall from them in 2016. As always, I look forward to catching up with you soon.