Investors find themselves paralyzed by uncertainty given mixed messages from prominent market experts and talking heads, some professing the sorry and deteriorating state of the global economy, and others cheerleading the continued improvement in the fundamentals, particularly here in the U.S. Indeed, the nearly identical chart of the S&P 500 in 2015 compared to 2011 gave hope to a similarly solid start to 2016 as we saw in 2012, but instead we have seen the worst start to a New Year in history.
It is no wonder financial advisors everywhere, with most of the their books belonging to older investors who worry more about return OF capital rather than return ON capital, are scrambling to interpret the morass. They know from experience that knee-jerk reactions to such market disarray often produce the exact wrong decisions, abandoning carefully structured financial plans at exactly the wrong time. As FDR famously said, “The only thing we have to fear is fear itself,” and I believe that is true today for U.S. investors as the smoke signals seem to point more to improving rather than deteriorating fundamentals. The best investment opportunities often occur when fear is rampant, while bubbles occur when things are just too darn rosy.
Market overview:
The headlines have been scary, no doubt. And there are many high-profile fund managers and market commentators with impressive pedigrees with convincing arguments as to why the global economy is doomed to implosion. I got an email the other day titled “The Dying Gasps of Bubble Finance,” saying that global economic growth has been all smoke and mirrors from central bank largesse. The meetings in Davos have produced a feeling of now-or-never when it comes to saving the global economy from the collapse of China and emerging markets, as China’s total debt has risen to 280% of GDP, and emerging markets aren’t far behind. Moreover, Brazil is on the verge of collapse even as it prepares to host the Summer Olympics. Oil prices continue to languish, even briefly falling below $30/bbl. Corporate earnings are in recession. Credit spreads are widening. Ever-morphing Islamic terrorism has the population on edge. None of the Presidential contenders evokes public confidence. The list goes on.
None of this is new, and indeed last year these issues led to a fearful, headline-driven trader’s market during which stocks demonstrated extraordinarily narrow market breadth, particularly after small caps hit their peak on June 23. To illustrate, just look at the performance difference of the large-cap, cap-weighted SPDR S&P 500 Trust (N:SPY) versus the small-cap, equal-weighted Guggenheim Invest Russell 2000 Equal Weight (N:EWRS). Since June 23, SPY fell -9.5% through last Friday while EWRS fell a whopping -25.1%. That’s a nearly 16% performance differential for the cap-weighted large caps over the equal-weighted small caps. Just incredible. And now the start to 2016 has been downright frightening.
But here’s the thing. There is no one (with the possible exception of ISIS) who wants to see the global economy collapse. It is all hands on deck around the world (including governments, central banks, corporations, and small businesses) when it comes to ensuring economic growth and stability. Sure, you can debate the effectiveness of certain tactics being implemented, but ultimately we are all in this together with a common goal of prosperity.
Keep in mind, China just reported 6.9% real GDP growth, and their government will do pretty much anything necessary to ensure continued growth. In addition, both the BOJ and the ECB are suggesting more QE stimulus. As for further rate hikes here in the U.S., Fed Funds Futures are now discounting just one rate hike from the Fed in 2016, if any, as compared to the four rate hikes signaled by the Fed’s dot plot back in December. Unemployment continues to fall. Bond rates remain low, which supports higher equity valuations. And as for inflation, technological advances are inherently deflationary by increasing efficiency and productivity, so perhaps the Fed’s 2% target is outdated.
The 10-Year Treasury yield closed Friday at 2.05% after briefly falling below 2% during a general flight to safety, while risk assets like stocks followed oil prices lower. The spread between 2- and 10-year U.S. Treasuries fell to 1.16 last week, which is a 5-year low and a strong signal that savvy bond investors are concerned about economic growth, although it is not so low as to be pricing in a recession. In comparison, the dividend yield on the S&P 500 is now around 2.30%.
The CBOE Volatility Index a.k.a. fear gauge, closed the year at 22.34, which is above the 20 panic threshold, but we are likely moving into a period of elevated volatility that might move the VIX range higher from the historically low levels it has been trading for the past few years. This week, market-moving news may arise from the busiest week of earnings reports as well as the latest FOMC announcement.
As corporations, investors, and consumers come to terms with our transition out of ZIRP era and the resulting rise in volatility, we expect this current flight to safety to evolve into a flight back to quality, including value, GARP (growth at reasonable price), and dividend strategies, which have all struggled mightily, especially since last June. A flight to quality means that “FANG” investing (Facebook (O:FB), Amazon (O:AMZN), Netflix (O:NFLX), Google (O:GOOGL)) should underperform. Low 10-year yields will likely persist, probably not exceeding 3% this year, which supports higher equity multiples. After an extended period of EPS growth relying upon productivity gains and stock buyback programs (facilitated by ZIRP and QE), further EPS growth will depend upon top-line growth from capital investment. It is likely that Energy and Basic Materials sectors will stabilize after an extended period of freefall, but not necessarily grow. And a recession here in the U.S. seems unlikely. In fact, with low unemployment, hints of wage inflation, low energy prices padding the average consumer’s wallet, and solid retail sales, the strength of the global economy rests right here at home on Main Street.
SPY chart review:
The SPDR S&P 500 ETF Trust (AX:SPY) closed on Friday at 190.52 after retesting and bouncing from the August lows. As I have observed before, the full year chart looks virtually identical to 2011. However, the start to the subsequent year hasn’t worked out quite same this year as it did in 2012. SPY remains below all of its key moving averages, including the 20-day, 50-day, 100-day, and 200-day simple moving averages (note that the 100 and 200 have converged together and now sit at about 201). Previous support levels have failed, and technical formations that seemed to have been forming have all fallen apart, and now a triple bottom is being tested at a critical support level around 182.5 dating back to October 2014 and August 2015. Oscillators RSI, MACD, and Slow Stochastic are all bouncing from deeply oversold levels, albeit on falling volume. Price should continue higher, perhaps to test support turned resistance at 195. If investors can shake off their inordinate fear and turn this back into a quality-driven rather than headline-driven market, bulls might have a chance at taking stock higher from here. Otherwise, there is a risk of further downside.
Disclosure: Author has no positions in stocks or ETFs mentioned.
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