First Quarter 2016

There’s an old saying on Wall Street, “as goes January so goes the year”. Since 1950, January stock market performance has foretold full year performance with surprising accuracy (89%) with all “down Januarys” being followed by a flat year, correction or bear market1
 

Benchmarks

 

12/31/2014

 

12/31/2015

 

% Change

Dow Jones Industrial Average (DJIA)

17,823.07

17,425.03

↓ 2.2%

Standard & Poor’s 500 Index (SPX)

2,058.90

2,043.94

↓ 0.7%

NASDAQ Composite Index (COMP)

4,736.05

5,007.41

↑ 5.7%

Russell 2000 Index (RUT)

1,204.70

1,135.89

↓ 5.7%

Federal Funds

0.06%

0.20%

↑ 233.0%

10Y US Treasury Bond

2.17%

2.27%

↑ 4.6%

30Y US Treasury Bond

2.75%

3.01%

↑ 9.4%

London Gold PM

1,199.25

1,062.25

↓11.4%

Moving into 2016, there are several things weighing on the stock market. But, first and foremost, this bull is seven years old, and with greater age comes greater volatility. Although we experienced a nominal correction in 2015, it is important to remember the stock market has tripled in value from its 2009 lows. Undoubtedly, some New Year selling is simply deferred profit-taking and repositioning of portfolios for the later stage of a bull market. Some is investor concern. More major areas of concern are global conflict, slowing growth in China and falling oil prices. Unfortunately, we won’t know how this January (or year) will pan out until it is behind us. But, it is important to bear in mind that years getting off to a rocky start often provide good buying opportunities for long-term investors. And, “it’s time in the market, not market timing” that count (another old saying). 

  • Global conflict
    On New Year’s Day, Middle Eastern tension spiked when Saudi Arabia (Sunni Muslim) executed 47 persons for terrorist acts, including Sheik Nimr al-Nimr, a prominent Shia cleric. Iran (Shia Muslim) accused the House of Saud of supporting terrorism and radical Wahhabi extremists, and warned the execution be its downfall. Embassies closed in Riyadh and Tehran.

    Although the Saudis and Iranians have been in conflict for hundreds of years, this may be different as collapsing oil prices are creating internal pressures for both. Saudi Arabia needs $106 a barrel oil to maintain its social programs, whereas Iran needs $87.20[2]. While both have substantial cash reserves, they are spending down and face spending cuts if OPEC fails to decrease production. Ultimately, this could destabilize for both regimes, which rely heavily on social programs to keep the peace.

    The Middle East isn’t the only hot spot. In early January, North Korea announced a successful test of its first hydrogen bomb. This prompted an emergency meeting of the U.N. Security Council, and condemnation from the global community-at-large (including China). Especially concerned are near-neighbors Japan and South Korea.
     
  • Slowing growth in China
    In 2016, economic growth is likely to decelerate further, as China continues its transition from an industrial-based economy to one that is consumer-based. Even so, its growth is forecast to top 6%.

    While disappointing to some, this growth should be viewed in perspective. In 2016, the global economy is forecast to grow at 3.0%, the U.S. and British economies are forecast to grow at 2.4%, the Eurozone is forecast to grow at 1.4% and Japan is forecast to grow at 1.1%. So, in truth, China (the world’s second largest economy after the U.S.) is doing its part to shore up the global economy. 
     
  • Falling oil prices
    The law of supply and demand is a basic economic principle. When an item is scarce and everyone wants it, its price will rise. Conversely, when an item is plentiful and no one wants it, its price will fall.

    On that note, oil prices are dropping like rocks. Very simply, there remains is too much production in the face of slow-to-moderate global consumption. Many analysts believe oil prices will drop to $20 a barrel before reversing course. Currently, they’re hovering around $30 a barrel. Of course, this will have a major negative impact on the leveraged producers and net exportersof oil, like archenemies Saudi Arabia and Iran. On the flip side, it will have a major positive impact on larger consumers and net importersof oil, like the U.S., Europe and Japan.

    Overall, the economy is likely to grow solidly, if not spectacularly, in 2016 and 2017. This means the risk of a recession or bear market is low even if January (and the year) proves to be down. Also, this means the Fed is likely to raise rates over the course of the year, as unemployment falls to 4.5% and inflation nears its 2% target. 

Outlook & Strategy

Equities. Currently, stocks are trading at average valuations with the Dow Industrials and S & P 500 trading at 15.16 and 15.65 times 12-month forward earnings, respectively3. That said; the stock market has shown positive total returns for seven years running, as illustrated below, and a period of “digestion” may be in order. 

 

 

2008

 

2009

 

2010

 

2011

 

2012

 

2013

 

2014

 

2015

S&P 500 Total Return

-37.0%

26.5%

15.1%

2.1%

16.0%

32.4%

13.7%

1.4%

 
As before, we anticipate prices will be impacted by profit-taking after seven years of gains and repositioning of portfolios for the later stages of an economic cycle. This is likely to rotate through most, if not all, sectors. Also, we anticipate stock prices will be impacted as the Fed begins normalizing interest rates and investors shift money back to the bond side of their portfolio. The sectors most likely to feel this pressure are the “interest-rate sensitive” sectors, like REITs, telecomm and utility stocks. 
 
For now, we anticipate holding stocks at the mid-point of our strategic allocations based on their average valuations and the likelihood the economy will remain steady in 2016 and 2017. As always, we recommend investing in high quality “blue chip” stocks, well-diversified across and within industry sectors. 
 
Cash and fixed income. Near-term, we anticipate keeping maturities “ultra” short to stabilize principal as the Fed begins raising rates. At this time, we anticipate the Fed will raise rates by 1% in 2016, perhaps at the rate of ¼ of 1% per quarter. Then, as bond yields become normalized, we anticipate beginning to extend maturities to “lock-in” higher yields for a longer duration.   How far and fast this occurs will hinge on how far and fast the Fed raises rates.
 
1 A correctionis defined as a market decline of at least 10%, but not more than 20%. A bear marketis defined as a market decline of 20% or more.
IMF Regional Economic Outlook: Middle East and Central Asia, October 2015.
Birinyi Associations, January 19, 2016.

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