End Recap and 2016 Projections
by Victor Sperandeo with the Curmudgeon
Disclaimer: All opinions expressed herein are those of Victor Sperandeo.
The 2015 investment year was a loss virtually everywhere you look, except in a handful of Nasdaq Stocks such as Amazon, Google/Alphabet, Netflix, LinkedIn, Facebook, and a few others. It is extremely rare to have the S&P 500, Russell 2000 (Small Caps), 30 year U.S. Government and long term corporate bonds (non-adjusted for inflation) all decline together. According to Ibbotson Associates data, this has only happened twice since 1926 (1931 and 1969). Both those years also included a loss on 5-year T-Notes.
Curmudgeon Note: Commodities (especially oil), gold, foreign bonds and stocks, alternative investments, etc. were also down in U.S. $ values.
The best thing I can say about 2015 is these and most other investments were down a relatively small amount, except for commodities which were beaten to a pulp. However, 2015 was not really close to a 2008 or 1931 to the extent of the pain felt by owners of equity assets. While this is only the first minor decline in most asset classes since 2008, the decline was broadly based. 2015 being the first down year in seven years may be misleading as it paints a "that's not so bad" feeling to investors. The important question is where does this leave us for 2016?
Analysis of Market Conditions:
The technical and fundamentals of the equity and bond markets, as well as the recovery of the economy, are all in poor condition. From a technical perspective, the full year of 2015 formed a massive "broadening top" of the S&P 500 and that is extremely ominous.
In my opinion, what should scare the day lights out of investors, but is not much discussed, is aggregate market valuations. Consider the (very high) 23.86 P/E of the S&P 500 Industrials, based on reported earnings of $114.65 (source: Barron's 1/4/16, page M47). Compare that to last year's rolling comparative earnings of $131.55, which mostly reflects a decline in oil prices. Somehow this seems to not be a concern to U.S. equity investors. It's as if energy earnings decline doesn’t count in valuations?
Peter Boockvar (Managing Director & Chief Market Analyst at The Lindsey Group) recently said in an interview that "the Median P/E of all stocks is the most expensive market in history." In 2000, the tech sector and Dot Com stocks were weighting aggregate P/E's to be higher. However, using all stocks today the "median" P/E is higher!
Curmudgeon Note: Bull markets are periods of P/E expansion. During Bull markets, investors are willing to pay increasingly more for each dollar of earnings. The opposite occurs in Bear markets, as P/E's contract/decline.
Also, this is both an old bull market and an old economic recovery, which are not far from record duration levels based on several standard measures.
Add the fact that Interest rates are finally rising, but this is not a normal cycle where growth can sustain continuous rises in rates. This, in my strong view, is a weak economy and cannot take further rises in short term interest rates, which will then cause a recession.
In the EU, 40% of debt is yielding a negative rate of return. Emerging markets are in turmoil. Commodities have been down 5 years in a row by more than a 15% compounded rate (on any commodity index you chose). Thereby, raising rates is out of the question on any rational basis, unless the economy changes its stripes quickly and begins to accelerate its growth rate.
Will Higher Inflation Occur in 2016?
If the world economy is to pull out of its multi-year stagnation pattern, higher GDP with inflation has to occur. However, inflation without GDP growth is also a possibility. Interestingly, ECB President Mario Draghi wants to "spur price gains.” He said in a speech in Frankfurt on Friday:
“If we decide that the current trajectory of our policy is not sufficient to achieve that objective, we will do what we must to raise inflation as quickly as possible. In making our assessment of the risks to price stability, we will not ignore the fact that inflation has already been low for some time.”
So what happens when Draghi gets his wish of higher inflation? Bonds will crash as yields rise, and the Euro rises, which causes GDP to decline. Whatever he is drinking, order me a case... It certainly makes him giddy.
This brings us to a dangerous place for inflation in the U.S. The official 2015 headline rate of U.S. CPI is 0.50% through November, while core CPI was up 2.01%. Note that oil traded at $94 in July 2014 and $50 in July 2015, which lowered headline inflation this year. Therefore, if oil in the 2016 summer (driving season) gets back to the high 40's/low 50's, that will cause year- over- year headline CPI to rise. Meanwhile, "service sector inflation was in the 3%+ area last year, so you may start to get rising (headline and core) inflation if the economy stays on its current trajectory. See Scenario C. below.
Now if the Fed can't raise rates due to a continued weak economy, then the December 2015 rate hike was it (one and done). In that case, the U.S. dollar will likely decline and commodity prices will rally (maybe explode upwards, depending on demand from China). Traditional assets would then likely go into full blown bear market territory which would coincide with the 5-year commodity bear market ending! Based on the above scenario, with the typical U.S. GDP at 2%, the precious metals will resume its long overdue bull market.
The old expression: "buy low sell high" was never more obvious than it is today. It's saying: Sell U.S. and EU stocks and bonds; buy: emerging markets, e.g. Brazil (-80% in dollar terms), Australia, Canada, stocks in their currencies, and commodities.
Bottom Line Economic and Market Scenarios:
A. Real U.S. GDP grows at 3%+; interest rates and the dollar rally.
B. The U.S. dollar stays where it is due to a continued weak economic recovery and/or modest inflation.
C. Inflation comes back strong, oil prices & commodities increase, the U.S. dollar declines, gold resumes its secular bull market.
In my view, rising short term interest rates in a U.S. Presidential election year is not going to happen.
Review of Earlier Forecasts:
Therefore, debt was the "worst threat" to the U.S., and the world. Of course, Central Banks have pushed the envelope on monetary policy [e.g. money printing, ZIRP, and buying debt (rounds of QE)] causing even more debt. Combine that with ineffective fiscal policies [e.g. government regulations (a hidden tax), middle class taxes (like Obamacare), taxing the upper class, and some inflation] have caused people (and companies) to hoard cash. That's enabled debt to be controlled by world governments till "another day."
Radical Islam as a Worldwide Wild Card:
I believe the greatest threat to the world today is Radical Islam. It is uncontrollable and ironically promoted through immigration policies in Europe and the U.S. Swiss army Chief Andre' Blattman recently warned that: "the risks of social unrest in Europe are soaring."
Recalling the experience of 1939/1945, Blattman fears the increasing aggression in public discourse is an explosively hazardous situation, and advises the Swiss people to "arm themselves" and warns that the basis for Swiss prosperity is "being called into question."
Blattman told Deutsche Wirtschafts Nachrichten that "despite a rise in security incidents over the past two years Switzerland’s means of defense were being reduced." The situation is growing increasingly risky, Blattman added.
"The threat of terror is rising, hybrid wars are being fought around the globe; the economic outlook is gloomy and the resulting migration flows of displaced persons and refugees have assumed unforeseen dimensions. Social unrest cannot be ruled out.”
This is certainly all possible and poses a huge risk to global economic stability and world markets. Any terrorist attacks would be uncontrollable by the Fed and play havoc with financial markets.
We continue to believe that China is the greatest risk to the global economy and financial markets, as noted in many previous posts. Michael Hasenstab, chief investment officer for Templeton Global Macro told the FT:
“Our call is that China will not have a hard landing... If for any reason we were to see that not occur, that would be a game changer. The China call is the most critical call any investor has to make.”
The chief global economic concern for 2016 is the pace at which the Chinese economy slows. And it's been slowing for a very long time! The Renminbi will be added to the IMF SDR's this October, even as the currency unexpectedly declined against the U.S. $ in 2015 as can be seen from this chart:
The Chinese authorities are attempting to manage a transition in the economy away from investment in building and infrastructure towards greater internal consumption of goods and services. Consider this chilling quote on China from this weekend's FT (on line subscription required):
“Get the mix of reform and economic stimulus wrong, however, and a crash would reverberate worldwide.”
Let's now recall the brilliance of one the Founding Fathers of the U.S.:
"The means of defense against foreign danger historically have become the instruments of tyranny at home." James Madison.
Good luck and till next time...
Follow the Curmudgeon on Twitter @ajwdct247
Curmudgeon is a retired investment professional. He has been involved in financial markets since 1968 (yes, he cut his teeth on the 1968-1974 bear market), became an SEC Registered Investment Advisor in 1995, and received the Chartered Financial Analyst designation from AIMR (now CFA Institute) in 1996. He managed hedged equity and alternative (non-correlated) investment accounts for clients from 1992-2005.
Victor Sperandeo is a historian, economist and financial innovator who has re-invented himself and the companies he's owned (since 1971) to profit in the ever changing and arcane world of markets, economies and government policies. Victor started his Wall Street career in 1966 and began trading for a living in 1968. As President and CEO of Alpha Financial Technologies LLC, Sperandeo oversees the firm's research and development platform, which is used to create innovative solutions for different futures markets, risk parameters and other factors.
Copyright © 2015 by the Curmudgeon and Marc Sexton. All rights reserved.
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