Dovetailing the Moving Parts of 2016

Dovetailing the Moving Parts of 2016 “So goes January, so goes the year[?]” – Wall Street Axiom (question mark, mine)

If this holds true, we can expect Mr. Toad’s Wild Ride this year. However, predicting the next few days is a futile exercise, so predicting the next year is wildly unrealistic. We can expect only the following:

The long run average real return (data from 1802-2015, thanks to Jeremy Siegel):

You’re likely thinking, “these return numbers are irrelevant to me, unless I end up like Fry from Futurama.” While this is likely true, long run average return numbers are still very relevant to us mortals today. It is a very good lesson in mean reversion, the theory suggesting prices and returns eventually move back to the mean or average. There will be up years and down years, but in the long run the equity market continues to grow.

The truth is, I simply don’t know what 2016 has in store for us, nor do any other self-described forecasters. Alternatively, let’s evaluate the here and now and what it means for our future going forward. We will look at the market from a variety of vantage points to see what may stand out:

The price of crude oil and the Chinese economy

The drop in oil prices from 2014 has been over a two standard deviation move. Crude oil is now well below the cost it takes most producers to extract it from the ground. The Bank of England (BoE) reported that 60% of the decline in oil prices is due to a lack of demand. Yet, the data points in a different direction. Year over year growth in demand for oil has increased by 4.3% globally, since 2013. Over the same period, China has sported high year over year growth at 9.7%. There is no demand weakness.

China’s growth, while slowing, cannot be called weak. Official estimates put gross domestic product at around 6.9% for Q3 2015, down from 7.7% in 2014. Unofficial estimates put actual growth from anywhere between 3.5% and 5.5%. China is the current scapegoat for the 35% implosion in commodity prices, but there seems to be other factors weighing in. Dollar appreciation, particularly against the Chinese yuan, has put a dent in the price of oil. However, as we have seen above, markets tend to be mean reverting, with the dollar’s long run average real return negative.

Your guess is as good as mine as to where oil trades this year. It seems more important to understand why oil will eventually bottom: increasing demand and declining production. These would largely help equities, as they would restore earnings power to the sector and the stocks of companies in the industry.  There are also some bad reasons: increasing geopolitical tensions. You could make a good case either way for oil remaining low or increasing in price.

Concerning China, I think most commentators simplify the debate, framing it in terms of this “hard landing” we’ve all been waiting for. While China’s near term outlook should hardly be trivialized, there is no doubt in my mind that China’s economy is changing. The IMF released a report examining the drivers of growth in Asian countries. In 2014, the services share of Chinese GDP hit 48.2%, higher than the combined 42.6% share of manufacturing and construction. And the gap is continuing to widen – services activity grew 8.4% year on year in the first half of 2015, far outstripping the 6.1% growth in manufacturing and construction.

It’s also important to remember that culturally Chinese are different than Americans. The West has always seen China through the same framework, however, they don’t solve problems the way we do; they don’t consider things we consider problems to even be problems. A good example of this is infrastructure and housing spending in China. We consider China’s ghost cities to be signs of excess capacity, because we look at unoccupied housing as a bubble waiting to burst. The Chinese have the Field of Dreams attitude of, “if you build it, they will come”. In the late 1990s Shanghai Pudong was a ghost city and the largest urban development in the history of the world at the time. It’s now fully occupied by 5.5 million people, essentially building a Manhattan type city from scratch. China moves between 15 and 20 million people a year from the countryside to the city, which is why they build infrastructure in anticipation of subsequent flow of migration.

Valuations and US GDP Growth

One of the biggest headwinds facing the market this year is valuation. No matter how we look at it, valuations are above average. Bargains are becoming increasingly harder to find. The problem with only looking at valuation is while they’re generally high when a bear market ends, by themselves they don’t end a bull market. There needs to be a more concrete catalyst.

The table below (data from JP Morgan Asset Management) outlines the characteristics of bear markets. As you can see – the causes, returns and macro environments were all very different:

The above table illustrates the conditions present in all the major crashes of the last hundred years. 2016 does not appear to be setting up for a crash, considering the variables above. Valuations are stretched, but not at extremes. Overall leverage has come down. There is certainly not a commodity spike and the Federal Reserve is still being extremely accommodating.

Interestingly enough, the P/E ratio for the S&P 500 (18.5x) is actually lower than the combined average for all countries (21.1x). Coming into 2014, valuations were already stretched with the P/E of the S&P 500 at 18.1x. Despite the 11% gain in the market that year, US companies saw revenue growth and the P/E declined slightly to 18x by the end of 2014. 2015 was a completely different story. The S&P 500 closed the year slightly down from where it started, but valuations have expanded as earnings declined.

Frankly who wants to pay 18.5x earnings for 1% GDP growth? No one, unless the US is growing at higher than 1% (which I suspect is the case). Both 2014 and 2015’s first two quarters were hit with a lot of bad weather, impeding growth. The weather seems to be cooperating this year, I think it would be wise to keep an eye on GDP numbers coming out for Q1 and Q2 of 2016.

Rate hikes and Inflation

How many times will the Fed hike rates in 2016 (if at all)? Via the Fed’s own projections, Yellen intends to raise to a 1.5% real rate by the end of 2018. This, of course, is contingent on core inflation rising toward their target this year and continued progress in the labor market (which is actually quite tight).

Tightness in the labor market will eventually lead to upward pressure on wages. This could cause spikes in inflation, which would make it difficult for the Fed to stay on the “gradual rate hike” plan. Having said that, deflation isn’t off the table. Remember when buying a television or a computer was a huge purchase for a family? Today it is simply not the case. Technology’s path has led to items being faster, smaller and cheaper. With the new sharing economy emerging, we should also see lower pricing in new parts of the economy. This leads me to believe there will eventually be pockets of inflation such as healthcare, but not a wide spread threat of inflation.

US Presidential Elections and Geopolitics

In an attempt to keep this piece apolitical, I’ll leave most of US politics unspoken. Having said that, it appears we will have a 2016 matchup between Hillary Clinton and Marco Rubio or Donald Trump. Wall Street thus far has managed to ignore Trump, possibly in the hope that he will go away. Fundraising mostly went to candidates like Clinton, Jeb Bush and Marco Rubio. The Republican Wall Street favorite Jeb Bush had a calamitous fall in the polls and thus it will be interesting to see how the market handles the primary elections.

Turning our attention globally, the Ukraine-Russia debacle that broke out in 2014 seems like nothing compared to the threats of terrorism from groups like ISIS. Still, capital markets have largely ignored the Paris attacks, the subsequent Middle East bombings and the San Bernardino tragedy. For now, the market sees these as isolated incidents. If such events occur again with frequency, both the economic and political landscapes will change. With the elections in the US and much debate in Europe over migrant policies, any future terrorist attacks are sure to reshape popular opinion and political realities fairly quickly. Currently, countries seem more inclined to intensify their military campaigns against the Islamic State.

Furthermore, Turkey appears to be one of the most critical players to watch in the Middle East. In 2015, Turkey shot down one of the Russian fighter planes in the region, much to Putin’s dismay. It seems President Ergodan plans to be much more aggressive beyond Turkey’s borders than his predecessor. There is a hard geopolitical truth behind Putin’s shock and consternation with Turkey. Russia knows the importance of keeping Turkey as a partner, due to Turkey’s position on the Mediterranean Sea and NATO membership. Turkey also holds the keys to the Dardanelles and Bosporus, the only way Russian vessels can reach the Mediterranean from its warm water ports in the Black Sea. As a result of its actions, Turkey’s neutrality on the US-Russia standoff is sure to be questioned this year.

Still, the US and Russia continue to be locked intractably, an issue that needs major attention. Hopefully some answers will come to fruition during the US presidential debates on foreign policy. Nationalism is resurfacing in Europe, particularly with Marine Le Pen gaining political ground in France. Commodity prices are low and continuing to fall. Immigration around the world is a heated topic. It is important to remember that these global trends are connected and have deep, rich history behind them guiding future decisions.

Stock repurchases and equity market volatility

Let’s say company XYZ has an active share repurchase program and buys back its equity at $100/share average cost. How does an investor feel when the stock drops 15% to $85?  In theory, it shouldn’t matter. The investor’s stake in the company grows because there are fewer shares or claims on XYZ’s earnings. Alternatively, the investor could have sold his stake.

In practice, we will see how this plays out as companies report their Q4 results in the coming weeks.  Hundreds of companies have repurchase plans in place, and for many of those their stock purchases from 2015 are out of the money. It’s possible that this will force companies back to investing in their businesses, since even a 5% new project beats a negative 15% return from an ill-timed stock repurchase. Conversely, we can look at share buybacks as a savior from the company making a bad investment elsewhere that could cost more than the poor market timing.

Since its creation in 1990, the VIX Index (now considered to be the standard for measuring equity market volatility) has averaged a reading of 20. This roughly translates to the market expecting 1.25% daily average moves from the equity market. There have been long periods of below 14 (less than 0.8% expected movement per day) and short periods of time above 26 (greater than 1.6%). From 1990-2015, the S&P 500 has compounded 7.2% annually including dividends. Why am I telling you this? Because 2016 may be more volatile than you remember, as the market has had low volatility for quite some time. Higher volatility does not predestine US stocks to negative returns. It simply means the path the market takes to appreciate will be a bumpy one.

Like most of you, I start every new year with optimism and hopeful resolutions. While I am warier of equities going into 2016 than in 2015, my feelings (also like most people) have never been a great predictor of market movements. In fact, I take my feelings out of the process entirely for this precise reason. You should too. You’re invested for the long run average returns, not for the day to day movements of the VIX, the ticks in the market due to the Fed or the CNBC’s apocalyptic fear mongering. You’re invested to meet your retirement goals, send your kids to college, take nice vacations and leave behind a legacy. It’s easy to forget when short-term outcomes don’t turn out as planned and it’s nice to remember why we are here. A very happy and healthful 2016 to you! Please reach out with any comments or questions.

Sources:

Jeremy Siegel, 2005 “Future for Investors”, with updates to 2015

Ghazanchyan, et al, (2015) IMF Working Paper, A New Look at the Determinants of Growth in Asian Countries

Reva Bhalla, Stratfor, ”Turkey’s Time Has Come” 12/8/2015

Kate Davidson, Wall Street Journal, “Economists React to the Fed’s Interest Rate Hike” 12/16/2015

EIA, Short Term Energy Outlook released 12/8/2015

Bespoke Investment Group – The 2016 Bespoke Report

JP Morgan Asset Management - Guide to the Markets Q1 2016

Steven Roach – “China’s Complexity Problem” 8/25/2015

Disclosures

This bulletin expresses the views of the author as the date indicated and such views are subject to change without notice. It is important to understand investing in general involves risk of loss that you should be prepared to bear. Please refer to our Firm’s Form ADV Part 2 Disclosure Brochure for more information regarding the risks of the investments held in your account. Our calculated perceived value is an opinion based on the information we have at the time of our forecast.  The risk assumed is that the market will fail to reach expectations of perceived value. Our opinions, forecasts or predictions of future events, returns or results are subject to change and are not guarantees of future events, returns or results. This communication is intended to be distributed to current clients and certain interested parties only.  This communication should not be construed as an advertisement offering our firm's investment advisory services.