On the anniversary of the 2015 stock market highs, the S&P 500 is about 5% lower. This recent decline follows the big bear market rally (which we forecast) from the multiyear lows in February. That rally not only failed to set a new record, but didn’t even recover the interim highs last fall. This pattern of progressively lower highs combined with a similar pattern of sequentially lower lows defines the early stages of a bear market. Our conviction that the bear market began in earnest last August remains firmly planted on the bedrock of shrinking corporate profit margins. By the time the bear market is confirmed in the press (a 20% decline), investors are likely to be panicking. Instead of panic, a 20% decline gives cash rich investors like ourselves, an opportunity to start putting a little money back into US stocks. The bear market in US stocks was the central theme of our 2016 forecast, but a whole raft of the other elements of our other forecast are falling into place:
- Interest rates fell in response to the stock market swoon in the first quarter. Although the subsequent stock rally recaptured those losses, weak overall stock performance has kept the Fed on hold. Rates remain near the lows for now. The Fed has been trying to boost consumer price inflation, in hopes this will stimulate economic growth. It is a bit ironic, because about the only thing boosting living standards for the last decade and a half has been the absence of inflation. Rising consumer prices will be even less successful than inflating asset prices (stocks, bonds and real estate) has been in boosting real economic growth. The Fed should have been more careful what they wished for. Rising inflation will ultimately lead to recession, rather than growth fantasized by the folks sipping tea in the Eccles building. In 2014-2015 domestic inflationary pressures were temporarily offset by the deflationary effects of an appreciating dollar and falling oil prices. Those trends (as we forecast) have now reversed. Fed rate hikes are on the way now that wages and inflation are rising, while the unemployment and the dollar are falling.
- Inflation as measured by the consumer price index (CPI) over the past year is once again above 1% and rising with “core” prices rising over 2% for the last few months. Unlike headline inflation that was depressed for the last two years by falling oil prices and a rising dollar, service sector inflation has been consistently around 3%. The rise in CPI is likely to accelerate as higher oil prices and a weaker dollar work their way through the system.
- The US Dollar has declined about 5% contrary to consensus forecasts of dollar appreciation, but consistent with our own forecast. Anticipation of Fed rates hikes will periodically interrupt, and restrain, but not reverse the ongoing decline in the dollar. Rates are set to rise, but inflation is rising faster. This is a formula for dollar weakness, not strength.
- Oil prices have rallied substantially, consistent with our forecast that oil would end the year 30% higher than where it ended 2015. US oil output is plummeting, so even higher prices are on the way. Early in the year when oil had dropped below $30 our forecast seemed wildly optimistic. In retrospect I may have been much too conservative. Oil prices are already up more than 50% from the lows.
- Gold and Mining stocks (our biggest holding) have been the hottest sector by a wide margin in 2016. The doubling of mining stocks from lows early in the year has enabled our diversified strategy to enjoy a double digit gain for the year outpacing even the hottest performing sectors and far exceeding the performance of the S&P 500. As usual, we were early to the party. Recently others like Stan Druckenmiller (former manager of Soros Quantum Fund) and George Soros have both indicated they are selling US stocks and buying gold and gold mining shares. After a monstrous gain in just a few months, a big temporary setback wouldn’t be surprising. Speculation is now rife. The sector is seriously overbought and vulnerable to short term declines from actual or anticipated rate hikes. Miners are still the largest equity exposure in our diversified strategy, but we took a big chunk of money off the table, just in case rate hikes create a new buying opportunity at much lower prices.
- Risk in the corporate bond market has increased. According to Bank of America, recovery rates on defaulted bonds have dropped to 29% from 44% in 2014. This was the inevitable consequence of the expansion of “covenant lite” lending we talked about in newsletters during the last couple of years. Even Exxon lost its AAA bond rating. It is unusual for losses from default to be this large when the economy is still expanding. At 29% the recovery rate looks more like the typical 70 cents on the dollar lost by lenders during recessions. When recession hits, defaults could get really ugly. High yield bonds offered a great buying opportunity at the lows in February, when yields were sufficient to cover typical long term default rates and still produce a decent return. The rally in March and April raised prices to a level where risk adjusted long term returns are mediocre at best and a there is lot of short term risk if stocks decline (high yield bonds and stock prices have a strong correlation). Although corporate profits are plunging and defaults are rising, the US economy remains a relative bright spot compared to risks in areas like China.
- Standard & Poors recently reported that the ability of state owned enterprises in China to service their debt fell to the lowest level since 1992. Chinese debt is at an astronomical 300% of GDP, making it highly unlikely that the recent flooding of the Chinese economy with lending is sustainable. While growth in China trends lower, the US is just muddling along and Europe is in worse shape. There simply is no engine of rapid growth anywhere on the planet sufficient to overcome the drag of excess global debt.
- Emerging market stocks and debt have enjoyed a major rally after hitting multiyear lows in the first quarter. Whether or not that was the ultimate bottom as we speculated on in the forecast remains to be seen. Like high yield bonds, emerging market stock and debt were excellent long term value at the February lows. The growth in emerging market debt (excluding China) in recent years has been more subdued than that in developed countries. Importantly, more of the debt is denominated in their own currencies compared with previous cycles. Emerging economies tend to be dependent on commodity prices. Now that the dollar is peaking and commodity prices are bottoming, the outlook is improving. Dollar denominated debt was however a big drag on growth in 2014-2015 when the dollar was appreciating. Now that the dollar is in retreat, servicing dollar denominated debt gets cheaper, providing an economic boost. Emerging economies are not out of the woods yet. Further weakness in China and a US recession in 2017 will reduce export demand. The prospect of Fed rate hikes in June and beyond will offer some temporary support for the greenback but will also put pressure on the sector. This is likely to set back emerging stock and bond prices. Even faced with that prospect, the emerging market debt looks like an acceptable risk at current levels. Emerging market stocks are considerably riskier. We will wait for another selloff before entering that arena.
- The Treasury yield curve flattened as we forecast. Long term rates have fallen while short term rates have inched higher. Short term rates will continue to move higher as Fed hikes become inevitable. As evidence of rising inflation increases long term rates will trend up as well. Rising rates across the curve will be periodically interrupted by stock market declines. These rate increases will foreshorten both the current housing boom and auto sales bubble in 2017 dipping the economy into recession.
- US economic growth remains positive but sluggish. A minor upward revision to the ½ % growth in the 1st quarter is likely. The preliminary estimates generated by statistical models fail to adequately account for the shift to e-commerce and will need to be adjusted. Second quarter growth is likely to be better, but when the dust settles, growth in the first half is still unlikely to exceed 1.5%. The second half will not get better as the combination of rising inflation and rates take their toll.
- The primary driver of what growth we have has been a strong job market. In chicken and egg fashion, that growth further increases demand for workers. More importantly a shortage of skilled workers resulting from baby boom retirements is creating job openings. After more than a decade of stagnation, wages are rising. This is typical business behavior late in the business cycle. Businesses mostly act on what they see in the rearview mirror. Rising wages are great for workers, but represent a major drag on corporate profits.
- Historically corporations have offset rising wages by making big investments to enhance worker productivity. Low interest rates created an unprecedented opportunity to make those investments by borrowing money at low cost. Instead the opportunity was squandered. With the exception of a lot of fracking equipment that is now rusting, net corporate investment in plant and equipment has been negligible for almost a decade.
- Corporations exploited the low rates by going deep in debt, but the funds were used to buy back shares, rather than invest in productivity enhancing equipment. The reduced share count temporarily masked the damage being done to profits. Declining total earnings have started to overwhelm the boost to “per share” earnings. As companies are forced to reduce the buybacks, due to lack of profits, the math changes. The negative impact of declining revenues and sales gets bigger while the positive impact from buybacks diminishes. Quarter after quarter, earnings are declining. Even the highly publicized “operating earnings” based on the fantasy we can ignore huge “one time” losses are in retreat. The shrinking buyback programs are the only thing postponing the stock market decline. According to a recent Gallup poll only 52% of American households own stock, that’s down from 65% in 2007. This means an ever smaller number of families own a larger and larger percentage of the market. When buybacks push up stock prices, existing owners think of the price rise as gains. However those owners were the very ones paying the higher prices with the funds of the company they own. If a 10% reduction in the share count raises the price of existing shares 10%, then each shareholder owns a 10% larger portion of the company. Rather than a 10% increase in the value of their existing holdings, that 10% simply represents an additional 10% of the percentage of the company the investor owns. This may be taxed as a profit, but that “profit” came out of the stock holders own pocket. Only stockholders who sell their shares actually realize the profit. Pressures on profit margins are also reducing dividend payouts. Dividends for companies in the S&P 500 have inched slightly higher; but if you look at the broader S&P 1500, payouts are being cut substantially.
- Substituting buybacks for new investment has resulted in a decline in worker productivity. Weak productivity requires workers to work more hours. In the short term, this is great for hiring, but ugly for corporate profits. In the long term low productivity means low wages, but with the economy at full employment, a shortage of skilled workers is driving wages higher right now.
- Corporate profits (which usually precede market trends) continue to plunge. Actual (GAAP) S&P 500 earnings are down over 20% from their highs at the end of 2014. A similar decline in stock prices is inevitable. Quarter after quarter analysts keep forecasting a rise in profits just a few quarters away, while quarter after quarter those forecasts are revised to declines as the quarter approaches. Wall St continues to emphasize “operating earnings” and “per share” profits that are driven by accounting gimmicks, but in the end, the bottom line is the bottom line.
Corporate profits are down, but at least for now, cap weighted US stocks (as measured by the S&P 500) are within 5% of record highs. The disparity between sharp earnings declines and only a modest setback in stock prices is not sustainable. The risk of a stock market decline is imminent. I still expect the S&P 500 (currently around 2050) to retreat to about 1400 before this bear market ends.
My concern does not extend to the outlook for the US economy, although I do expect a mild recession in 2017. Corporate cost cutting in an effort to maintain profit margins will take its toll on the economy. Hiring will slow and layoffs will increase, but most of the layoffs will come from attrition as baby boomers continue to retire. Pensions and social security will partially offset their loss of income while GenX and Millenials get wage hikes to fill most of the empty slots. Severe recessions like 2008-2009 are the result of a collapse in consumption, and a dysfunctional banking system. Unlike 2008-2009, household debt service is unusually low. Most families will get by with some serious belt tightening this time, rather than losing their homes to foreclosure. Bank profits will continue to suffer from both weak revenue streams and rising defaults but unlike 2008-2009 their solvency won’t be threatened. Capital ratios at banks are at record levels and can withstand these setbacks. Both the consumer and the banking system are positioned to muddle through making economic collapse only a very remote possibility. Growth will slow to a snails pace, and may even take a few steps backward, but consumption will not implode and the banking system will not freeze up this time.
Market Strategies
Our diversified strategy, having outperformed the S&P 500 by a substantial margin since the end of 2014, is off to a great start in 2016. Like the market, our strategy has good and bad days, but while the S&P 500 index has oscillated between double digit losses and a gain of less than 3 %, our strategy has done the opposite, oscillating between a loss of less than 3% and a double digit gain. In addition to gold and mining stocks, we used the February decline to restore a portion of our positions in the Fidelity Floating Rate High Income Fund (FFRHX) and the Fidelity New Markets Income Fund (FNMIX) that we sold last year at higher prices. We then used the recent rally to increased the size of our hedged position in the Hussman fund. FFRHX and FNMIX yield around 5% while FFRHX hedges most of the risk of higher rates implicit in FNMIX. We expect some minor setbacks from defaults and recession fears as the year progresses, but the income from these funds will cushion those costs. Those setbacks will enable us to increase those positions (as well as FSAGX) back to normal on very favorable terms. A substantial market correction will allow us to start building a position in emerging market equities. Longer term, the unfolding bear market in US equities should offer us another spectacular opportunity to get back into US equities at bargain basement prices.
Clyde Kendzierski
Chief Investment Officer
Unless otherwise indicated, investment opinions expressed in this newsletter are based on the analysis of Clyde Kendzierski, Managing Director and Chief Investment Officer of Financial Solutions Group LLC, an investment adviser registered with the California Department of Corporations. The opinions expressed in this newsletter may change without notice due to volatile market conditions. This commentary may contain forward-looking statements and FSG offers no guarantees as to the accuracy of these statements. The information and statistical data contained herein have been obtained from sources believed to be reliable but in no way are guaranteed by FSG as to accuracy or completeness. FSG does not offer any guarantee or warranty of any kind with regard to the information contained herein. FSG and the author believe the information in this commentary to be accurate and reliable, however, inaccuracies may occur.
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Past performance is a poor indicator of specific future returns. It, however, may be useful in your evaluation of how FSG performs in different market environments. Investors have the ability to achieve results similar to benchmark indices by investing in an index fund or Index-tracking ETF, typically with lower fees.
Past performance of any security is not a guarantee of future performance. There is no guarantee that any investment strategy will work under all market conditions.
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This material is intended only for clients and prospective clients of the FSG.It has been prepared solely for informational purposes and is not an offer to buy or sell or a solicitation of any offer to buy or sell any security or other financial instrument, or to participate in any trading strategy.
S&P 500 Index is an unmanaged, market value-weighted index of 500 stocks generally representative of the broad stock market.
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