Stock Market Analysis
It has been said that as the first five days of trading go January will follow and as January goes so will the stock trading for the rest of the year. Historically this has often been true, especially when the first trading week moves by 2% or more. With the Dow Jones Industrial Average declining over 6% and small-cap Russell 2000 Index falling almost 8% to bring in the New Year, most investors would not mind a do over.
The problems for the market began in China. China trading started 2016 with new stock market circuit breakers; it is a mandated time out from trading if the markets fall too much in a single day. In China these circuit breakers actually created more volatility instead of cooling it off as investors became increasingly worried their money would get stuck in stocks and they would not be allowed to sell at all. So far the Chinese stock market (CSI 300) is down almost 10% for the young year.
As we discussed at our Economic Outlook in December we expected China to have an oversized impact on financial and economic issues. While their stock prices have tumbled their economy also has issues. With many experts examining the country’s “official” GDP numbers with a high degree of skepticism other factors need to be viewed to get a more accurate understanding.
One such method is shipping. Is China seeing a resurgence in moving their materials and products around? No. Tonnage on rail freight in China has been declining at an alarming rate and the Baltic Dry Index, which captures shipping costs around the world, set a new record low this week.
While one needs to keep an eye on China what of the United States? There are obviously problems. Long-term valuation methods like Shiller’s Cyclically Adjusted Price Earnings (CAPE) remains elevated as do comparisons of the market value of all stocks to the economy. Again, these are more long term issues.
Of more immediate impact is the Fed has taken away the punch bowl of Quantitative Easing (QE). Stock prices have enjoyed a strong correlation to the Fed’s balance sheet. Put simply, the more money the Federal Reserve pushed into the system the higher stock prices went. Unfortunately with these programs at an end the market has headed sideways and needs something new to propel stocks now.
Regrettably, the new catalyst is unlikely to be a strong economy. It is true the number of jobs created in December expanded at a better rate than Wall Street expected. Unfortunately most of these jobs remain in lower paying industries. Further, the entrepreneurs, the true backbone of the country, have been seeing their numbers fall over the last year.
Other problems include falling spending in construction and woes in the industrial sector. The Institute of Supply Management PMI data are showing their worst levels since 2009. Some claim the country is already in a manufacturing recession. Indeed the overall economy is on a disappointing pace. The Atlanta Fed’s “GDP Now” forecast (based on their quantitative model) suggests 4th quarter GDP will only ring in at a disquieting 0.8% pace. Wall Street economists, with their long history of inaccurate forecasts, presently project a GDP number of 2.5%. Whether one likes to follow quantitative ideas or be a contrarian to popular mass thinking, the conclusion is the same: GDP will be less than stellar.
Having stated the problems there are a few positives that should not be dismissed. One is the contrarian investor view. The American Association of Independent Investors (AAII) latest survey suggests only 22% of their investors are bullish. Further the Put/Call Ratio has been extraordinarily high lately (with a reading on Friday of 0.93). Both of these are at levels suggesting too much pessimism and that an opportunity for the short to intermediate term might arise.
Presently our long term indicators continue to deteriorate. Given this and the unpredictability of China it will likely make sense to treat 2016 with caution and avoid setting high expectations. Still, this is not a situation to sell all stocks and go to cash. We believe the high level of fear reached so quickly suggests a bounce would be normal and our intermediate indicators agree. Should those conditions arise it may make sense at that time to lower risk levels where appropriate.
David W. James, CFA
Bond Market Analysis
The bond market rallied this week as worries over China crept back into the U.S. markets. Stocks took it on the chin while the bond market, especially high quality, edged higher on the week. Investor’s appetite for risk fell as they moved out of the equity markets and into the safety of U.S Treasury bonds. The yield on the 10-Year U.S. Treasury note fell to 2.13% from 2.27% the previous week; prices for intermediate U.S. Treasuries gained 0.6%. Long-term U.S. Treasuries were even stronger as prices increased 1.8%.
The U.S. employment situation continued to show signs of improvement, at least that is what the headline numbers suggest. The unemployment rate remained unchanged at 5% as the non-farm payrolls gained 292,000 jobs in December. When you look inside the numbers, a different picture emerges, one of weakness in a couple of areas.
First is the employment condition for the adult population which looks to be growing faster than they can find jobs. In addition, the self-employed over the last 12 months have lost over 150,000 jobs; this is concerning given the 2.6 million jobs gained over the past year.
Over the past year the slowdown in manufacturing has negatively impacted a number of industries mainly in the oil and commodity industries. Given the recent numbers from the ISM it looks as if there is no end in sight for the struggling sector. The December release for the ISM Manufacturing PMI index fell for a sixth straight month and back to levels last seen during the “great recession” in 2008. Of the eleven main indexes provided by ISM, seven point to negative growth.
We feel bonds should hold up better this year, especially given the current environment in the stock market and economy. The Fed, in this setting, will find it difficult to raise rates again anytime soon. The implied probabilities in the future markets currently show a 0% chance of a rate hike later this month. Our indicators are neutral and we continue to focus on high quality bonds and suggest moderate durations.
Trent Dysert, Portfolio Manager
