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TAKING STOCK AFTER THE RALLY

Stocks have had quite a nice run. Since the February 11, 2016 lows the S&P 500 has gained 14%. The rally has been driven by many factors — chief among them, better U.S. economic data, higher oil prices, the Federal Reserve’s (Fed) slower rate hike timetable, increased confidence in China, and more stimulus from overseas central banks. These factors have enabled stocks to trade more on fundamentals than fear, and have pushed the S&P 500 to just 2.4% below its all-time high. Here we assess the likelihood that the rally continues from this point forward, and, if so, how much further it might have to go.

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VOLATILITY SPIKES, BUT EQUITIES PROVE RESILIENT

U.S. economy weathers market volatility as labor market improves and manufacturing steadies. Based on data received so far, first quarter 2016 real gross domestic product (GDP) growth is tracking at 1.5 – 2.0%, following 1.4% growth in the fourth quarter of 2015 and 2.0% growth in the third. Concern about global economic weakness and tightening financial conditions prompted the Federal Reserve (Fed) to delay further rate hikes and lower its internal forecast from four 25 basis point (0.25%) rate hikes in…

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CHECKING IN ON TRADE

The U.S. has run a trade deficit (importing more goods and services from other countries than it exports) since the mid-1970s, which acts as a drag on overall gross domestic product (GDP) growth [Figure 1]. Although the trade deficit narrows during recessions, when imports typically fall faster than exports, the trade gap has increased over time, and currently stands at around 3.0% of GDP. Along with the massive budget deficit, the trade deficit is one of the major economic challenges facing the U.S. and has fostered the…

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BEIGE BOOK: WINDOW ON MAIN STREET

The latest Beige Book suggests that the U.S. economy is still growing near its long term trend, but that the drag from a stronger dollar and weaker energy prices, along with the slowdown in emerging market (EM) economies — most notably China, are still having a major impact on the manufacturing sector. In addition, our analysis of the Beige Book confirms that there has been some spillover of weakness from the energy and manufacturing sectors to other parts of the economy in recent months. Comments in the Beige Book also continue to indicate that some upward pressure on wages is beginning to emerge; but the wage pressures are not accelerating, which should keep the Federal Reserve (Fed) from raising interest rates aggressively this year.

Overall, the Beige Book described the economy as expanding at a “modest or moderate” pace in 7 of the 12 districts, a downshift from the 9 of 12 citing “modest or moderate growth” in the January 2016 Beige Book. In general, optimism regarding the economic outlook far outweighed pessimism throughout the Beige Book, as it has for the past two years or so, but pessimism is running high in the energy producing regions of the U.S. The Beige Book is a qualitative assessment of the…

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TOO SOON FOR MARCH MADNESS?

As we enter March, market participants are already looking ahead to the Federal Reserve’s (Fed) next Federal Open Market Committee (FOMC) meeting. While the meeting isn’t until March 15 – 16, 2016, markets are already trying to decipher how the widening disconnect between what the Fed plans to do with the fed funds rate and what the market thinks the Fed will do will be resolved. Part of the problem is timing. The latest set of “dot plots” — where each of the 19 FOMC members think the fed funds rate will be at the end of 2016, 2017, 2018, and beyond — is nearly three months old, having been released at the conclusion of the December 15 – 16, 2015 meeting. The December 2015 dot plots show that the Fed plans to raise rates by 100 basis points (1%) this year (or four 25 basis point hikes). The market, as measured by the fed funds futures market, doesn’t think the Fed will raise rates again until late 2017. Yes, you read that correctly, late 2017, nearly two years from now.

Based on recent comments from Fed officials and the Fed’s relatively high tolerance for financial market volatility, our view is that the March 2016 update of the FOMC dot plots may show that the Fed plans to raise rates by at least 50 (and perhaps even 75) basis points this year. Although this adjustment would help to narrow the disconnect between the FOMC and the market somewhat, it is nowhere near closing the gap completely. So, why the disconnect? March madness, perhaps?

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DATA-DRIVEN PERSPECTIVE ON A ROUGH START TO 2016

It has been a rough start to 2016 for the stock market. In fact, it’s been one of the worst starts to a year in the history of the S&P 500. This week we look at how stocks have done historically after other similarly bad starts, compare current fundamental and technical conditions to prior bear market lows, and discuss some potential catalysts that could help turn stocks around. While recession odds have risen (we place the odds at about 30%), we do not expect the S&P 500, down 12.5% from 2015 highs, to enter a bear market.

Down 8.8% though 29 trading days, 2016 is the third worst start for stocks over the past nearly 90 years. Going back all the way to 1928, the S&P 500 Index (and its predecessor S&P Index) has been down at least 5% on the 29th trading day of the year 19 other times. So what has happened the rest of the year? The good news is that after a bad start, for the rest of the year the S&P 500 has averaged a gain of 5.3% (the median is also 5.3%), and the rest of the year has been positive 58% of the time.

The best rallies after bad starts were 49% in 1935 and 36% in 2003. Going back 40 years, the S&P 500 has been down 5% or more after 29 trading days 10 other times besides this year. The rest of the year was down more than 10% only once, in 2008. That year saw a 33% drop from the 29th trading day until the end of the year. In other words, a sizable drop from here for the rest of the year would be extremely rare.

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Valentines Day Inflation

It is not often that a mundane financial market concept like inflation crosses paths with a very real part of our everyday lives. Inflation is often thought of as a bogeyman that erodes our financial well-being and causes us to work harder to make sure we “keep up.” Price increases are averaged into one of several widely followed inflation indexes and reported throughout financial markets and the popular media so we know the inflation rate, which affects our cost of living and influences investment decision making.

Inflation gets more interesting if we apply it to upcoming purchases and how it may impact gift giving for Valentine’s Day, the fourth busiest shopping holiday behind Christmas, back to school, and — only marginally — Mother’s Day. When measuring cost increases over time, the rate of inflation, most investors think of the Consumer Price Index (CPI). The CPI is a broad measure of price changes on over 200 items (yes, more than 200), organized into eight broad categories that include apparel, housing, recreation, and transportation. If there is an item for sale to consumers, the cost is likely tracked by the CPI.

Digging into the CPI may help answer the question of what to buy a significant other for Valentine’s Day. By taking a look at several Valentine’s Day–themed items measured by the Bureau of Labor Statistics (BLS) in the CPI calculation, we may be able to add some insight on gift giving for this upcoming holiday.

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GROUNDHOG DAY?

In Punxsutawney, PA, a groundhog named Phil either will or will not see his shadow and we’ll either be doomed to repeat the first six weeks of winter again (which haven’t been that bad in Boston at least) or have an early spring. Groundhog Day enthusiasts claim that the climate predictions made by Phil the Groundhog (and his “cousins” across the country) are accurate 75 – 90% of the time. The United States National Climatic Data Center (NCDC), the keeper of all weather statistics for the federal government, stated, “The groundhog has shown no talent for predicting the arrival of spring, especially in recent years.” In recent weeks, there have been plenty of “groundhogs” in the financial markets and in the financial media. For some investors, the fear is that the market’s performance in January 2016 will be repeated over and over again, as in the classic 1993 film Groundhog Day starring Bill Murray and Andie MacDowell. Other investors fear that 1998 will play out all over again, triggered by central bankers’ policy mistakes, volatile currency markets, wave after wave of currency devaluations, and eventually a sovereign default. Another group of Groundhog Day aficionados think that the drop in oil, the rising U.S. dollar, a lack of corporate earnings growth, a manufacturing recession, a hard landing in China, and global central banks “running out of bullets” have returned the global economy to the precipice of another 2008.

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FIVE FORECASTERS: FEW WARNING SIGNS

The Five Forecasters still favor the continuation of the current bull market and no recession. The Five Forecasters, which we first introduced in 2014, are five indicators that, collectively, have historically signaled the increasing fragility of the U.S. economy and a transition to the late stage of the economic cycle and an oncoming recession.

Currently, these indicators are generally sending mid-cycle signals (similar to our cycle clock from Outlook 2016). Three of the five indicators are flashing a warning signal and suggest the cycle may have moved past the midpoint, while two of them are still benign. Here we review these five indicators, which still signal that this bull market may continue and that the latest S&P 500 correction may stop short of a 20% decline.

Bear market declines of 20% or more for stocks are not always accompanied by a recession, although more often than not, that is the case. Accordingly, we believe these indicators can be used to give some advance warning of an impending bear market. The average S&P 500 decline in a bear market historically is about 33%, compared to the 12% peak-to-trough decline from the all-time high on May 21, 2015, through January 20, 2016.

 

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Scenario Planning For Current Market Conditions

In the Outlook for 2016, we highlight some areas where uncertainty or important changes may lead to opportunities as the year progresses, such as interest rates, energy, and emerging markets. For each of these areas, as well as for the volatile market environment as a whole, we share an overview of our playbook for added flexibility in 2016. Running through all of these playbooks are some basic themes:
ƒƒ- Patient doesn’t have to mean passive. Stay with your plan, but there
may still be times when it makes sense to lower a portfolio’s riskiness.
ƒƒ- Protect but don’t panic. Some protection can create flexibility.
– ƒƒPursue opportunities. Flexibility creates room to pursue opportunities.

With this more tactical approach, technical analysis can be a more important tool for gauging market behavior and can be useful both to help mitigate risks and take advantage of opportunities. Technicals have always been part of our process in analyzing market behavior. In more volatile markets, where fear can create sustained gaps between what’s going on in the markets and what’s going on in the economy and corporate America, the ability to measure market sentiment through technicals can become even more important.

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