First Quarter 2016 – Market Commentary

Index Performance

Markets started off 2016 right where 2015 left off, in the red. Bears came out of hibernation for a month and a half until traders couldn’t sell anymore. On February 11th the sellers threw in the towel: that day the S&P 500 index closed down -10.5% and the Dow Jones Industrial Average closed down -10%. This was the turning point, as after this date all equities markets rallied to recover lost ground by the end of the quarter. The S&P 500 ended up .7% and the Dow managed to gain 1.5%. The technology-heavy Nasdaq index fell as much as 15% and finished the quarter still in the red, down -2.75%. Likewise the growth-oriented Investor’s Business Daily Mutual Fund Index was able to bounce off the lows yet remained negative, closing down -1.9%. The Russell 2000 small company index similarly ended the quarter down -2%, an improvement from its bottom of down -16%. Bonds gave investors a safe harbor but growth was mild: the Barclays Aggregate Bond Index finished the first three months up 3% and the Dow US Treasuries index was up 4%.

The first quarter of 2016 got off to an ominous start. In January the stock market suffered its worst opening week to a year ever. That is, in the history of our stock market, there has never been a worse opening week than the one we went through this year. And things just got worse from there until the depths of despair were finally reached in mid-February. Markets charged back following this bottom and were able to close the quarter roughly where they began, with some mild positive performance. What explains this bipolar behavior? After all, the fundamentals of the economy did not change with the flip of a switch on February 11th to have justified either the sell-off or the subsequent buying spree. Below we attempt to explain the two-faced market by way of considering where traders looked to assess the health of the economy. The first part of the quarter they looked abroad and were discouraged by prospects of low growth, low oil prices, and desperate central bank policies. The latter half of the quarter traders turned their focus inward and, although they weren’t energized by America’s economy, they at least were reassured that a full blown meltdown wasn’t necessarily on the immediate horizon. And so the markets closed the first quarter 2016 approximately where they began – recovered from the deep bottom yet still struggling for positive performance. Our forecast for the rest of 2016 mirrors these previous three months: much downside risk owing to the global slowdown and few prospects for growth for the very same reason.

Looking Abroad – Oil

Oil prices and central bank policy, the two principal drivers for the market’s direction, maintained their roles and were the primary reasons for the pronounced first quarter volatility. The first half of the quarter saw the continuation of the talismanic power the barrel of oil had on equities traders. Of course, as we examined last quarter, the price of oil has become the preferred measurement for the health of the world’s economy so any incremental increase or decrease caused reverberations worldwide. Once oil discovered its own level (between $30 and $40) attention then turned to central banks as traders took a microscope to every last word from bankers’ mouths in hopes that monetary policy could deliver an elixir to the world’s stagnation.

The global slowdown that so frightened investors early this year made itself known in the price of oil. Crude started the year in the low $30 range and fell straight down, the markets followed in lock step. The bottom was reached in mid-February. This bottom, precisely $26.21 per barrel of West Texas Intermediate, was a price we have not seen since 2003. OPEC finally took notice of this reversion to 13-year old prices and they immediately started to leak stories of supposed curbs on production. Saudi Arabia, Qatar, Venezuela, and non-OPEC member Russia quickly agreed to freeze production at January levels, a superficial move because January’s output was already record-breaking. The hollow agreement worked, though, as prices have steadily gained through the end of February and into March. Prices briefly touched above $40 on the speculation of more supply-side adjustments, although that currently appears to be a ceiling. In early April prices have fallen back into the mid-$30 range. A meeting of major oil producers, including the breakneck producing Iran, is planned for mid-April in Doha, Qatar. Expect production freezes to be discussed in addition to the damage wrought on North American shale drillers.

Barring geopolitical calamity, oil prices are expected to remain low for the foreseeable future. We reiterate our belief that the collapse of oil has been the result of waning demand. We are awash in oil supply because the world is not consuming it at the pace it had been. And consumption has dropped because economic productivity has slowed to a near standstill. Christine Lagarde, the Managing Director of the International Monetary Fund (IMF), has called this a “loss of growth momentum.” The IMF has continually revised its global growth figure down and is expected to do so again in the coming weeks. A brief look at markets overseas justifies the IMF’s gloomy outlook and helps to explain why our domestic markets started the year off falling at terminal velocity.

Foreign Markets Languish

China led the global march downward on continued fears of its shaky economy. The world’s largest importer of oil exhibited unmistakable signs of weakness as its central bank struggled to implement pro-growth policies. The much-maligned currency devaluation the People’s Bank of China (PBOC) engaged in last year and continued to do so in January failed in its intended effect. By weakening the yuan the PBOC made Chinese goods cheaper for foreign countries to buy. In theory this would boost exports and limit imports (because more yuan would be needed to buy foreign goods). Just like last August the devaluation only stoked fears of China’s fragility and utterly failed to have any effect on exports or imports. In fact China saw a 25% drop in exports in February from a year earlier, the largest year over year decline since the recession.

Moreover, if domestic equity indexes looked bad at the beginning of the year, indexes abroad looked even worse. Bear markets are defined as losses of twenty percent or greater from recent highs. China’s Shanghai index fell as much as 50% off its high reached last year, and it remains firmly in bear territory (it is still down around 40% from the high). In Japan their Nikkei index fell as much as 28% from its recent high and is stuck in bear territory still. Europe’s markets barely fared any better. Germany’s DAX index dropped 29% below its recent high and, as of this writing, has not escaped the bear market. The Brit’s FTSE 100 index reached its nadir at 22% off 2015’s high but has made its way out of the bear market and into correction territory (losses between 10% and 20%). Traders thus faced significant headwinds from companies and economies that could not provide reliable prospects for growth. And so attention turned, as it often has these last eight post-recession years, to the soothsayers at our central banks to pacify and inspire, notwithstanding the banks’ dwindling monetary arsenal.

Central Banks to the Rescue?

Whereas central banks used to do their work behind the scenes monitoring inflation and the money supply, their importance in moving markets is now undeniable. Rather than being reticent about this new role the banks and bankers have embraced it. Thus have they deployed quantitative easing, interest rate movements, and prophetic prognostications at the behest of frustrated governments and investors in hopes of prolonging our seven year old bull market. Certain central banks have been more successful than others. Earlier this year Haruhiko Kuroda of the Bank of Japan (BoJ) surprised the world as he decided to set interest rates below zero, following Europe’s lead. Japan’s economy has been in a persistent doldrums for years and has experienced recessions (contractions in growth) in the same span. The BoJ had hoped that negative rates would spur banks to lend more to businesses instead of paying just to sit on the cash. Enthusiasm for the abrupt change faded quickly, however, as observers around the world saw the move less as an act of stimulus than as an act of desperation. Still others saw the move as a shrewd, fancier way of devaluing Japan’s currency (the yen), as opposed to China’s crude manipulations. Whatever the BoJ’s intentions, it seems that negative rates have not worked. Japanese stocks have continued to sell off and the yen has only appreciated. Here at home the BoJ’s drastic actions reinforced the notion that the global economy is in trouble. As the famous bond trader Bill Gross has emphasized, if businesses have not invested in growth at zero interest rates, what makes bankers think they’ll start to invest at negative rates?

Not to be outdone by Japan’s Kuroda, European Central Bank President Mario Draghi, “Pulled out the monetary version of a man-portable, recoil-free anti-tank rocket launcher,” in the words of the Wall Street Journal. Facing a slow growing Eurozone economy and weak inflation numbers, Draghi took it upon himself to jolt markets awake with even lower interest rates and a €20 billion increase to the quantitative easing program. Banks depositing funds with the ECB will now “earn” -.4% on that amount; in other words banks will pay the ECB for the privilege of parking money there. ECB quantitative easing, the technical term for a central bank buying lots of bonds, now amounts to a whopping €80 billion per month. Draghi also laid out plans to begin buying corporate debt in addition to sovereign debt, a process with definite potential to distort markets. European investors are already running into liquidity problems as the ECB gobbles up bonds and becomes the largest holder of certain issues of debt.

At first downtrodden traders once again willfully suspended disbelief and indulged the fiction that Super Mario Draghi, a sort of economic deus ex machina, could fix what ails the continent’s markets. Indexes rose for one day on news of Draghi’s policy bazooka but they very soon found a reason to doubt their monetary savior. In his press conference announcing the ECB’s most recent blitz Draghi made passing hints that interest rates might not go further negative. This vague aside was enough for the rally to end abruptly after one day and for traders to act like petulant children. One investment manager quoted by the Wall Street Journal whined, “They gave the market a gift and then took it away within an hour.” Clearly this is not a market trading on the fundamentals of the companies making up the indexes. Rather the markets have gotten used to and dependent on the schemings of our central banks. The banks have been more than happy to play the role of puppet master, although it has become increasingly apparent that they are mostly powerless against the invisible hand of the markets. Even so, this does not alter the fact that the rally we observed from February through March was fueled principally by speculation surrounding the most important central bank in the world, the Federal Reserve of the United States.

The Federal Reserve Tail Wagged the Market Dog

Thus did traders turn away from instability abroad to focus on America, the last reliable refuge for healthy economic growth. With oil’s bottom discovered in February the spotlight was then shown on the Fed. In spectacularly ill-timed testimony in front of Congress, Fed Chair Janet Yellen divulged that the Fed had considered the implications of turning its key interest rate negative. This was likely the catalyst that caused the market to bottom: Yellen testified the morning of February 11th and the Dow closed that day down 237 points. Yellen’s honest presentation was at first interpreted as evincing a deep pessimism about the economy going forward, leading to the last gasps of the quarterly sell off that day. Traders decided the next day to disregard this pessimism and focus on the fact that further interest rate hikes this year have become even less likely. Rising interest rates are widely believed to be bad news for equity prices. A week after Yellen’s testimony the market had risen 4% based chiefly on minutes from the Fed’s January meeting that showed that the experts at the Federal Reserve had no idea where the economy is going. As the New York Times put it, the Fed “threw up their hands.”

You will recall that in December the Fed raised short term interest rates to a range between .25% and .5% and they had planned for four additional rate hikes this year. The Fed hikes these short term rates – the rate they charge financial institutions for borrowing funds overnight – in order to put the brakes on inflation. Many believe that rising rates mean increased borrowing costs so that corporations will issue less debt and this will then lead to a contraction in growth. So a staving off of rising rates is viewed as good news to the market, and that proved to be especially true this past quarter.

The Fed met in March and issued a short statement that rates would not be hiked anytime soon. They blamed “global economic and financial developments” and Yellen confirmed that any rise in rates this year will be gradual. The market loved this language and the various Fed Presidents’ speeches and press conferences reiterating the point only served to juice equities higher. The S&P 500 was up 6.6% in March alone and the Dow gained 7%.

By their words and inaction the Fed was able to dig us out of a hole, but indexes remain flat. This raises several questions about, and causes us to question, the vitality of this rally. As we mentioned above, the fundamentals of this economy have not changed. Global growth is weak, demand has not caught up with the oversupply of oil, and American growth has remained stubbornly anemic (see the economic indicators below). The following chart helps to illustrate the point. It is the return for the S&P 500 from November of 2014 (the end of the Fed’s quantitative easing program) to March 31st of this year.
As you can see the index has struggled to return even 2% in nearly a year and a half. What we are also observing here is the market acting without the distorting influence of the Fed buying bonds by the billions every month. This tells us that stocks have been unable to appreciate based on their own implicit values; that they need a market-mover like the Fed to corner a portion of the market in order to motivate investors to buy equities simply because they are starved for the yield they couldn’t receive from buying bonds.

For the first time since 1995 there were zero tech initial public offerings (IPOs) in the first quarter. Corporate earnings are expected to drop for the fourth consecutive quarter, with the most recent drop being the largest in six and a half years. We need growth. And growth is not going to come from a Federal Reserve President discussing interest rates at a luncheon at the Ritz.

Real economic growth can occur when government gets out of the way of innovation and encourages businesses to make profits. We have seen this before when President Reagan cut taxes in the ’80s and when President Clinton implemented pro-business policies in the ’90s that allowed Silicon Valley to thrive. Lately, bureaucratic red tape has discouraged startups and high corporate tax rates have motivated companies to leave the country. Instead of addressing these problems the government has exacerbated regulation and has purposefully convoluted the tax code to prevent companies from seeking favorable treatment overseas. The stakes are set for the presidential election in November and the contrast between the two choices is stark. We will see which path Americans would like to take.

Technical Analysis

Market technicals look decent on the surface. They are decent enough to allay fears of an out and out recession, but not showing strength enough to inspire a bull market. The two major large company stock indexes, the S&P 500 and the Dow, rallied to overtake their 200-day moving averages – the simple rolling average of the last 200 trading days’ prices – in March. While this is usually a sign of a bull market, other indexes are telling a different story. The Nasdaq was finally able to break through its 200-day at the end of the quarter, though it has since fallen back below it. The Russell 2000 small company index remains appreciably below its 200-day after having dropped beneath it last August. The following chart shows the 52-week performance of the Russell. Note the 200-day moving average represented by the red line.

Note also the downward slope of the moving average line indicating a declining market. All of the major stock indexes’ 200-day moving average lines are in a similar downward slope.

This is not to say that markets couldn’t charge ahead the rest of the year and turn their moving averages into positive slopes. It is just to say that underlying technical indicators of the recent rally are making this scenario appear less and less likely. First there is the problem of volume; or the actual number of shares traded on the market each day. Volume peaked in January at the height of the sell-off. The mid-February through March rally took place with 35% lighter volume. This belies a lack of confidence in the rally and is not an encouraging sign. Next there is the problem of who the buyers and sellers actually were. For the last half of the rally in the first quarter the buyers boosting the market weren’t investors but the companies themselves performing massive stock buybacks. The companies making up the S&P 500 purchased $165 billion worth of their own stock, the most in a quarter since 2007, the year before the Great Recession. What’s more, in addition to companies buying their own stock, the other buyers contributing to the rally were traders covering their short positions. Traders who short a stock borrow shares and sell them betting the price will drop. They then buy them back, or “cover” their short to take either a profit or loss when they return the borrowed shares. Shorts spiked in January with many traders believing the market would continue its fall. When these traders covered their shorts and bought back the stocks it helped to goose the rally as the first quarter wrapped up. We see then the wobbly foundation on which the rally was built: corporate buybacks and short sellers instead of investors exhibiting confidence enough in the economy to invest in growth.

Key Economic Indicators

Gross Domestic Product

Fourth quarter 2015 GDP estimates were revised upward but still proved underwhelming. In the final analysis of how the last months of the year performed, GDP was found to have advanced 1.4%. The bump in the estimate – from 1% to 1.4% – was attributed to stronger than predicted consumer spending. Consumer spending, however, was mild considering the substantial windfall of cheap fuel prices. While holiday season expenditures propped up the GDP number, America’s businesses took a drubbing. Corporate profits fell 3.6% for the quarter year over year, and declined 8% from the third quarter to the fourth. Business investment, or the money that American businesses put toward expansion and growth, similarly declined. The post-recession economic malaise looks as if it will persist as advance estimates for first quarter 2016 GDP are again predicted to be below 2%. The Federal Reserve Bank of Atlanta has continually downgraded their projection for first quarter GDP growth and as of this writing they anticipate a weak .1% growth rate.

Job Situation

Job growth since last quarter has been satisfactory. Neither hot nor cold, a familiar refrain to which we have become accustomed in these post-2008 years. The past three months have seen an average of 203,000 jobs added per month. Decent gains, to be sure, but underlying data remains questionable. The unemployment rate ticked up to 5% but this was because more Americans have entered the workforce. The labor force participation rate has recovered from its September low – recall that this number hadn’t been seen since the late ’70s – and now sits at 63% of eligible Americans working. Many economists predict that the rate will drop off in coming months as more baby boomers decide to retire and their positions go unfilled by cost-cutting corporations squeezed by weak earnings growth.

It is also helpful to examine where job gains have been made. In March, retail and healthcare services posted significant gains but many of these jobs are either part-time or temporary. Construction and trade contractor jobs were also up, which is encouraging for commercial and personal building growth. Most revealing was the fact that manufacturer and miner employment numbers were flat for February and suffered losses in March. These high productivity sectors are victims of low oil prices, a strong US dollar, and waning global demand. The effects of these struggling sectors are also being felt in the weak GDP numbers reported above. The broad U-6 unemployment rate went up last month to an uncomfortably high 9.9%.

Consumer Confidence

The University of Michigan Index of Consumer Sentiment dropped in March for the third consecutive month. The final number recorded for March was 91, which is still above the non-recessionary year average of 87.5. Thus far in 2016 the sentiment number has been trending downward, tracking with the lower GDP estimates. This could be consumer perception of the volatility of capital markets in combination with rebounding gasoline prices. Or it could be consumer reaction to continuously stagnant wages and few prospects for real growth. Whatever the case, we will keep abreast of this number as the American consumer makes up two-thirds of the GDP in the world’s most important economy.
Looking Forward

As outlined in some detail above, it is quite apparent that global growth is stagnant at best. Moving forward, there is as great a chance of sliding into recession as there is of experiencing moderate growth. With every central bank in the industrialized world pulling out all the stops to create an environment in which economic growth can occur, they are only getting tepid, fragile and unsustainable economic growth. This raises the question: if low interest rates are not the solution, what is? As briefly mentioned above, lower income tax rates for both individuals and corporations combined with much less intrusive government regulation have proven to be the most productive policies to foster economic growth. Unfortunately the current political vogue both here in the United States as well as in Europe is the exact opposite philosophy. We are seeing the contractive growth effects of the dual misguided economic policies of taxing corporations heavily – those engines of economic growth and prosperity – and taxing successful individuals at confiscatory tax rates to extract their wealth and award it to others in an effort to create economic fairness and prosperity for all. One need only look at the health of the European economies to realize that the bureaucratic “redistributive” economic policy is counterproductive, if not disastrous, virtually every time it is employed. As the economist Milton Friedman has stated, “If the twentieth century taught us anything, it is that socialism fails and capitalism creates wealth.”

Careful examination of the chart above shows the near-term market peak was May 21, 2015 with several troublesome patterns of near-term highs not going as high as the previous highs and near-term lows are lower than the previous lows. This pattern historically indicates a market in the very early stages of decline. The violent moves we experienced the first quarter are not trends in and of themselves; they are merely emotional reactions expressed in short-term investor sentiment causing almost-manic movement. It is human nature to want to avoid entirely, if possible, sharp declines and participate fully in the sharp rebounds. Unfortunately we are aware of no system with any degree of consistency that can fully avoid short-term corrections while at the same time being able to fully participate in the ensuing short-term rallies. However, maintaining flexibility within a portfolio is probably as important now as any time in recent history. The ability to exit certain sectors as they begin to decline, or to increase or decrease exposure to a specific index such as the S&P 500 are very viable options in markets such as these. Traditional managed mutual funds have had a very difficult time these past eighteen months outperforming their benchmark indexes. We believe this difficulty may stem from the very diversification that many mutual funds found appealing in the past. By investing in a broad cross-section of companies in various industries at a time in which only very narrow parts of the S&P 500 have been productive, the diversified mutual fund’s performance is bound to lag its benchmark and its overall performance will be dampened for the long term.

A portfolio structured with the inclusion of some risk-appropriate, lower-volatility investments to help as stabilizing factors appears to be a viable strategy for the markets we have been experiencing of late. The interaction between these stabilizers and the more active approaches allows for participation in short-term up movements while at the same time they lessen volatility and try to reduce abrupt short-term price declines.

Investors who gauge satisfaction based on their portfolio’s relative performance compared with a pure equity index such as the S&P 500 or the Dow may be setting themselves up for greater risk and very high volatility as evidenced during the first quarter of this year. It is important to realize that a “risk-appropriate” investment does not necessarily mean that the investment will appreciate in value over the near-term. Nevertheless, the price movement experienced by more risk-appropriate investments tends to be less volatile thereby making them more comfortable and acceptable to investors.

It is interesting to note that the four most prominent stocks last year referred to as FANG – Facebook, Amazon, Netflix and Google – all but one (Facebook ) experienced negative performance year-to-date as of the end of the first quarter. If the stocks were not part of your portfolio last year it would be difficult to imagine performance that outpaced the S&P 500. This year three of the four performed significantly worse than the S&P 500 in the first quarter. This is a prime example of chasing instruments with risk profiles not commonly found in retirement-oriented or moderate risk portfolios in an effort to achieve short-term performance.

For moderate risk profile investors, we believe a balanced approach with a blend of both stocks and bond mutual funds selected based on their quality and volatility profiles offers a flexible approach to portfolio management for markets such as the ones we are experiencing. Note that your portfolio composition may differ from those discussed here depending on your personal risk profile and investment goals. The ability to be responsive in portfolio management is even more important in uncertain economic times, so a quantified, disciplined approach to allocating portfolio assets offers the potential for reasonable returns with acceptable volatility.