As 2016 starts, we have the major capital markets in a short-term swoon phase. Among various asset class returns to date, I note the following (all returns are price only, and exclude dividends/income flow and are as of 1/15/16):
| S&P 500 Index | -7.8% |
| Russell 2000 Index | -11.9% |
| EAFE Index (Developed foreign equities) | -7.8% |
| EEM (iShare Emerging Market ETF) | -11.1% |
| Oil Price | -16.8% |
As oil prices have continued to decline, capital market asset values have followed suit. Declining oil prices (commodity prices in general) are negatively impacting capital spending activities, lowering industrial output activity on a global basis. Many pundits are now muttering the “R” word…recession. The weight of the evidence I’m focused upon is telling me the U.S. economy has probably hit a soft patch with GDP growth at less than 2 percent during Q4 2015 and Q1 2016, but I still see little evidence of an impending recession immediately on the horizon.
Why the Current Swoon?
So if the probability isn’t extremely high that we are heading into a recession, why has asset price volatility increased?
Four factors come to mind as to why asset volatility has increased and prices have fallen so rapidly this year.
- The Fed has started to raise interest rates: This sounds rather obvious, but it has been more than 10 years since the last Fed engineered interest rate cycle increase. Since 2009, the world’s capital markets have benefited by high levels of liquidity being pumped into the capital system. This has started to vanish. Is there reason to panic concerning this issue? Not in my opinion.
- Realization that the economic model in China has shifted away from industrial output growth towards consumer growth, creating growth disappointment pockets: Most of the data I am seeing from China focuses primarily on industrial output growth (bad numbers) and not consumption (decent numbers). China’s Purchasing Manager’s Index (PMI), an index which shows the strength/weakness of the manufacturing sector, was recently released at 48.2 – any number below 50 suggests contraction. This index has been below a reading of 50 since April of last year, so this isn’t new information, and actually the year-over-year point change has become less negative over the last six months. I’m currently more worried about capital outflow from China into foreign banks – this capital outflow is like the central bank raising interest rates at a time when their economy is slowing. Add it all up, and it appears China’s sovereign wealth pool has shrunk by almost $1 trillion over the last year or so.
- Oil prices have continued to swoon: Following what appeared to be a certain level of stabilization in the mid-to-upper $30 per barrel range during December, oil prices have taken another dive to the downside. On Jan.15, 2016, it was at $28 per barrel, prices have declined by more than 16 percent since the first of the year.
- Economic recession: The final driver of high levels of volatility is the current focus of investors on the possibility that yes, indeed, the world is heading towards an economic contraction. Some pundits have come out with what I would consider radical pronouncements advising clients to “Sell Everything”. Additionally, an analyst with SocGen announced that the S&P 500 was headed towards 550 (down 75 percent) as it becomes apparent that the world has entered a new economic recession. It is wise to understand that these types of pronouncements come out of the woodwork when market price volatility rises. Bad news sells newspapers. Of these issues, the one I need to discuss further is the probability of the world falling into an economic recession. Recessions are normally accompanied by stock markets declining by more than 20 percent (remember 2008-2009?). I call for a 10 - 20 percent correction occurring sometime this year, but dismiss the idea of a new bear market rising, due to the lack of evidence pointing to an economic recession.
Of these issues, the one I need to discuss further is the probability of the world falling into an economic recession. Recessions are normally accompanied by stock markets declining by more than 20 percent (remember 2008-2009?). I call for a 10 - 20 percent correction occurring sometime this year, but dismiss the idea of a new bear market rising, due to the lack of evidence pointing to an economic recession.
New Bear Market?
Going back over the last number of decades, the stock market has entered bear territory for one of four reasons. • Economy going into recession. The weight of the available evidence tells me, that while possible, the probability of the United States entering a recession is reasonably low. The labor market is strong, the leading economic indicator index is robust, consumer sentiment is okay, and inflation seems low. Recessions occur because of imbalances. Domestically, I see few serious economic imbalances.
- Federal Reserve tightening money supply aggressively. While the Fed recently increased interest rates, monetary policy is far from being restrictive. Annualized M2 (money supply) growth rates are higher than nominal GDP growth rates, indicating that excess money is still flowing from the Fed.
- Equity valuation levels are extended and euphoria dominates investors’ attitudes towards risk. Currently the S&P 500 is selling at 15x earnings and 14.2x projected earnings. These numbers are nowhere near past periods of valuation euphoria. I know segments of the equity market are selling at extreme valuation levels, but that is normally the case. With interest rates at 2 percent (long-term treasury yields), the market flatly isn’t overvalued at 15x earnings.
- Geopolitical stress or war. The eruption of a war or another event is, by its nature, unforecastable. But normally, if a serious geopolitical event is truly disruptive, then gold prices should be rallying hard to the upside. Gold is up 3 percent this year as stock prices have swooned. Gold prices have not risen to levels which support the view that geopolitical risks will drive us into a new bear market.
In summary, I don’t see the start of a new cyclical bear market. The seeds haven’t been sown, which normally accompanies the launching of a new cyclical bear market.
Recession Coming At Us?
This is a valid question as some of the more vicious bear markets occur during times of economic recession. Are we heading towards a recession? Of course, I don’t know (nobody does), but two indicators with good historical track records tell me we are not heading toward a recession.
- 6-Month Rate of Change of the Leading Economic Indicator Index: +3 percent as of the end of November (December read has yet to be released). The U.S. economy HAS NEVER ENTERED A RECESSION WITH THIS INDICATOR AT THIS LEVEL – AT LEAST SINCE THE END OF World War II. We have experienced 10 recessions since then, and this index has had a read of at least -3.5 percent in all but one recession.
- Shape of the yield curve: Most pundits who are saying we are in a recession are discounting the shape of the yield curve, which represents the relationship of short- to long-term interest rates. Currently, short-term interest rates are very low while longer-term interest rates are higher, resulting in a positive shaped yield curve. Going back in time, it is rare to find the United States falling into a recession when the shape of the yield curve is positive. Normally the curve is negative – that is short term rates are higher than long term rates. So, this indicator indicates the U.S. economy is a way off from experiencing an economic contraction.
Another data point to consider: Could we see a contraction in asset values without experiencing a negative yield curve? Yes. According to Ned Davis Research (NDR), going back to 1956, the stock market has generated a negative return of 34.1 percent when the yield curve has been negative, as compared to bear market returns of -19.4 percent when the yield curve has been positive.
Can we see a market correction of 15 - 20 percent this year? Of course. But since the yield curve is positively sloped, if we see this type of correction, my best guess is it will prove to be short-term in nature (the average bear the market has experienced during a period when the yield curve is positively sloped is less than half the duration and 50 percent less vicious as when yield curves are negatively sloped).
Optionality
If indeed the world isn’t heading into recession, as the weight of the evidence of my work suggests, then the correction phase we are experiencing should be limited to a 20 percent decline. This type of decline obviously isn’t painless. I urge investors to take advantage of this type of price decline.
Due to higher levels of price volatility, investors and their wealth advisors may need to consider the level of optionality in their portfolios. What do I mean by “optionality”? It is a measure of the ability of a portfolio to take advantage of what may be short-term price dislocations within various desired asset classes. There are two ways an investor can view declining prices – optimistically or pessimistically. Naturally, humans see something falling in value and the immediate reaction is fear. Depending on the circumstance and the investor, I urge individuals to consider looking at price declines as a period of opportunity. It’s a time to look for opportunities rather than looking for reasons to flee.
Successful investors have the inherent ability to look at falling values, discover the reason behind the decline and deduce the sustainability of that decline in value. When the decline in value appears to be temporary, the ability, or the option to act on that price decline by purchasing the asset tends to lead towards higher long-term returns. Two possible strategies to maintain optionality in portfolios are:
- Portfolio rebalances: Let’s say your strategic normal equity exposure is 70 percent of your holdings. If stock prices decline by 20 percent, your exposure to equities would be 65 percent (assuming other assets held their value). The option of selling assets to purchase stocks would be present. Taking advantage of those types of price declines may indeed lead to higher long-term returns.
- Maintain a reasonable level of exposure to a liquid, low-volatility asset class in your portfolio: Cash, short-term fixed income assets, etc., may be appropriate for allocation in your portfolio, given your individual circumstances. Some would call this market timing, which in professional circles carries negative overtones. On the other hand, during times of higher expected price volatility, maintaining a reasonable level of liquidity in a portfolio may make sense. Maintaining optionality.
Conclusion
I have called for a higher level of asset price volatility this year as compared to the recent past. We are currently seeing the first example of that higher volatility level in today’s market action. There are two ways of looking at volatility – aggressively or negatively. I suggest investors need to look at today’s increased volatility patterns aggressively.
William B. Greiner, CFA, is Chief Investment Strategist at Mariner Holdings.
