Two months ago we sent a Special Report titled A Time for Caution. At that point, the year 2016 had just opened with serious weakness. Crude oil was plunging and pulling down other financial markets with it. Now oil is climbing again. Is the time for caution past?
In a word, we think the answer is “No.” We still see many reasons to stay defensive as we approach quarter-end. In our view, the risk of serious loss is still unacceptably high. Our managed account programs remain defensively positioned.
Unlike some money managers, at Republic we are not dogmatically bearish or bullish. We recognize that markets go through boom-bust cycles, and we try to stay on the right side of them. We believe this gives us the best chance of earning acceptable long-term returns.
Among the many factors we consider, five are currently telling us to be cautious. We’ll discuss each in turn below.
Financial markets fluctuate from day to day, but over time they move in discernable trends. Right now, U.S. stock market benchmarks are falling into downtrends. You can see this in the S&P 500 (large cap) and Russell 2000 (small cap) indexes.
Data source: Bespoke Investment Group
Both indexes reached all-time highs in mid-2015 and subsequently moved downward. The negative trend is steeper for the Russell 2000, but both are well below last year’s high points.
In a healthy bull market, we would expect to see these major benchmarks recover from downdrafts quickly and move to new highs. Neither is happening. This tells us the stock market still faces substantial selling pressure.
Worse, the weakness is worldwide. This Bloomberg screenshot shows how most world markets are down this year, many by double digit percentages even after meaningful moves off of mid-February lows.
The only green spots are indexes in Canada, Mexico and Brazil. All three of those countries have other issues that make investing in them problematic. As a practical matter, stock markets around the globe are either flat or declining.
Flight to Safety
U.S. Treasury bonds are the ultimate in safety because the federal government can always repay its debts. It can raise taxes if necessary. That’s why Treasury yields are always lower than corporate bond yields of similar maturity.
What are Treasury yields telling us now? The chart shows a downtrend extending back to 2011, with another leg down in early 2016. Interest rates on the 10-year bonds are now well below 2%.
Yields fall when more people want to buy Treasury bonds. It means they are willing to give up the higher yield of corporate bonds in exchange for the safety of Treasury bonds. The “Yield Spread” chart shows this differential. You can see it has been declining since early 2014 and is now below 1%. A falling yield spread often precedes recessionary periods, as shown in the gray vertical bars.
With this happening at the same time stock prices are struggling, it looks like investors are choosing safety over both yield and capital gains. This could change, of course, but for now the bond market is telling us something important – and it isn’t good for stocks.
Weak Corporate Profits
Stocks are valuable because they represent part ownership of a business. They give the owner a share of the company’s profits, or at least hope for profits in the future. Shares in a company that are not making money now, and have no reasonable hope of turning a profit in the future, are less valuable.
In a bull market the opposite is more common. Companies see steady growth in both the top line (sales or revenues) and the bottom line (profits or earnings). Ideally you want to see both the top and bottom lines growing. Investment analysts recognize that companies can have a soft quarter, or that some businesses are seasonal. For this reason, they typically look at the “year over year” change: the 4th quarter of 2015 vs. the 4th quarter of 2014.
By that standard, the 500 large companies that comprise the S&P 500 Index don’t look very impressive.
With 494 of the 500 having reported their most recent quarter, aggregate year-over-year sales growth (or lack thereof) was -4.0% and earnings “growth” was -7.5%. The average company saw slower sales and less profits than the same period a year ago.
Not surprisingly, the sector breakdown shows the worst pain was in energy and materials companies, along with the utilities sector. Collapsing oil prices since 2014 wreaked havoc on the domestic energy sector. Worse, it is starting to spill over into the financial sector since much of the activity in new U.S. shale fields was debt-financed. Many oil drillers and producers are hard-pressed to keep up their loan payments, even after laying off workers and cutting every cost they can.
There is a solution: convert the debt financing to equity. Banks are already pushing their energy customers to do this. Weatherford International, for instance, intends to issue new stock and use the proceeds to pay back its JPMorgan Chase credit line. The notable part is that JPMorgan Chase is also underwriting the stock offering. The banks are offloading risk from their own balance sheets and forcing shareholders to bear it.
There are some bright spots in the earnings picture. The telecom, health care, and consumer discretionary sectors show some growth, but even in those sectors the good news of a small number of outperforming stocks skews the rate of change to look more positive.
The U.S. economy goes through expansions and recessions. The length varies but historically recessions occur every 5-10 years. As of this month, it has been 6 ½ years since the last recession ended in September 2009. That means we are well into the economic danger zone.
Moreover, the current expansion has been far weaker than normal. Millions of people are still unemployed, underemployed at far less than their prior wages, or working part-time because they can’t find full-time jobs. Inflation is supposedly minimal, but the actual “cost of living” for middle class Americans is anything but flat. Rapidly rising health care and housing costs, not to mention taxes, are offsetting the benefit of lower fuel prices for many people.
The chart below shows the relationship between corporate profits and stock prices. Since 1985, every time profit growth (the dark line) declined for more than two quarters, stock prices (gray line) responded with a 20% or greater drawdown. There was usually a time lag in between, but falling profits are not consistent with rising stock prices.
This ought to concern anyone with money in stocks because the last quarter of 2015 marked a fourth consecutive year-over-year profit decline. Looking at revenue, which in many ways is a better indicator, it was the fifth consecutive quarterly drop. Either this time is an exception to the longstanding pattern, or further price weakness should be expected. We think the latter is more likely.
Flailing Central Banks
In theory, central banks like the Federal Reserve, Bank of Japan (BOJ), and European Central Bank (ECB) use monetary policy to encourage economic growth, reduce unemployment, and control inflation. In practice, central banks seem to be losing their touch.
The Fed, for example, has been trying to stimulate the economy with near-zero short-term interest rates since the 2008 financial crisis. They also tried three rounds of “quantitative easing” to inject liquidity into the economy.
Did it work? Few people think so. At best, you could argue the economy would be even worse if the Fed had not acted, but they definitely didn’t create a boom.
The same is happening in Europe and Japan. Just this week, the ECB pushed its interest rate on bank reserves to -0.4%. That’s right, they have negative interest rates. Banks must pay the ECB to hold their reserves. The idea is this will encourage banks to lend money into the economy instead of keeping it parked. It hasn’t worked out that way so far.
The central banks are actually working against each other. The BOJ and ECB are reducing their key interest rates while the Fed is in the process of raising ours. We’ll find out next week if the Fed tightens another notch. For them to raise rates while the economy is so close to recession is very strange and possibly counterproductive. After years of dramatic measures with little discernable effect, investors and traders are losing confidence in the institutions that are the foundation of modern banking.
The political side is also creating uncertainty. In Europe, the Syrian refugee crisis is straining the European Union. The United Kingdom will soon hold a referendum to withdraw from the alliance completely. This plus the theatrics of the U.S. presidential election add to the overall risk aversion and pessimism in the markets.
We spend a great deal of time trying to sort out all these competing factors. It is as not an exact science. We never expect to buy precisely at the bottom and sell precisely at the top. Our goal is to capture some of the gains (or avoid the losses) between the two extremes.
Our ultimate goal is to achieve your long-term investment goals. You engaged us to make these difficult decisions, and we will always do our utmost to get them right. We appreciate your confidence. As always, we are glad to discuss your individual situation at any time. Feel free to reach out by phone or e-mail if you have any questions.
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