New Year Nose Dive Into The Abyss

My colleague, Doug May, put this together, and I thought it was a great piece worth sharing.

“The New Year opened with the stock market experiencing its worst sell-off in history. The broad index fell 6% in the week. The market is roughly 10% below what we think will ultimately be its May 2015 market top. Measures of market volatility have remained elevated since last August and most client portfolios are as conservatively positioned today as we were going into the 2008 crisis. So, what’s going on? Are we concerned about a repeat of that crisis? What will we do with all that cash? Here’s our take.

We believe that we are in the midst of a “non-economic bear market.” We believe that the bear market began last Spring and we fear that there is more downside from here. We think that we may be in the midst of a bear market – not at its bottom. While news in China and plunging energy prices make the biggest headlines, and certainly contribute to the market’s decline, we believe that the main reason that U.S. markets are falling is that the U.S. economy is entering a “profits recession” that will cause corporate earnings to decline, slightly, in 2016. Overall, our leading economic indicators are forecasting stability for the overall economy. At this point, we’re not anticipating an economic recession. We believe that this bear market will be more of a financial markets event; its impact on “Main Street” may be rather limited.

While the recent sell-off in China makes headlines, it must be kept in perspective. Even after this first week (the worst in history!), the Shanghai market which is at the root of the sell-off is up about 50 percent from where it sold in early 2014, just 18 months ago. The problem is that China’s stock market experienced a bubble, from which it was bound to nose dive. Regardless of global economic activity, regardless of whether North Korea decides to send spit balls toward its neighbors, regardless of whether empty apartment buildings in Beijing finally start getting tenants…the Shanghai market was destined to fall because that, inevitably, is what happens after a bubble pops. Although China’s economy might, in fact, be weakening – I wouldn’t base that conclusion on what’s going on in the Chinese stock market. That market is tanking, and has further to fall, simply because it was allowed to become a bubble during 2014. Similarly, the market nose dive in China will have very little to do with what happens in the U.S. market. We didn’t enjoy a 400% gain in 2014/15, so we won’t be a party to the 75% decline that they’re in the midst of now.

Back in the U.S., the hardest hit industry groups are in the energy sector. As we said a year ago in our Economic Forecast, there will be real pain felt by businesses in the energy sector. We wondered, a year ago, if we wouldn’t be buying these companies at some point last year. As it turned out, buying in 2015 would have been premature and we managed to squelch our contrarian instincts and wait patiently for the stocks to get cheaper. On the other hand, Exxon’s pain is Joe the Plumber’s gain. Lower energy prices put more disposable income in the pockets of U.S. consumers. One of the reasons that our Leading Economic Indicators have remained stable is that retail spending remains pretty robust. We believe that lower energy prices are responsible for much of that strength.

The employment situation also remains pretty positive. At the end of 2015, unemployment in the U.S. was reported to be about 5 percent. We are near the point where economists speculate that we’re at “full employment.” Jobless claims fell below 300,000 claims per week throughout most of 2015, which is historically the level you see when the economy is performing well. If the job market continues to stay reasonably strong, more than likely U.S. consumers will continue to spend money, driving the U.S. economy forward.

The international situation seems pretty bleak, but typically geopolitics have little impact on the health of the U.S. economy. It’s an election year, which should provide a lot of free entertainment for the electorate, but most elections don’t move the needle on economic activity. Wall Street might blink if an avowed Socialist makes it into the White House, but most of the celebrities and politicians vying for POTUS in our upcoming regime change are not likely to have much impact on the market. Even the Fed increasing short-term interest rate, from ludicrously low to pretty darn low, isn’t likely to prompt too many investors to sell stocks in order to “lock in” a 1.25% Treasury Bill yield. Instead, we think that the primary news driver will be the (small) decline in profit margins and what it means about forward earnings estimates. Once the decline is apparent, Wall Street analysts will probably forecast declining profits forever, which could reduce investors willingness to pay up for stocks.

We believe that several good opportunities will be created in this sell-off and look forward to reinvesting the cash hoard we’ve built in most accounts when the opportunity comes.”

Doug can be reached at Avant Garde Advisors

Our technical work suggests much of the same, as the NYSE Advance / Decline line (number of climbing issues vs. falling) peaked back in May of 2015 well ahead of the market!

Market BREADTH can often lead price.

Here's our thoughts on the NASDAQ, which were published Jan. 11, 2016

This was originally shared on Captain John's Charts