My 2016 Market Outlook - Opportunities Will Abound

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Includes: DIA, IWM, QQQ, SPY
by: Lawrence Fuller

Summary

A bear market decline of 20% or more will ensue from last year's peak for the S&P 500 in 2016.

Deteriorating economic fundamentals combined with a corporate earnings recession substantiate lower stock prices, but it was a rise in short-term interest rates that instigated last week's decline.

Our precarious market structure will hasten and exacerbate this decline during the first half of this year.

Ultimately, long-term investment opportunities will abound as market prices realign with fundamentals in a market that once again serves as a discounting mechanism.

I see the potential for significant investment opportunities in the US stock market and abroad in 2016. While this may seem like a bullish departure from the downbeat articles I have written in the past, let me preface by saying that I expect these opportunities to emerge as a bear market decline of 20% or more in the S&P 500 index (NYSEARCA:SPY) ensues. There will certainly be opportunities along the way, as some market indices and sectors are nearing, or have already surpassed, a 20% decline. The Russell 2000 index (NYSEARCA:IWM) of small-cap stocks has fallen 19% from its high last June. The biotech sector (NASDAQ:IBB) has shed 25% of its value since peaking last July. The energy sector (NYSEARCA:XLE) has declined more than 40% from its high achieved in June 2014.

Whether it be in individual companies, sectors or broad market indices, I think many of these opportunities will present themselves during the first half of this year. Why so soon? The process of realigning market prices with fundamentals is well underway, and our extremely precarious market structure lends itself to periods of significant price movements over relatively short periods of time that typically overshoot. Keep your powder dry. Combine this factor with a monetary policy that is no longer fueling the demand for financial assets, but is instead instigating a deleveraging process that began in earnest on Monday, and things can happen very quickly.

It may appear to be opportunistic to introduce a bearish market outlook for 2016 after the worst start to a year for the US stock market on record, but my writings have been far from sanguine for a very long time. From what I have read, China is to blame for this horrific start to 2016, because its economy is sputtering, its currency is weakening, and its stock market is in free fall. I don't believe this to be a valid reason. The rate of growth in China's economy is gradually slowing from what was 10% several years ago, to what is probably 5% today, as it intentionally transitions from a manufacturing- based economy to one that is consumption-based. Its stock market is relatively new (25 years old) and its participants are predominately inexperienced individual investors, so extreme volatility should come as no surprise. China, however, is a poor excuse for the recent plunge in US stock prices. The real reasons for this decline can all be sourced from within our borders.

One important reason is that we are in the midst of a corporate earnings recession that I alerted investors to in an article last February. Corporations have exhausted every measure possible to elevate profit margins and fuel earnings growth through cost-cutting measures, restructurings, debt-refinancing and stock buybacks. Despite these continued efforts, profit margins have peaked as rates of revenue and earnings growth have rolled over. Broad market indices like the S&P 500 managed to remain flat throughout most of last year, as breadth slowly deteriorated and investment dollars flowed out of smaller, lower-quality company stocks and into the largest and highest- quality market caps. Now the fundamentals of market darlings like Apple (NASDAQ:AAPL) are being called into question and the mega-cap stocks are joining the decline. They are taking the broad market indices with them.

Another reason is that the rate of economic growth in the US is slowing. The manufacturing sector, which accounts for approximately 12% of the economy, is most likely in recession. The energy sector has gone from boom to bust with the collapse in crude oil prices to a 12-year low. The rate of growth in consumer spending, which accounts for two-thirds of economic activity, continues to slow on a year-over-year basis, despite continued job growth. This is partly due to a lack of wage growth. It is also due to the fact that monetary policy pulled forward demand that would have otherwise occurred gradually. Lastly, a lot of consumption was fueled by rising financial asset prices, but financial asset prices have not risen over the past year.

Despite this deterioration in corporate and economic fundamentals, the Federal Reserve decided to raise short-term interest rates in December. I believe this to be the primary reason for the precipitous decline in US stock prices that began on the first day of trading in 2016. It has instigated a deleveraging process in risk assets that is an unavoidable consequence of seven years of zero-interest-rate policy. Who is deleveraging? The institutional behemoths, primarily hedge funds, who have used the repurchase market (repos) as a source of short-term borrowing to fund their speculative investment strategies on a longer-term leveraged basis. A mere 25 basis point (1/4 of 1%) increase in borrowing cost may not impact a consumer's decision as to whether or not to buy a car or a home, but it may completely undermine a speculative investment strategy that has paper thin margins and employs leverage.

On the last day of 2015, the Fed sold a record $475 billion in Treasury securities to banks, funds and brokers though its reverse repo facility, which is a part of its open market operations intended to raise short-term interest rates. It is effectively withdrawing liquidity from the financial markets. The result was rise in short-term lending rates above the 50 basis point target for the Fed Funds rate. Is it a coincidence that this increase coincided with the onset of a stock market plunge the very next day? I don't think so.

As for the magnitude of the relentless decline that took place last week, I believe our broken market structure contributed to it. We used to have non-profit exchanges where human beings had obligations to make fair and orderly markets. They have been replaced with private, profit-seeking exchanges that cater primarily to computerized trading programs. These computer algorithms have replaced the human market makers, but they have no obligation to make markets. When there is an imbalance between buyers and sellers in either direction, they exacerbate the move by providing liquidity to the market or withdrawing it all together. It depends on whether or not they can profit. I believe last week was an example of what happens when they withdraw liquidity. Perhaps 2016 will be the year that high-frequency trading is finally exposed as a manipulative and destructive scam that has absolutely nothing to do with investing. Until then, prepare yourself for a continuation of the type of volatility we witnessed last week, but in both directions.

I have painted a pretty dismal picture for the stock market during in the first half of this year. How then can I conclude that investment opportunities will abound later in the year, especially if the fundamentals that support prices have yet to start improving? I expect that price declines will overshoot, creating value and improving the prospects for price appreciation moving forward. I also believe that the Fed's waning influence on financial asset prices will restore the markets ability to serve as a discounting mechanism. This means that prices will turn up in anticipation of an eventual improvement in earnings or economic fundamentals. The stock market used to serve as a leading indicator of economic activity prior to the Fed's decision to use it as a catalyst to help achieve its mandate.

Disclosure: I am/we are long AAPL.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.