"Investors face not one, but two major risks: the risk of losing money and the risk of missing opportunities."
-- Howard Marks
Some have spent a lifetime trying to come up with a concrete definition of risk and they don't mind spending money searching for it. The thought process is that if all risks can be measured accurately, then they can be hedged away. This leads investors to hedge out their hedges to the point where there's now no risk being taken which subsequently leads to no returns either. Whether you measure risk or not, you still have to bear it at some point to make money in the markets. There are no shortcuts.
Speaking to the proliferation of statistical models that have overwhelmed the average investor, Howard said:
"I think more money was spent on risk management in the early 2000s than in the rest of history combined and yet we experienced the worst financial crisis in 80 years. There's little evidence that they add value."
In my view, the best a risk model can do for the investor is point out where potential areas of risk exist, not how that risk will manifest and play out. This is where investors get caught up in the negativism by concluding the worst possible outcome just has to be the result.
We are seeing this now when the conversation turns to the energy sector and the associated high yield issues. The "risk" has been identified, now it is a matter of accepting the worst case scenario as gospel.
When I look at this topic, I come to the conclusion that "risk" is personal. You cannot define risk or risk tolerance without first assessing the unique characteristics of the investor in question.
I'm a big believer in focusing on what YOU can control as a form of risk management. While we're never going to be able to perfectly measure risk, one of the best ways to manage risk is to have a comprehensive plan in place.
Having a plan doesn't mean you can eliminate risk altogether. That's impossible. Part of that plan is realizing that an investor's appetite for risk will likely ebb and flow with the markets even if your ability to take risk based on your financial situation hasn't changed much. Therefore, you want to make sure you are not always acting on these impulses.
Intelligent investors understand the importance of planning for a wide range of outcomes by thinking in terms of probabilities, understanding that they will be wrong from time to time and having the willingness to admit they can't or don't need to know everything.
Taking risk makes sense. You just don't want to get into the habit of taking unnecessary or unacceptable risks, based on your personal makeup.
Now all we have to do as investors is figure out what those "unacceptable" risks are.
Last Week's Market Action
The first trading day of the new year immediately tested the nerves of investors. The intraday drop on the S&P was a whopping 54 points. Some semblance of order (if you can call it that) was restored and the S&P finished the day down 31 points.
The narrative blaming China was the story of the day. But there may have been other fuel added to this fire. S&P 500 futures didn't plunge below 2,000 until after the European cash open at 3:00 AM. In other words, I think there was more to Monday's market selloff than just "China fears".
I was leaning to the same day incident between Saudi Arabia and Iran. I think this has far more potential impact for the world than the 0.4 decline (48.2 from 48.6) in China's PMI. My initial thought that the Saudi geopolitical event was also a culprit on Monday was confirmed the next day. The "other" geopolitical event this week regarding North Korea hit the wire and was met with the same knee jerk "sell" reaction.
I will add that the Fed's Loretta Mester commentary in the morning, expressing that she prefers a bit quicker interest rate hike, didn't help the nervousness of investors either.
With the fear that is present, market participants immediately extrapolated the situation in China to a U.S. recession.
It seemed that traders and investors then decided that the Chinese stock market was THE leading indicator to watch to confirm their views. All eyes riveted on the Chinese indexes. I saw this "movie" last August, and as I wrote back then, it is the height of absurdity for one to be fixated on the Chinese stock market.
In my view, the actions of the Chinese regulators added to the "panic".
Their imposed "circuit breakers" didn't work. The Shanghai Composite Index hit its second circuit breaker in the first half hour of trading, ending the session. The trading halt after only 30 minutes of trading did not get the desired result, it just added more pressure to those wanting to raise cash.
Restricting one's ability to sell doesn't necessarily remove that entity's or individual's obligations to raise cash, especially if one is levered up. So what happens if one has to raise cash? They end up selling what they can, not necessarily what they want to, and thus, you get the contagion effect sending ripples across the globe. In other words, it is just "sell", "get me out".
First in Europe, then the U.S., and investors and traders tend to seize up. They sit and wait until the dust settles because of the risk of stepping in front of a forced liquidation that causes markets to move to the downside beyond what "fundamentals" might suggest is a reasonable level.
The final comment here is that China has abandoned its circuit breakers, and that seemed to calm their market.
Whatever reason one chooses to believe, the S&P fell by 1.5% on the first trading day of the year and it was only the 14th time this ever happened. The negativity ramped up, the skeptics started saying, "I told you so", and it now seems fashionable to write off the entire year after just one week.
I will take more of a sensible systematic approach and say I am not so sure we need to jump to that conclusion just yet. Ryan Detrick provides information relative to the first trading day of the year. What is notable about the chart below is the rest of the year has seen some big moves. Many moves of 20% or 30% (up or down) are mixed in there.
Source: Ryan Detrick
He follows up with statistics on the Dow, which also indicates large percentage moves.
Source: Ryan Detrick
Now before the critics jump on the data presented in the charts, understand that I am not calling for similar percentage gains. The point is that one week does not necessarily make a year.
For sure, the stock market is now caught in a "Negative Feedback Loop". Every story is spun negatively. Bad news is bad and embellished. Good news is bad as it is dismissed entirely.
Scott Grannis also takes a sensible approach with his thoughts on what investors need to keep in mind during the market turmoil.
Let's move on and take a calm systematic approach to the markets. Panic and fear accomplish nothing, and often lead to rash decisions. I witnessed that action all week.
2016 - Presidential Election year
If you are a follower of the Presidential Election Cycle, you have surely been disappointed by the performance of the S&P 500 in 2015. That's because the Presidential Election Cycle says that the 3rd year is the strongest in the cycle. Not so in 2015.
With the caveat that 2015 didn't follow the presidential election script, I will note that the 4th year is the second strongest of the 4 presidential cycle years. However, the first few months often start with political uncertainty until the primaries narrow the field. The market hates uncertainty, making the timing of an election year rally dependent on when the winner is well known, regardless of party. This could also be adding to investors' nervousness. Post WWII, the S&P has climbed an average of 6.6% during election years.
High Yield Debt Issue
Last year saw high yield debt markets have one of its worst years on record. The S&P was down fractionally, and since both asset classes have been closely correlated, it makes the last years' performance divergence even more notable.
As much as the decline in high yield debt in 2015 has been notable, it doesn't really tell us anything other than the fact that high yield had a bad year. Yet, the assumption is that this situation won't improve.
The chart below shows the annual returns of high yield debt and the S&P 500 since 1987. In both charts, the red bars indicate returns following a down year for high yield. As shown in the charts, following prior down years for high yield, the asset class has seen a major bounce back in the following year with positive returns every time.
In addition, the four best years for high yield since 1987 all followed down years. Equities have also seen nice returns following a down year for high yield. Following the five prior years where high yield declined, the S&P 500 was up an average of 22.3% in the next year with positive returns four times. I am not suggesting that type of gain for equities in 2016 , but if prior history is any guide, there is a distinct possibility for high yield and the stock market to see a nice bounce back this year.
Source: Bespoke (High yield annual returns as measured by BofA Merrill High Yield Master II Index)
For those who haven't seen it, here is a view from Scott Grannis on what may develop in 2016 for the economy and the markets.
December PMI manufacturing here in the U.S. came in at a weak 48.2%.
This past week's ISM report for the month of December came in weaker than expected, falling from 48.6 down to 48.2 compared to consensus expectations for an increase to 49.0. December's decline marks the sixth straight month of declines, which is tied for the longest losing streak since November 2004.
ISM Services fell to 55.3 from 55.9 the month before.
The Institute of Supply Management reports:
"The U.S. economy's service sector expanded in December, but at its slowest pace in 20 months, according to an industry report released on Wednesday. A reading above 50 indicates expansion in the service sector and a reading below 50 indicates contraction. The business activity index rose to 58.7 from 58.2 the month before. That was just above expectations of 58.4"
Some critical internals were positive, with export orders, new orders, employment, and business activity all accelerating.
The trend towards stronger services versus manufacturing continues, although it has moderated somewhat over the last few months. I don't read anything into this reading other than to note that it confirms the story that nominal manufacturing output is telling us. There's broad pressure on the manufacturing and industrial sector while the services sector continues to hold up in terms of output, outlook, and employment hiring.
The negative feedback loop continued with solid jobs numbers reported on Friday. It was met with a muted market response. The commentary about the report went something like this:
"The participation rate is no good, the jobs were primarily "part time" and it's not generating GDP growth."
Therefore, the report is deemed meaningless.
I always shake my head wondering how more people being employed is a bad thing.
China took center stage on the economic front this past week. However, all that matters to investors is their Manufacturing PMI data which many believe caused the global equity selloff this past Monday.
The Caixin Media and Markit Economics survey of services-purchasing managers fell to a 17-month low of 50.2 in December, down from 51.2 a month earlier, according to the report released Wednesday.
"This was the second-lowest figure for the sector since record keeping began in November 2005. The decline likely raised investors' concerns that the slowdown in Chinese manufacturing is spilling over to the services side of their economy."
While that conclusion is what investors are concerned about, let's not dismiss the recent third-quarter GDP out of China. That report reflected 6.9% growth, but the consumer portion was a stronger 8.4%. For the first time, the Chinese consumer now accounts for more than half of its economy. This suggests that perhaps China's transition from a manufacturing to a consumer base is working.
It appears that somebody is doing some buying in China, as Ford's (NYSE:F) car sales there jumped 27% in December. I'm not of the opinion that these types of results imply that China is about to take the world into a global recession.
Eurozone manufacturing finished 2015 on an upbeat note.
Markit Economics reports:
"A Purchasing Managers Index for the industry rose to 53.2 from 52.8 in November, exceeding a December 16 estimate for an increase to 53.1. For the first time since April 2014, manufacturing expanded in all nations covered including Greece."
German Industrial Output fell in November as production was down 0.3% in November vs. estimate for a 0.5% increase.
Christian Lips, an economist at NordLB in Hanover, said:
"Economic momentum in Germany continues to be fed by private and public consumption, and additionally by a pickup in construction. China's economy moved into the focus again this week, but for Germany, we are convinced that the economic recovery will continue".
For those calling for a global recession, Bespoke Investment Group assembled the recent PMI data from around the world. The accompanying notes are from Markit Economics.
Generally speaking, there were improvements in a few surprising places, including the emerging markets. Europe seems to be performing very well, while the UK and the US lag and slow dramatically. China is also lackluster, but Japanese activity is quite robust.
At this point in time, I do not see a global recession in the offing.
All we hear is how China's economic numbers can't be trusted. The gripe is that their numbers are all inflated. Of course, we all know the bad numbers can be trusted but the good numbers can't. (Sarcasm intended)
Here in the U.S., the Commerce Department just may have underestimated GDP by miscalculating construction spending. I now assume the skeptics will disregard this revision since it is a positive.
EARNINGS & VALUATION
Thomson Reuters reports:
496 of the S&P 500 companies have reported Q3 '15.
The forward 4-quarter estimate as of December 24, 2015 was $122.51 versus last week's $122.99.
The P/E ratio on this week's forward estimate was 17(x).
The S&P 500 earnings yield this week was 5.93%, versus last week's 6.13%.
The "Forward 4-quarter S&P 500 estimate" growth rate turned positive for the first time since April 2015, and that is a positive as we look ahead to 2016.
Last week I put together a case indicating that the present interest rate and inflation environment suggests that the S&P trading at a P/E of 17 or 18 may not be excessive as everyone is crying about.
"In short, I can't blindly say the "average" P/E is where the market should be trading at because we are nowhere near the "average" regarding interest rates."
Another way to value the stock market that just about everyone says is overvalued is to look at the Tobin Q ratio. The Tobin Q ratio was originally formulated by Yale University professor James Tobin. James Tobin is a Nobel laureate in economics. The theory behind the ratio is the combined market value of companies on the stock market should be equal to the replacement cost of company assets. The Q ratio is defined as the ratio of the market value of a firm to the replacement cost of its assets. When the stock market trades at a 'discount' to the replacement cost of its assets, the market is inexpensive. This discount is when the ratio is below 1.0.
When the ratio is above 1.0, the market trades at a premium to its replacement cost.
As of the third quarter, the Tobin's Q ratio declined below 1.0.
As the below chart shows, this reading below 1.0 is the first since the Q ratio equaled .986 at the end of Q2 2013.
According to Money Terms:
"A Tobin's Q of less than one suggests that the market value of the assets is less than replacement cost, making acquisitions cheaper than capex; buying cheaper than setting up from scratch. This should increase share prices and reduce asset prices, again pushing Q towards one."
Perhaps that explains the record M&A activity that we witnessed in 2015. Of course, with that comes yet another warning from the skeptics that the magnitude of record M&A activity recently was last seen in 2007. Yet another 2007 comparison.
I'm not suggesting that we blindly follow this valuation model, but I was curious when I saw it due to the fact that the ratio showed equities were "overvalued " during this bull run until now.
Crude oil continues to fall, closing at new lows. However, when we look at history, we do not have good evidence of a decline in oil prices leading to a U.S. recession. In fact, it's just the opposite: rising oil prices very frequently cause recessions.
As I watched the crude oil trade play out this past week, it is an example of the "negative feedback loop" that I mentioned earlier.
This past week we saw crude oil stockpiles falling considerably more than expected, increased tensions in the Middle-East and now North Korea claiming they successfully detonated a hydrogen bomb, one would think this is a dream backdrop for crude oil prices to rise.
If you haven't noticed, the reality is the complete opposite. Crude oil prices gave up the $34 level and traded down to their lowest level since February 2009 and are now right at the credit crisis low of $32.40 in December 2008.
THE TECHNICAL PICTURE
Here we go again, support level after support fell by the wayside this past week. Many are now saying a retest of the August, September lows is a certainty.
I added another "oversold" symbol to the chart this week. The indicators that I use show the S&P at a level that matches the August lows.
Short-term support is at the 1,901 and 1,869 pivots, with resistance at the 1,929 and 1,956 pivots.
For those that are filled with anxiety and looking for some sort of market support, its notable that when markets are under pressure, they never bottom on a Friday. I expect to see a follow through early Monday morning, then a semblance of stabilization. At the moment, the bears are in control and the bulls sit on the sidelines and watch.
SUMMARY AND CONCLUSION
The "bears" look at a long-term chart of the S&P and see a "broadening top". The "bulls" look at the same chart and see a year long consolidation in 2015 following a 41% rally in the prior two years.
That leaves many market participants in a quandary, asking themselves is the market about to rollover or was 2015 more of consolidation year for equities?
I posted my thoughts on that topic last week based on the information at hand. For the moment, I will "stay the course".
The reason is simple. Those that told us to change strategy and hide under the covers hugging your pillow full of cash since the last panic attack the market witnessed in August have been wrong, and here is why.
As an "investor", there is nothing wrong with staying the course to at least see if the August lows hold. Yet, that seems to be constantly questioned and proclaimed foolish by the pundits that remain steadfast in their thoughts the bull market is over.
The market participants that sold out and shorted at the lows last year based on the thought of the next "major downdraft" predictions have a dilemma that the bulls don't have. Their decision has been made.
They are out of options IF the August lows hold and the dire predictions don't come to pass.
For those investors who stayed the course, they still have an opportunity based on their personal investing profile to make a decision and change course IF and when those 'lows" are breached.
As an investor, you ALWAYS want to give yourself options. There is another reason I have not raised a mountain of cash. I don't possess the "God like" ability that the skeptics seem to have. They seemingly know for SURE that the S&P, after trading higher for 4 months, will now breach the August lows.
So I am left with the tools and indicators that, in my view, will tell investors when to get cautious and outright bearish.
Those that have stayed the course aren't any worse off and have an option or two left. Even after the precipitous drop that we just witnessed this past week, the S&P sits at 1,921. The midpoint after the lows were made in August sat right at these same levels. Exactly what has an "investor" lost by looking at the market in a calm sensible fashion and watching how things are playing out?
In the world of investing, having options at your disposal versus having none is the difference between night and day.
As we have seen from many pundits nowadays, there is the other side of the story as JPMorgan now says it is the time to sell the rallies. That is a very popular strategy at the moment.
I commented last week when I called for new highs on the S&P this year that investors would face a critical juncture with the markets in 2016.
"For me, 2016 presents issues that get right to the heart of whether this secular bull market continues without pause, or the market experiences a setback and drops into a cyclical bear market."
With the "negative feedback loop" firmly in place and the market sitting just above the August lows, making a decision on how to proceed in the short term gets very tricky.
Selecting that next low and deciding it's time to "step in" or realizing that we are indeed going to fall further and enter a bear market will be the biggest quandary for investors in 2016.
Stay tuned, the story gets even more interesting in the days and weeks ahead...
Best of Luck to all!
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.