How Low Can This Market Go In 2016?

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Includes: COF, DIA, IWM, JNK, SPY
by: Mark Bern, CFA

Summary

Where are we in the market cycle now?

Which cracks in our economic foundation do we see and which are still at the hairline fracture stage?

How I expect the market to react to the growing weaknesses in the U.S. and global economies.

Conclusion and what steps I am taking to prepare.

I wrote an earlier piece about this same subject on August 24 (publish on seekingalpha.com on August 25), 2015, the day of the flash crash. You may want to refer back to that original article for more breadth on the subject by clicking on the link below.

How Low Can This Market Go? August 25, 2015

I'd like to begin this article the same way with this quote,

"It often begins with denial, which only makes things worse in the end. By denial I am not trying to blame our government, the Federal Reserve (well, maybe a little because it should have seen this coming and probably did), the financial institutions (well, maybe a little for all the little things that add up to big things which I will explain in a moment), or the financial talking heads (how can I blame the child-like innocence of the misinformed)."

In that article I explained the cracks that had formed in the miracle that is the Chinese economy. I will not go into that in detail here, but I hope those cracks are now more apparent as I predicted they would become.

Next, I wrote about the crack in the U.S. economy called junk bonds. I actually recommended a hedge strategy in this article using the SPDR Barclay's High Yield Bond ETF (NYSEARCA:JNK) predicting that the junk bond market has a lot further to fall; and it still does. Hold onto those gains and them increase if you own the recommended positions. This lead to problems of U.S. dollar-denominated debt issued by companies in emerging markets as another crack that would be exposed.

Finally, the third crack I mentioned was the increased issuance and rising default rates in subprime car loans. I also wrote an article very recently on how to use Capital One Financial (NYSE:COF) to hedge against the next credit crisis which I believe is coming soon. For more detail on why please refer to the link. If you hold those positions we have gains over 65 percent in just one week with much more to come.

Where are we in the market cycle now?

Today I want to focus more on the bigger picture to start before drilling down into the cracks of the foundation. I generally take a longer view of the economy rather than trying to discern what is going on from week to week. It is my opinion that short-term manifestations tend to get people more tangled up in the barely relevant weeds that do not have lasting effects on the economy. Looking at the trends over time can be much more illuminating in understanding what to expect in the future. If you want to know what is going to happen next week, well I am no better at short-term fortune telling that the lady in the turban down the street. My focus is what is more likely to unfold over the coming months and years and how to use those expectations to my investing advantage.

Many of the "reliable" indicators of the past have been undermined somewhat (and in some cases, entirely) by interventions by central banks here and around the world. Never in history have we experienced so much ostensible coordinated cooperation by central banks to keep the global economy from collapsing. I am sure everyone is aware of the multiple quantitative easing [QE] programs in the U.S., Europe and Japan. Central banks [CB] around the globe have lowered short-term interest rates artificially and held those rates low for years. CBs have also been taking additional actions in attempts to drive their local currency lower against other currencies in an effort to make exports cheaper and promote local growth. By any other name this would be called a trade war. (But we cannot use that term because that would be politically incorrect. So, let me go on record as saying that this is not a trade war!) Sovereign debt is being issued at negative interest rates for the first time in history to my knowledge. And yet there is not inflation to be found in developed economies. What does that tell us?

CBs and governments around the world are pulling out all the stops to fight deflation. Deflation is the ugliest word in the economist dictionary. But it is a natural occurrence and cannot be stopped completely. It cannot be contained completely. It can only be postponed temporarily.

There are two components to the economic puzzle that have brought us to the edge of the deflationary vortex: supply and demand. We are awash in commodities such as oil, natural gas, copper and iron ore because the companies that produce these normally valuable industrial inputs expanded production beyond the world economy's capacity to consume it all. Mining companies opened new mines, oil and natural gas producers brought online new production from both traditional sources and shale deposits using radically improved technologies; all in an attempt to feed the growing miracle of China and the voracious appetite of the U.S. consumer economy.

Then the rate of growth began to slow in the U.S. and later in China. The Great Recession was a difficult blow to the global economy but, alas, what could have become another depression was avoided. Or was it? I want to ask a big question: how well has the world dealt with its debt problems since 2008-09? What does McKinsey have to say about that issue?

Source: beforeitsnews.com

Looking at the above chart above on the right, we see that from 2007 through mid-year 2014, global debt had increase by $57 trillion (in U.S. dollars), from $142 trillion to $199 trillion (yes that is trillion with a "T"). Global debt has increased faster than global GDP. This is not a good sign for future growth. By now the picture is far worse. Oil and gas E&P companies were still borrowing heavily throughout 2014 to expand production and have been borrowing more to stay alive in 2015. The European Central Bank [ECB] continues to vacuum up debt issued by its member countries at a steady rate that may need to increase in the near future. The U.S. government has not slowed down its spending, adding to the deficit like clockwork. Car sales are supported by a rising number of loans to lower quality borrowers and student loans are now the second largest category within consumer debt, next to mortgages at $1.3 trillion and climbing. The rate of growth in debt may have slowed over the last year and a half, but I suspect that it is still outpacing GDP growth as that metric has slowed, too.

But, as you can see from the chart above on the left, the U.S. is not nearly the only economy with a debt problem; China, aside from Japan, is in the worst shape of major world economies. Chinese financial institutions hold more debt than their U.S. counterparts and corporations in China have far more debt than U.S. corporations.

^DJT Chart

^DJT data by YCharts

The Dow Jones Transportation Index (^DJT) has been a trusted indicator of how the U.S. economy is doing. The above chart does not give me a lot of hope.

Source: Nasdaq.com

The price of copper is generally considered a good barometer of economic health. Granted, overcapacity issues are plaguing the mining sector but the continuance of this trend is not encouraging.

The next indicator has more predictive value regarding the business cycle. Corporate profits/GDP rise and fall, generally peaking prior to periods of U.S. recession and bottoming near the end or after a recession is over. Take a look at this chart from the St. Louis Fed.

Click to enlarge

While growing profits are generally a good thing, when a peak is formed a recession usually follows. Since 1950 this ratio has not been this high, ever, as it was in Quarter one of 2012.

Now take a look at the indicator that Warren Buffett likes to use to foretell a recession is coming.

Click to enlarge

Look what happened the last two times the total market capitalization of U.S. equities rose this high above total U.S. GDP in March 2000 and September 2007. Notice that the bottom in market cap for each of the previous two periods was nearly the same at the bottom of the trough.

We are definitely near the top of the cycle, in my opinion, and no amount of intervention will be able to change the inevitable correction on the horizon. I believe that CBs have done everything possible already to forestall the next recession. The question is not if but when and how bad?

To answer the question of where we are I would have to say we are right about where we were at the beginning of 2008 or early 2000, for perspective. I could be wrong and we may be earlier in the process which would be good because it would give us all more time to prepare. As I mentioned at the beginning of this article I am better at predicting long-term outcomes than what will happen next week. But the trends are in place and it appears to me that we are not about to change course.

Which cracks in our economic foundation do we see and which are still at the hairline stage?

Since I have already detailed the cracks in the previous articles linked at the beginning of this one, I will try to be brief. Cracks that should be obvious by now:

  1. The crack that China represents is beginning to unravel before our eyes and is nowhere near as bad now as it could potentially get.
  2. The crack that is high yield corporate debt is just beginning to spread but will probably accelerate over the next few months.

The cracks that have yet to be exposed:

  1. The crack that exists in USD-denominated debt issued by companies domiciled in emerging markets has yet to be noticed by most but it is there and will spread like a contagion as a result of both rising yields being required by investors and by continued weakness in China. China is the primary trading partner of many emerging economies and its slowdown is causing pain there. And all the while the natural resources that many of these countries rely upon continue to lose value due to shrinking growth in demand. Bankruptcies here and abroad will be necessary to purge the excess debt in the system.
  2. The crack that is subprime auto loans will be affected negatively by the rising cost of debt for issuers and by a rising default rate. When this crack becomes apparent and begins to spread it will spell doom for the auto industry. If it is not a precursor to recession it will definitely be a consequence as layoffs will lead to fewer auto sales and more defaults.
  3. The crack that is student loans is going to be with us for some time and act as a drag on economic growth over time (think of a ball and chain attached to the ankle of a sprinter - it does not work). Unless a solution can be found to lower the cost of higher education and solve this problem for those already shackled, many in the millennial generation will be held back from consuming at the levels of the baby boomers that are being replaced in the workforce. As the boomers retire and spend less our economy will need new consumers.

There are other cracks forming and more will form as the economy slows further. When layoffs begin in earnest, housing sales will falter and construction jobs will be lost…again. The travel industry will suffer as businesses cut or cancel business travel in favor of video conferences to hold down costs. Vacations will include less travel, more by car and less by plane, as people fear jobs losses could come knocking. People will eat out less, especially in the medium and casual dining venues. Some will even forego a Starbucks or two each week to save money, just in case. The list could go on, but I suspect you get the picture. The oil glut will just get worse and commodity prices will continue to fall as demand begins to contract.

How the market will react to the growing weaknesses in the U.S. and global economies

In my earlier article I stated that there would be two factors to watch to determine how things will unfold.

"There are really two primary keys to watch to discern how much more damage the global economy and, by extension, equity market are likely to sustain. The timing of the events will be hard to determine until we see them unfold, of course. But we should be able to determine the direction of the trend from day to day and week to week based upon the severity of these two factors: the Shanghai Index and the WTI crude oil price."

I want to add another indicator to this list: high yield bonds, or the ETF symbol JNK as a proxy. China's Shanghai Index began to tumble again last week and the WTI crude oil price reached new 11-year lows. Those two factors are leading the way lower. JNK has been trending downward for more than a year but it has not yet broken down completely. When it does I believe we will see equities fall off rapidly and the economy will sink in to recession. The recession will have already started by that time but it will not be reported until months later. Waiting for the official recession designation could mean losing in a big way. If you look again at the 2-year chart for JNK shown earlier in this article you will see that the price for the ETF dropped from about $36.50 in late October 2015 to near the current level of $33.48 by mid-December 2015. That represents a fall of only about 5.5 percent. Considering that the average duration of bonds held by the fund is only about six years that is a significant move. The next leg down should be just as bad and if it occurs over a similar or shorter time period I believe it could represent the last straw on the economic camel's back.

2016 down The slowing of global growth will continue into 2016 and it is only a matter of time when the demand side of the equation begins to fall into contraction. Several sectors are already in contraction: mining and commodities, energy, transportation, and manufacturing have all shown year-over-year contraction for multiple quarters. It will not take much more to push this soft global economy over the proverbial cliff.

Where is the bottom? When will it come? The answers to those questions are guesses by whoever may try to respond. Let me say that it is possible that a bottom could be reached in 2016 but it may be equally possible that the bottom is not reached until sometime in 2017. As to how far equities could fall I would not be surprised to see the indices fall to near the levels reached in each of the last two recessions/crashes. That may sound a little harsh (okay, maybe a lot) and it may not come all at once. If CBs and governments try to soften the blow it is likely that we could get another rally off what would appear to be a bottom that could last for more than a year. Then the final leg down could take us all by surprise. If the excess debt is not purged from the balance sheets of weak corporations through the bankruptcy process it will continue to drag down future growth prospect until the sheer weight of it all breaks down the financial system once again. Is it not ironic that by trying to support a failing system governments just make things worse. Of course, that does seem to be what governments do.

The longer the economy keeps from a natural cleansing the higher I believe will be the piper's bill.

Conclusion and what steps I am taking to prepare

Over the long term everything will be fine…eventually. But over the short and intermediate terms we are facing a very rough patch of road ahead that will contain more than just a few potholes. There will be bridges out and detours and traffic jams. There will be setbacks for those who are not properly prepared.

I have written extensively about my own inexpensive hedging strategy but it is becoming more expensive to hedge at this stage with elevated volatility. It will probably cost more to hedge from this point forward. However, if there is another rally in equities before the bottom falls out (and there should be) I will take advantage of adding more hedge positions for further protection. I may even sell a few positions to raise more cash.

I invest with a very long term horizon. Even at my age of 66 I tend to look for investments that will provide reliable rising income streams over the next 20 years or more.

I do not reach for yield. That would require taking on more risk, something that many investors are becoming painfully aware of as they scramble to exit high-yield bond positions. Others will take their place thinking that they have locked in an excellent yield and income stream only to find out later that, as the issuer files for bankruptcy, the investor may receive only pennies on the dollar of invested capital. It is the age old theory of the greater fool. Then again, some will get lucky and find those few high yield bonds issued by companies that find a way to survive. I prefer not to gamble.

I will continue to hold quality companies that I have researched as thoroughly as I can and that I expect to maintain enough distributable cash flow to increase dividends every year for as far out as I can see. I own those companies because I know that the share price will always come back when the economy improves and because I want the rising income. I should point out that I buy only when the majority of investors are selling, usually during recessions.

I hold about 40 percent of my portfolio in cash at the moment and have more than enough cash on hand to cover expenses for the next year outside of my investing accounts. It is important to take heed of what could happen if the financial system locks up. ATM machines and banks may limit how much cash we can withdraw. Credit card issuers may decide that if you have more than one card you are now to high a credit risk and cancel your card(s). You or someone in your household could lose a job or some other form of income that you depend upon. Having a cushion of at least six months of cash to live on is prudent during normal times to be able to withstand the unforeseeable events that somehow always find their ways into our lives. At times like I believe we are about to enter, it may be more judicious to have more like nine months of cash readily available.

I smell great opportunities coming for those who have cash available to invest. We are not there yet in my opinion, but patience will reward those who wait. I have been accumulating cash for more than two years now and I am confident that the reward of that patience will be paid via higher future yields on bargains that I buy when blood is running in the streets, even my own. Somebody famous said something like that long ago. Sage advice.

This is not a time to be fearful. It is time for sage investors to be prepared.

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.

Additional disclosure: I hold put options on JNK and COF.