James A. Kostohryz Positions For 2016: An Upside Surprise For The Year?

by: James A. Kostohryz


Despite claims to the contrary, it's unlikely that in 2016 the US economy will experience a contraction of economic activity that characterizes a full-fledged recession.

Concurrent and leading indicators of US domestic demand are suggesting continued and even improving strength.

The transition the Chinese economy is undergoing is providing and will continue to provide a net boost to the US economy.

The oil market is being driven by a new paradigm that the world is just barely beginning to understand.

As for markets themselves, more downside from current levels is likely. However, the S&P 500 is likely to recover and make new highs within the next year or two.

Stocks continue to get pummeled as investors move into the New Year. As of Jan. 15, the US markets fell to their lowest level since October 2014. Oil fell below $30 a barrel, a price not seen since 2003. And China continues to weigh on the minds of Wall Street observers.

While pessimism abounds, one Seeking Alpha contributor sees light at the end of the tunnel. James A. Kostohryz has been covering the markets at Seeking Alpha since 2009. There may be some short-term pain ahead for investors, but as the year progresses there could be surprises. He recently shared his thoughts on the direction of the markets with Editor Michael Hopkins.

Michael Hopkins: What is your forecast for the US economy in 2016? Many prominent voices are saying the US is headed for a recession, and this view seems to be gathering momentum in recent weeks. Do you agree?

James A. Kostohryz: No. While I think it is possible that the US economy could experience a "growth scare" such as the one experienced in 2011, I believe that it is quite unlikely that in 2016 the US economy will experience the sort of severe and prolonged contraction of economic activity that characterizes a full- fledged recession. Indeed, relative to general expectations that have been drastically lowered in recent weeks, I think the US economy in 2016 is more likely to provide an upside surprise than it is to enter into a recession. In the current context of lowered expectations, I would define an upside surprise as GDP growth of 2.0% or higher. I will lay out my reasoning for my relative optimism in considerable detail in my 2016 Economic Outlook to be published in the next couple of weeks here, but one of the most important reasons has to do with the improving health of the US consumer. First, US consumers on average have significantly deleveraged to the point where their debt and debt service payments are lower than at any time since the early 1980s. Second, the best leading indicators of US domestic demand are looking quite good. For example, household formation has been very strong. To complement this, total employment is growing strongly, hours worked per week are rising, wages are finally starting to pick up and inflation is very low. Rising personal income in the context of strong household formation and pent-up demand portends extremely well for US domestic consumption. And don't forget that the US economy is primarily driven by domestic consumption!

Critics often point out that some of the labor market-related measures I just cited are "lagging" indicators. However, this sort of critique is based on highly superficial analysis; these indicators are "lagging" at the very end of a business cycle. But this begs the question. The question is: Are we at the end of this business cycle? The reality is that the particular indicators I just cited above are still early in their respective sub-cycles. The US has almost never entered into a recession when these particular indicators have been at this early stage in their respective sub-cycles. Indeed, these indicators suggest that the overall US business cycle has at least two more years of growth ahead of it before entering a recession, and probably significantly more. There are a number of other reasons why it is unlikely that the US will enter recession in 2016, but I highlight these factors both because of their critical importance and because of the myriad misconceptions that are typically parroted by financial and economic media pundits in regard to these labor market-related indicators.

MH: Some pundits have been loudly sounding the recession alarm bells based on the theory that the US has entered into an "industrial recession" and that that such conditions in the past have acted as leading indicators of economic recessions. Are you worried about this?

JAK: A slow-down or contraction in manufacturing growth clearly represents a headwind for the US economy; all things being equal, it represents a recession risk factor. However, not all things are equal. The first thing people need to understand is that the US economy is not primarily driven by the sort of old-line manufacturing industries that disproportionately drive the indicators (e.g. PMIs) that the bearish pundits are worrying about. First of all, the US economy is not primarily driven by manufacturing at all, much less old-line manufacturing. The entire manufacturing sector today only represents 12% of US GDP. So, just as an example, if US manufacturing output fell by a dramatic 8% (unlikely), this would still only represent a hit of less than 1% to US GDP growth. Second, many of the indicators that pundits tend to look at such as the PMIs are dominated by old-line manufacturing industries that represent a progressively smaller percentage of that shrinking (12%) share of GDP that I just referred to. Third, for reasons directly related to the prior two points, my own detailed study of manufacturing activity indicators such as the ISM Manufacturing Index shows that these indicators have given very large number of false signals despite a small sample size and, most importantly, that they have become increasingly unreliable over time. Finally, my own detailed study of the matter reveals that these indicators have only been truly relevant in the past to the extent that they were indicative of weakening US domestic demand. But, as I mentioned earlier, this is not what is going on at the present time. The weakening of the manufacturing indicators is almost entirely being driven by factors related to external demand such as the dramatic strengthening of the US dollar (that has made US exports less competitive) and slowing global growth. By contrast, concurrent and leading indicators of US domestic demand are suggesting continued and even improving strength, as I alluded to earlier.

MH: What about China? Many people are worried that the problems in the economy there could eventually have major repercussions for the US economy.

JAK: I'm going to publish a detailed report in a few days here that goes completely against the consensus on this issue. I will summarize some of the points here briefly. First of all, the direct impact of China's economy on US GDP is minor, to the point of virtual insignificance. For example, a dramatic decline of US exports to China of -10% (which is unlikely) would impact US GDP by less than 0.01%. It's simply not relevant. Second, the slowdown in the Chinese economy is primarily impacting Chinese demand for stuff that the US doesn't export, such as oil, copper and iron ore. By contrast, the areas of the Chinese economy that are actually growing quite strongly, and which the Chinese policy makers want to reorient their economy towards, are areas where the US has comparative advantages - industries directed at the domestic consumer. Third, the Chinese economy is merely slowing down; it's not contracting overall. Thus, there is little reason to fear a "crash" in Chinese demand - much less in the areas of demand that are most relevant to the US economy. Fourth, the indirect effects of slowing Chinese growth on the US economy are minimal. Yes, the Chinese economy is the second-largest economy in the world. But China's net contribution to global demand is far smaller than the size of its economy and particularly its imports would suggest, since much of what is imported into China is part of an export value chain that manufactures products that are ultimately not consumed in China. Fifth, to the extent that slowing Chinese demand for oil and other commodities is contributing to the ongoing decline in commodity prices, this is providing a net benefit to the US economy since the US is a net commodity importer. Sixth, the financial linkages between China and the global financial system - and the US financial system in particular - are negligible. US banks and investors have negligible exposure to China. In sum, while the subject of China's impact on the world deserves careful attention and more detailed analysis than is possible to provide in this interview, my thesis is that for the reasons above and others, the impact of recent Chinese economic and financial developments on the US economy has been greatly exaggerated. Not only that, I will go one step further: I believe that the transition that the Chinese economy is currently undergoing is currently providing and will continue to provide a net boost to the US economy. In this regard, my view is completely contrary to consensus.

MH: What about the surging U.S. dollar? Will that continue? And what does that mean for investors?

JAK: My followers know that I have correctly been a dollar bull for several years now. I think there is still some upside risk in the next year or so, because, as I mentioned, I think the US economic recovery still has plenty of room to run and that some upside surprises may be forthcoming. However, from a longer-term perspective, the US dollar has become severely overvalued relative to most major global currencies and some emerging market currencies. Furthermore, the ratio of US GDP growth relative to growth in most of the rest of the world is likely to fall somewhat going forward. All of this means that reward to risk ratios are shifting away from the USD and towards exposure to other currencies. In sum, while the strategic situation is changing, I have tactically not yet pulled the trigger on the USD. A combination of events and technical analysis will determine my tactical decision.

MH: What is your view of US stocks? In 2015, you correctly called for a high likelihood of a 10%-plus correction due to a series of fundamental factors and timed the onset of the decline extremely well with the aid of technical analysis. What do you think will be the performance of equities in 2016?

JK: Equities are a very tough call in 2016 - more so than usual and I will provide significant detail regarding my thinking in my 2016 Stock Market Outlook that I will publish here in the next two weeks. Overall, I think some more downside from current levels is likely. However, I also think the S&P 500 is likely to recover to make new highs within the next year or two. Right now, I am working with a target for the S&P 500 of around 1820. This is the level at which I expect to give serious consideration to increasing equity exposure. However, this is just a provisional target as both fundamental events and technical factors will be key in my ultimate decisions.

Central to my thinking about the performance of equities in the next 12 months is that the US is unlikely to experience recession in 2016 or 2017. This is important because bear markets are relatively rare outside of recessions, and the ones that have occurred have almost always been relatively mild and short-lived. In this regard, 1820 on the S&P 500 would represent roughly a 15% correction from the highs - a level that presents a good reward risk-level if you think the market is likely to revisit the old highs within the next couple of years and if you also think a recession is unlikely during this time-frame. This is because history suggests that outside of a recession, a 20%-plus decline is unlikely to occur and is in any case unlikely to be sustained for long. This suggests a probability weighted downside of less than 5% on a 12-month basis from the targeted level vs. potential upside to new highs that is probably in the order of 20%-plus over a 1-2 year period. In addition to these strategic considerations, 1820 is also an area that is also well supported by technical analysis.

Having said all of the above, 1820 is not a "slam-dunk" technically or fundamentally. Technically, I would characterize that level as significant, but not extremely strong. Fundamentally, I have a number of concerns. The first relates to the business cycle. There is little risk of recession in 2016 and 2017, but the fact is that the US is entering the "late" stage of the business cycle. For purposes of this discussion I shall define the "late" stage of the business cycle as the period immediately after full employment is reached (full employment was reached in November in accordance with the CBO's methodology). Historically this has not been a great time to invest in equities. Returns in the 12 months following the achievement of full employment have been sub-par, and drawdowns have been significantly greater than average. Second, and related to the first, the late stage of the business cycle has typically been a time of significant PE contraction. This is consistent with economic theory on a number of counts and is, in fact, an observed empirical regularity. This factor is especially worrying at the present time given that PE ratios are currently significantly higher than average for this stage of the economic cycle - it implies that there is even more reason than usual at this point in the business cycle to be concerned that there is more downside than upside for PE ratios. Finally, an S&P 500 index price of 1820 would only offer values roughly in the middle of the "normal" range of the most relevant valuation metrics. The problem is that valuations usually do not go from expensive to merely normal; they typically swing from expensive to cheap.

Given all of the above risks, 1820 cannot be safely considered a downside "floor." Therefore, the decision on whether to increase equity exposure if and when the S&P 500 index reaches 1820 will not be automatic. It is a "tactical" decision that will largely be determined by the technical behavior of the market, sentiment indicators plus certain event triggers that I am looking for.

Among the "event triggers" I am looking closely at is the potential capitulation of energy stocks. I feel that it is likely that the bottom in the overall stock market will not be reached until there is significantly more capitulation in oil stocks than what has been seen thus far. Oil stocks are currently pricing in scenarios that are quite rosy relative to the futures price deck would imply. This is not the stuff that bottoms are made of. Bottoms tend to be made when stock prices are pricing in unreasonably pessimistic scenarios. Currently oil tock prices reflect a great deal of complacency and "faith" in a significant long-term recovery in oil prices, not the sort of pessimism characteristic of a bottom.

MH: Some suggest that stock valuations have been driven to unsustainable levels. Do you agree?

JAK: My answer is that sustainability is not the best framework for thinking about valuation. All valuation levels are "unsustainable," in the sense that they are never sustained for very long. "Average" valuations are not sustained for very long, high valuations are not sustained for very long and low valuations are not sustained for very long. So, the issue is really not "sustainability." The issue needs to be framed in terms of probable long-term relative returns given the valuation level at any given point in time. If you buy stocks cheap, your long-term returns are likely to be better than average. If you buy stocks when they are expensive, your long-term returns are likely to be lower than average. However, for periods of anything less than five years, valuations provide very little predictive power at all. For periods of around 10 years, valuations have been fairly good predictors of relative returns. But to do this sort of prospective return analysis properly, you need good tools. The Shiller PE10 and similar tools trumpeted by Grantham, Hussman and others are very deficient technologies. In this sense the public is being mis-educated. The more useful tools I use suggest that valuations are not as high as commonly believed. However, my own detailed analysis suggests that returns will nonetheless be sub-par relative to history. If you are an investor that maintains constant equity exposure at all times - whether as an indexer or as a stock-picker - you are unlikely to do much better than a 2%-4% real return over the long term given current overall valuation levels. The way to improve on those sorts of returns for most individual investors is via disciplined strategic asset allocation. This is where I focus most of my work with individual investors. Valuation is a very important part of that process. But again, in order to do this properly you need good tools.

MH: The Fed had its quarter-point hike to close out 2015. Could further interest rate increases impact markets? Is a rate hike that big of a deal?

JAK: I will start to answer your question by suggesting that it is more profitable to think of interest rate increases as symptoms rather than causes of economic and financial phenomena. Fed Rate hikes are reactions to what is happening in the economy (or what Federal Reserve Open Committee members think is happening in the economy). So, people need to focus on understanding the causal dynamics of the business cycle rather than focusing on the impact of Fed rate changes per se. If you can get a grip on this - even approximately - then what the Fed does or does not do becomes of secondary or tertiary importance. Sure, there are complex feedback loops between expectations, Fed action and real economic activity. But, ultimately, the Fed is merely a tail that is wagged by the big dog, which is the macro economy. In this case, the relevant issue is whether the economy is able to grow at a healthy pace. If it does so, the Fed will most likely raise rates. But if the Fed raises rates with the economy growing at a healthy pace then there is really nothing to worry about! If the economy is not growing at healthy pace, then the Fed is highly unlikely to continue raising rates. So, again, the Fed is almost an after-thought! When you start thinking about Fed policy more as a symptom rather than a cause, your perspective changes considerably. So, to directly answer your question: No, interest rate increases will not be a big deal if US economic growth is healthy - say, above a 2% annualized pace. If economic growth is not healthy, the Fed won't be raising rates, so that sort of risk becomes a non-issue. A more significant risk is that the Fed could potentially fall "behind the curve" at some point, as it has in the last two economic cycles. However, this does not present a near-term risk to markets; it is a potential source of upside.

MH: Oil prices are at the forefront of investors' minds. What is your view of oil prices and stocks in the oil sector?

JAK: If I could leave readers with only one thought regarding oil, it is that the crude oil market and the entire oil industry is at the leading edge of a long-term paradigm shift. We are moving from a world that until recently was preoccupied with so-called "Peak Oil" toward a world that is discovering a new reality: Much of the world's oil supply is going to become a "stranded asset" within the next 30-50 years. Everything that is happening in the oil market at the present time - from the over-supply caused by US shale fracking - to the new Saudi policy vis a vis OPEC, and even the possible partial privatization of Saudi ARAMCO - is ultimately being driven by this new paradigm that the world is just barely beginning to understand. The reality is that due to new technologies that have vastly increased recoverable reserves of oil and gas plus the development of alternative energy sources that will inevitably replace the role of crude oil and natural gas, there is far more crude oil and natural gas in the world than humanity will ever need. This is inexorably producing a race to the bottom in terms of long-term oil pricing as large reserve holders have a pressing economic interest in monetizing their reserves before they become stranded. Now, even in this context, oil will remain a volatile cyclical commodity and it will have many cyclical bull runs in the future. But the long-term secular trajectory for the purchasing power value of oil, and the profitability and economic value of the oil industry more generally, is one of terminal decline.

In the short-term, I think oil might dip below $30 for a while before 2016 is out. Warm weather, tepid demand growth, stubborn over-supply and limited storage suggest rallies may be short-lived while the risk of dramatic downward spikes in the price of oil is very real. However, over the course of the next decade, I think that the oil price is likely to fluctuate fairly widely around a central tendency that will establish itself at roughly $55. Why? The bursting of the cost bubble in the oil industry (a consequence of the "Peak Oil" era of optimism) and the consequent cost deflation within the oil industry that is barely in its initial stages is going to take the marginal global cost of oil production down from somewhere in the 70s where it is currently to the mid 50s.

In a world where crude oil reserves will be stranded if not monetized quickly, prices will tend not exceed marginal cost for long. To the contrary, there will be a tendency for prices to hover below marginal costs as owners of reserves race to take advantage of any price increases above marginal costs to monetize assets that will otherwise be stranded.

Note that crude oil prices could spike at any time. This is simply due to nature of the market for this particular commodity: It is a function of the fact that in the short term, both supply and demand are inelastic and there is relatively little idle capacity or storage. Supply is also subject to periodic disruptions due to instability in the Middle East. So, the fact is that future spikes are inevitable - as they always have been. And under current technical conditions, the spikes can be violent. Traders can take advantage of these situations. The question is what long-term investors should do. It is my view that during the next spike in oil prices, long-term investors need to seriously consider jettisoning virtually all oil and gas investments. This includes integrated oil companies, producers, refiners, mid-stream pipeline companies, etc. The fact is that oil and gas is an industry that is in terminal decline, just like the coal industry that is dying in an agonizing fashion before our very eyes. Given the new realities, oil and gas stocks are suitable for speculative traders only.

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. I have no business relationship with any company whose stock is mentioned in this article.