The market started the year with quite a bang, selling off to a degree not predicted by any event that occurred at the end of 2015. The ensuing sell-off has not only caused a fair amount of stress among investors, but also analysts who are struggling to explain what exactly is happening. To that end, I will argue we are seeing two events: an unwinding of the major post-recession trades followed by the markets attempting to find "the new trade." Most importantly, current turmoil is the result of the inability to find new investment thesis.
The following two trades dominated the post-recession investment environment:
- Low rates in the US forced investors to seek higher yielding returns. This led to money flowing into both developed and emerging equity markets.
- Additionally, the Chinese government greatly increased fiscal stimulus to prevent a recession. This continued their massive consumption of raw materials, which in turn continued the large investment in raw material extraction in the southern hemisphere.
A fair number of people have criticized the Fed for QE, arguing the program created a bubble. This argument makes little sense for two reason. First, there would have been a huge backlash had the Fed done nothing. Second, subsequent research demonstrated the natural rate of interest is very low, indicating the Fed made the right decision. But regardless of whether or not you agree with the Fed's decision, there is absolutely no reason to "fight the Fed;" when they cut rates, you go long equities.
And, just as important as the Fed's rate cut is the growth in corporate earnings, which naturally support higher stock prices. As for China, their massive stimulus simply continued their trend of infrastructure investment started a long time ago. And with the Fed lowering interest rates, money flowed to more profitable projects, such as those involving raw material extraction in emerging economies.
Two events occurred in the last 30 days that signal both basic thesis no longer apply. The first was the first Fed rate hike in nearly 10 years. Not only did they raise rates, but they signaled they would continue to do so, with perhaps as many as four increases this year. Assuming this total, rates would only be 1.25%, which is hardly a contractionary level. But, the markets reacted negatively anyway.
Second, the Chinese market started the year with a very large sell-off. Although a strong argument can be made that the Shanghai index was very expensive, the magnitude of the drop combined with the botched policy response signaled to the market that perhaps something far worse lurked underneath the Chinese economic headlines. This led investors to sell their equity positions across the globe.
For the sake of argument, let's assume you've sold-off your positions in whatever security over the last few weeks. Ask yourself this question: what's the next big trade that everybody is talking about? The answer is none. And that is the real problem the markets currently face. Some are putting money into undervalued energy or raw material producers, largely as a purely contrarian play.
We've also been some movement into treasuries. And the defensive sectors (health care, utilities and consumer staples) have also benefited. But none compare in scope or magnitude to borrowing cheaply in the US and using the funds to invest in a wide swath of companies and countries, all of whom are raw material exporters. And the lack of the next big thing is the primary reason for recent market weakness.
Market overview: the market is expensive. The current and forward P/Es for the SPYs and QQQs are 20.69/20.95 and 15.38/16.92, respectively. And earnings are still a bit weak. From Factset:
The blended revenue decline for Q4 2015 is now -3.5%. At the sector level, the Energy and Materials sectors are reporting the largest year-over-year decreases in sales of all ten sectors. On the other hand, the Telecom Services and Health Care sectors are reporting the highest growth in sales for the quarter.
In terms of revenues, 49% of companies have reported actual sales above estimated sales and 51% have reported actual sales below estimated sales. The percentage of companies reporting sales above estimates is below both the 1-year (50%) average and the 5-year average (56%).
Looking at Q4 as a whole, total earnings for the S&P 500 index are expected to be down -6.8% from the same period last year on a -4.6% decline in revenues. The Finance sector's growth has improved following the aforementioned respectable bank industry results, with total earnings for the sector now expected to be up +10.1% on -3% lower revenues. Excluding the Finance sector, total earnings for the index would be down an even bigger -10.5%. The Energy sector's impact is in the opposite direction, with total earnings for the sector expected to be down -71.3% on -38.1% lower revenues. Excluding the Energy sector, total earnings for the index would be still be below the year-earlier level, down -1.1%.
Let's place the current market drop in perspective. The following bullet point list shows the total decline from their respective high for each ETF:
The larger, most publicly visible averages (the S&P 500, the Dow Jones and the NASDAQ) are all in a technical correction (drops of at least 10%). The transports - which theoretically confirm or deny a trend - are in a bear market. And as we go up the list in terms of risk exposure (from mid-caps to small caps), we see increased selling with the Russell 2000 now in a confirmed bear market. The above data tells us we're moving lower.
However, a rally may be brewing. While the consumer staples, utilizes, and healthcare were the sector leaders over the one and three month time horizon, last week we saw cyclicals, technology and energy lead the markets:
And with a very high percentage of NASDAQ and NYSE stocks above their respective 200 and 50 day EMAs, it's likely that a countertrend rally may be afoot:
But with the weakening in the riskier parts of the market, don't expect the rally to last. The weight of the evidence says we're probably moving lower for now.