February 2016 Market Outlook

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Includes: DIA, IWM, QQQ, SPY
by: Clint Sorenson, CFA, CMT

Summary

Valuations remain stretched despite the drawdown in equity indices.

Economic activity continues to slow globally.

Market internals have weakened and an oversold bounce was expected.

The Fed has made a major mistake and will most likely have to reverse course.

Last month we reviewed four important factors that we believe influence future market direction. The factors are as follows: valuations, market internals, the economic environment, and Federal Reserve policy. A thorough analysis of all four factors led us to the conclusion that, "investors should stress test their portfolios for a significant decline in asset prices in the coming years. Investors should make sure that they can handle equity values being cut in half." The situation remains the same and our aforementioned recommendation stands.

1. Valuations, even after one of the worst starts to a year, remain incredibly stretched. According to indicators that we believe to be reliable, the market is still in the top decile of valuation measures ever recorded.

2. Market internals have weakened substantially since the beginning of the year. We would need to see market internals correct meaningfully to change our opinion. For example, equity participation to the upside would need to be witnessed broadly, advances would need to be accompanied by strong and increasing volume, and credit spreads would need to tighten significantly to display signs of a potential sustained uptrend in prices.

3. The economic environment has continued to deteriorate to start 2016. As we expected, the strong dollar and resultant global deflation has meant a recession in corporate profits and industrial activity. As long as the US dollar remains the stronger currency, economic growth will be difficult to come by. As economic data continues to come in weaker than expected, we would assume the lagging employment indicators to begin to reflect a lack of confidence in the US economy in the coming months. Fourth Quarter GDP slowed to 0.7 percent and real GDP grew year over year at around 2 percent. The recovery has been extremely slow and the risks of a recession are high. The services reports have been the only ray of hope for the US economy. The only issue with relying solely on services is that this data has historically lagged the industrial economy. Maybe this time is different.

4. The Federal Reserve, in our opinion, has made the largest policy mistake since 1937. The Fed has tightened policy in the face of slowing economic growth, no inflation, and global central banks moving the opposite direction. The result has been a collapse in economic activity and a resurgence of volatility in asset markets. Our expectation is that the Fed will have to reverse course if the prevailing trends continue. The pervasive deflationary conditions should result in lower yields on longer term bonds for a long period of time (lower for longer). Like most other developed economies, it would not be a surprise to see 10 year US Treasury yields below one percent over the next couple of years. History has shown us that interest rates can remain low for a long period of time. When rates hit their lows in the late 1930's, they stayed low until the 1950's. Japan has dealt with low interest rates since the late 1990's. Many European countries have 10 year yields that are lower than 0.50 percent. It would be flawed for us to think that the US will maintain its interest rate divergence from the rest of the developed economies. The Fed may be intent on raising interest rates, but the slowing global economy could mean that long term yields actually fall.

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.