2016 started out in a storm, a direct continuation of the decline of late 2015. Frankly, at the beginning of the year there was real panic supported by pessimists and journalists, and the stock indexes around the world have experienced sharp declines that entered them into a bear market (a decline of over 20% from the peak). If you managed through the 2008 sub-prime crises, the current declines are a piece of cake for you. If not, welcome to "the cyclical nature of the capital market" club: 4 to 6 years of increases (sharp and blissful), then 1 or 2 years of declines (that really bomb-out). If you take a look at the chart below, you will immediately understand that in order to be successful over time, you must hold on through the negative periods along the way. After which, the good times will strongly compensate for the declines, especially if you hold cheap shares.
But this is not what I wanted to talk about. This time I wanted to discuss the key factors that will determine the direction of the markets in the upcoming years. In my opinion (and I'm not reinventing the wheel here), there are four factors that raise the bar for concerns of investors and cast a shadow on the markets at the moment:
- The slowdown of growth in China and its negative impact on the world.
- The decrease in oil price and its impact on companies from the industry (and the US financial system).
- Lukewarm financial results of leading US companies.
- Stock prices that are not cheap.
In this review I will discuss these issues and will try to look a few years forward to assess where the market may go, specifically the US market. Please note that this is a comprehensive and relatively long review, so I recommend you get yourself a cup of coffee and cookies...
Is the Chinese economy in danger of collapse?
The Chinese government recently reported a growth of 6.9% in 2015. Personally, I do not believe this figure- this growth does not seem logical for a country in which almost every economic parameter you can look at has gone down this year. I'm not just talking about the housing prices in China that took a sharp dive, but also about the dramatic decline in the purchase of goods, infrastructure construction, reduction of activities in factories and more. But let's assume for a moment that we are buying the numbers given by the Chinese government, the fears of investors derive from two things: first- a collapse of the financial system in China, and secondly, that the slowdown in the country will negatively affect companies and countries around the world who sold goods, products and services to China on a huge scale in the past and now see a significant decline in their income. Many of them have sharply leveraged over the years, and now they may find it difficult to repay the debts. It is a real concern.
According to the data, China's overall debt grew very fast in the last decade, at a rate much higher than the growth of the country. Today, China's overall debt is 4 times the GDP of the country (!). The interest on the debt alone is 20% of the GDP. Add the fact that the growth has recently shrunk, and you can understand why China is in an acute financial problem.
This bubble (as well as the real estate bubble that exists in the country) cannot be solved easily, so I estimate that it will weaken China's economy in the upcoming years, but probably will not lead to its collapse. This is due to the fact that the Chinese government has enough tools to deal with the problems. For example, it can continue to lower interest rates, reduce the Yuan in a controlled manner, and by doing this improve China's exports and the employment market, and use the vast foreign reserves held by the central bank (currently US $3.5 trillion) to help local banks through the difficult times. Still, China's problems will not disappear overnight, and even if all the necessary steps are taken, this will continue to weigh on the markets in the upcoming years.
Another worrying issue rises from the financial difficulties that many worldwide companies may encounter as a result of the slowdown in China's economy and its transition to internal economy instead of an exporting one, as it has been in the last decade. It is not difficult to understand that companies that have a strong dependence on sales in China could be dramatically affected. Take Apple (NASDAQ:AAPL), for example, whose stock has been recently bleeding, following the fear of a sharp decline in sales due to China's slowdown (and also because of the stagnation in sales of the iPhone). In a broader look, the US economy is a relatively closed economy and exports to China are not an important part of American companies' sales (less than 10%), so that the harm done to them would be limited. Still, US companies that have been leveraged over the last few years might have cash flow problems. In fact, after years of companies being focused on pleasing the shareholders (dividends distribution and buybacks) they will now have to focus on paying back loans to creditors. For some it will be impossible in light of the decline of sales in China.
Happily, out of the companies in my portfolio, the only one that has exposure to China is JP Morgan (NYSE:JPM). The bank's exposure was US $16.3 billion in loans and investments in China at the end of the third quarter. The bank, known for a relatively prudent risk management, began to reduce its exposure to China over a year ago and at the end of the second quarter, the exposure was $17.7 billion, so it is likely to predict that it is now no more than $14 billion. The division is roughly half and half between loans and tradable and non- tradable investments in the state.
Even if it seems like a lot, it is just a few small percentages of the Bank's huge equity (almost 250 billion dollars), so even if there is an escalation in China's financial situation, it is not what will break JPM. The slowdown in the US, where most of the bank's loans and investments are, will have a much more negative impact on the Bank's activities if it happens. But, as mentioned, the US economy dependency on China is not significant, so the United States can continue to grow reasonably well, even if China continues to fester. In addition, if the Fed persists with its agenda to raise interest rates four times during 2016, it will contribute to a significant increase in the net income of JPM. In other words, even if China's slowdown will continue, it should not concern investors in US companies that have no significant exposure there.
Click to enlarge
From JPM's quarterly report
How much of a danger is the diving price of oil to the US economy?
Take a look at the graph of oil prices (I listed the prices adjusted to inflation and chose WTI, which represents the US oil price, but it is also similar to Brent's behavior, representing the price of oil in the world). It is just amazing. The current oil price of less than 30 dollars a barrel is almost a historical low of all time. We have only seen these prices around the worst financial crisis in Asia (in 1997-1998) and before the 1970s.
At the end of 1997 one of the greatest crises in the history of Asia was recorded. Together with Japan, the continental countries accounted for nearly 80% of the increasing demand for oil between 1990 and 1997, and the crisis led to a sharp drop in demand for oil and its price took a dive to below 20 dollars per barrel (in today's prices). The crisis led to the crash of the oil stocks all around the world and a wave of bankruptcies. It also affected the banking system who lent a lot of money to these companies.
The situation today is different. The fall of the price of oil does not come from a decrease in demand for commodities but from a huge increase in supply, and also, the exposure of US banks to the sector is not as large as in the crisis of 1998. On the supply side, not only did the OPEC members decided not to restrict the output, last year the United States became the largest oil producer in the world and recently it presents a record production of all time. The decision to open the American oil for export increased the pressure on the price of the "black gold", and the recent lifting of sanctions on Iran released additional amount of barrels per day to the market. This led to a collapse in oil prices. Assuming the picture will not change in the near future, oil prices may continue to drop, perhaps even below 20 dollars (as Goldman Sachs analysts think).
Of course at these low prices new oil exploration projects which were planned for the coming years will not be carried out, and it is also clear that countries and companies around the world will have severe liquidity problems. The worst case scenario is a wave of bankruptcies of oil producers all over the world, who took large loans for the development of reservoirs and now will not be able to repay debts. Just a week ago we saw BP Global (NYSE:BP), the energy giant who recorded a 91% drop in fourth-quarter earnings and a loss in 2015, which was the largest in 20 years. Exxon Mobil (NYSE:XOM) also presented a 50% fall in annual profit. According to the latest US employment report, in 2015 129 thousand workers in the mining sector were dismissed, and it is likely that the number will increase if the price of oil will remain low for a longer period. The problem is even more severe for the smaller players in the industry, whose resources and additional funding capabilities are limited.
The problem does not end with companies, but has arrived to countries themselves. Big oil producers such as Russia, Canada and Saudi Arabia already suffer from the situation. Smaller producers, such as Nigeria, who recently sought a financial bailout of $3.5 billion from the World Bank, or Venezuela, are already close to economic collapse due to the falling price of oil. To stand on their feet again, most oil producers worldwide need the oil price to be higher than 60 dollars a barrel. The price currently is less than $30. The fact that Saudi Arabia, one of the world's major oil producers, who is also trying to cope with a huge deficit, will probably not initiate a reduction of output in the near future (although there have been rumors of some contacts between the Saudis and the Russians), is the winning blow for the "black gold."
The fear of investors is that the wave of bankruptcies in the oil industry will lead to large losses of debts in banks worldwide. US banks are also exposed to loans and investments related to oil, and that is one reason that bank shares have lost a large percent of their value in recent weeks. But, as mentioned, the balance sheets of US banks are very different from those at the crisis of 1998. Indeed, most banks have exposure to billions of dollars in loans and investments in oil, but the part of these loans is very little compared to the loan portfolios of the banks and certainly in relation to their equity. For example, Bank of America (NYSE:BAC), which is the most exposed in the sector, has loans of 21.3 billion dollars to oil companies, Citigroup (NYSE:C) 20.5 billion, Wells Fargo (NYSE:WFC) 17 billion, JPM 13.8 billion and PNC Financial (NYSE:PNC) has $2.6 billion of loans to oil companies. Sounds like a lot? But, it is not. In comparison to the loan portfolio of the banks these are no more than a few percent: 3.3% for Citigroup, 2.4%, for BOA, 1.9% for WFC, JPM is at 1.6% and 1.3% for PNC.
Still, the banks are not taking this matter lightly, and have already begun to set aside hundreds of millions of dollars in reserves to cover loan losses that oil and gas companies will not be able to meet. JPM for example has already set aside $124 million for the matter, and the chief financial officer of the bank said that number could rise up to 750 million dollars if oil prices continue to remain low for a period longer than 18 months. 750 million is a reserve of 5.4% from the total loans of the bank, a very high percentage that would require a lot of bankruptcies of companies in the industry for it to not be enough.
This is probably the reason why the bank's CEO said he "sleeps soundly" even at the price of 30 dollars per barrel of oil. He also said that in addition to the fact that the exposure was very low compared to total assets of the company, most of the loans are to stable companies (high debt rating), and most of them are also backed by tangible assets, which means that banks can return the bulk of the loan even in the case of a default. Moreover, most of the loans of JPM to drilling and production companies are through generous credit lines, which, if necessary, can be closed at any time. And above all, even if the Bank will need to transfer $750 million to reserves to cover bad debts, that number is still only a small percentage of the bank's profit before tax (nearly 25 billion dollars a year!), so it will have only a minor financial affect. This means the problems of the gas-oil sector can produce no more than "a dent" for these banks. This is probably the reason why Jamie Dimon, JPM CEO, recently bought 500,000 shares of the bank (this purchase is equal to his entire salary for 2015).
Despite the all-clear sirens about banks like JPM and PNC, other banks (e.g. BOA or C) may still be hurt more severely, and their shares may go down and drag the rest of the financial stocks down as well. The crisis could also seep into other sectors of the US economy and hurt its growth, so there is a risk that the sector's shares will continue to "bleed" in the near future. On the other hand, it's worth taking a look at what happened to the JPM share during the crisis of 1998- it sharply plunged by tens of percent's down, but within a few months came back to precisely the same point, and continued to climb up (and then went down again because of the dot-com crisis, but that's another story...). If history repeats itself, this time we will also see a sharp correction once investors realize that the collapse of oil prices is not a catastrophe for US banks (by the way, JPM is currently trading at an earnings multiple of 9.5, 25% lower than the average historical of the Bank. Pricing is very, very cheap, and that is before we consider the possible rise of interest rates and the substantial increase it would bring to the net profit of the bank).
In addition, you don't have to be an expert to realize that oil price below 30 dollars is unreasonable for a long period of time, simply because it is not profitable for most companies and oil-producing countries on a large scale. The decrease in price is probably not only due to supply being higher than demand, but is also part of a war for supremacy in the area (and possibly part of world currencies) between Saudi Arabia and Middle East countries, to the United States, Russia and other major produces, and on the way they had to make sacrifices - companies and countries who have leveraged excessively and will bankrupt. I believe that in the longer term oil price will have to return to a more normal level, around $60 a barrel, according to estimates of experts.
How will it happen? Logic says that as long as the price of oil remains low and even decreases, the number of companies who go into difficulties will increase, the number of players in the sector will drop, the supply will decrease and the price of oil will be able to return to a normal level. When will it happen? It could take a month or it could take a year or more. I have no idea. My gut feeling is that the bottom in oil prices has not been reached yet, but the price increase will have to happen sometime in the next few years.
It is also important to remember, and it seems that most investors ignore this, the other side of the coin- cheap oil is positive news for the global economy, and we all feel it in our pockets when we fill the car up with gas. When energy prices are low, industrial companies who consume oil as a major raw material can increase their profitability, our travel costs will be reduced and we will be able to consume more goods and services and increase economic growth. In other words, the problems of companies in the industry are a heavy weight, but they pale in comparison to the great contribution of cheap oil prices to the industry and consumers in the long run.
Has the US economic growth come to a halt?
After returning to a reasonable growth of 2%-2.5% in the last two years, the US economy is showing weakness again. According to the first reading (out of three), the US GDP grew by 0.7% in the last quarter of 2015. This is no surprise- economists estimated growth of 0.8%, but it is a disappointment to those who expected the US to continue the line of the previous two quarters. Still, the US economy grew by 2.4% in 2015. Not bad. Certainly not a sign of going into a recession like some of the pessimists think.
On the other hand, there are many economic parameters that indicate a slowdown. The US manufacturing sector, which constitutes 10% of the economy, is deteriorating from month to month, and as proof the ISM index which represents the activity of the sector has experienced a decline for six months in a row. The ISM index of the non-manufacturers sector (service sector) has also shown a weak reading in January (53.5 points), but the index remained above 50 points, which is still considered an expansion. The corporate results are also not very encouraging. Most major US companies have recently published reports showing a lukewarm decline in revenues and profitability as a result of the slowdown in many markets worldwide, especially in China. Tim Cook, Apple's CEO, has recently said, and for good reason, that "extreme negative conditions are seen almost everywhere you look." Most medium and small size companies have not published their financial reports, but salvation cannot be expected to come from there either.
On the other hand, the positive points must be emphasized, for example the fact that the US labor market seems strong (although the percentage of part-time jobs out of all jobs is higher than before, and the median income has not dramatically improved) and the housing market also demonstrates stability and expansion. The Fed also thinks so and that's why it is starting to increase rates. In other words, the US economy is certainly not in its highest gear, but in my opinion it is not going into a recession in the near future. It will probably continue to grow in a reasonable manner as it grew in the last 2 years.
Going back to oil, according to the figures, the energy sector is about 4% of US GDP, and only 1.5% of the labor force. Indeed, the investment in fixed assets (MUTF:CAPEX) per worker in the energy sector are higher than in other sectors, and therefore a sharp decline in investment as we see recently is likely to increase the negative impact of the slowdown in the US GDP, but this is still a relatively small factor. Therefore, even if the price of oil will remain low for a long time, the US will still be able to continue to grow at a satisfactory rate. Therefore, in my opinion, investors' fears from lack of growth are exaggerated, certainly if you believe (as I do) that the price of oil will correct itself up in the foreseeable future.
Are stocks cheap?
In order to price a particular stock market, say on Wall Street, I like to look at the sales ratio of the market - the total market value of listed companies in the United States to the US GDP. Currently, this indicator stands at 1.05 which suggests the US stock market is a bit expensive (historical average of this ratio is around 0.9 in the modern era). But, and this is a big but, this indicator built mainly for a normal interest rate environment, around 3% -4%. Today the US interest rate is 0.25%, so the sales ration of the market is a little off and other multiples should be looked at, for example, the stock's earnings yield.
Earnings yield (EY) is a parameter that examines what percentage of profit was received for every dollar invested in the shares of a company. It is actually the opposite of the Price to Earnings ratio (P/E). Now, investing is a game of alternatives, so of course if shares are traded in a higher earnings yield than the yield to maturity of long-term government bonds (which represent a risk-free investment), there will be a priority to invest in stocks (since they are expected to yield a higher return). On the other hand, investing is also a game of risk management - investors demand a premium yield over the bond market to compensate for the extra risk inherent in investing in stocks. Historically, the earning yield of the S&P500 was 2.6% higher on average than that of 10-year US treasuries. Thus, if today the yield to maturity of US bonds for 10 years is 1.87%, the shares have to be traded at an earnings yield of 4.47% (I added 2.6% to 1.87%) or a "fair" P/E of 22.4 (1 divided by 4.47%). The current P/E of the S&P500 is around 20.6, which means that the market should rise about 9% to reach its fair value. So have we reached the bottom?
The big question is where the interest rate is going to in the near future. If you believe the Fed, which speaks of four interest rate hikes in 2016 and the stabilization of interest rates at over 1% at the end of the year, then the answer is no. In this case the yield of 10-year treasuries will rise to at least 2.87% (i.e. a loss of over 10% to bond holders, ouch), which would require an increase in the stock's earnings yield to 5.47%, i.e. a decline in P/E 18.2. To get there, the stock market should go down another 11%.
On the other hand, we must remember that this is only the fair pricing of the market. As long as the earnings yield of the stock is higher than bond yields, there will be a preference to shares, and therefore there is nothing to prevent P/E from being even higher. How high? Even 34 (1 divided by 2.87%), which translates to an increase of almost 70% in value of the S&P500. Are we going there? Slim chance, certainly not with the lukewarm results of the companies in the last quarter of 2015.
So what's the bottom line? Where do we go from here?
For those who have been following me long enough, you already know I do not usually embellish reality or bury my head in the sand, so there is no point in deluding myself or you with being over-optimistic this time either. Looking objectively, I think the world's central banks have lost control of their economies last year, mainly because they have carried out to wide quantitative easing. Too much money was thrown into the market, the interest rate was too low for a long time, companies have become addicted to cheap debt, and now when revenue and profit decline many of them find it difficult to cope with the situation. Raising the interest rates could worsen the depth of the problems. Therefore, we must admit that we are facing a difficult period for the stock market.
On the other hand, the bright side is certainly encouraging. First, there are no alternatives to stocks. The bond market yields almost zero percent in the short term and even 10-year treasuries yield less then 2%, so that capital gains are rather limited, while if the US interest rates will rise, bondholders will be hit hard (especially long duration bonds). Therefore, investors will not run to sell shares to replace them with bonds. This does not mean that the stock market is not expected to decline, but apparently the decline is limited.
Secondly, if you hold shares of stable, cash flowing, growing companies, who do not have high exposure to the mess in China or the decrease in the price of oil, it seems that there is no cause for concern. On the contrary, any non-rational additional decrease in price makes them even more attractive. It is psychologically hard to see your stocks lose value, but I have no doubt that it is a temporary thing. A dollar bill, even if at some point people go crazy and are willing to sell it for half a dollar, eventually will return to be worth one dollar. Let's not fool ourselves, the majority of shares will not go back to their fair price tomorrow morning. It may take time and stocks can even go down more in the near future, but in the range of 1 to 3 years, sanity will return to the market, and whoever purchases cheap stocks now is expected to sell them for a nice profit.
So where will the market go to in the near future? I have no idea. I will not be surprised if it goes down another 10% or so in the near future (more than that is hard for me to believe) while I will also not be surprised if it will rise by 10% in the coming months. Still, for those who fear the continuing declines and are contemplating an escape for cash, I suggest taking a glimpse at last week's trading chart of JPM warrants (which I hold).
The warrant fell almost 23% during the week but suddenly changed direction (after the CEO announced he bought shares of the bank), went up and ended the week at a higher level. This is not something that can be scheduled (and anyone who thinks that they can is deceiving himself). The same exact scenario could happen to the entire stock market- it is likely to continue to go down for a while, then suddenly, without warning, to turn direction, go up and compensate in a month or two for all the declines of recent months. This too, is not possible to schedule.
The way to succeed with long-term investment in stocks is by ignoring these short-term fluctuations of the market and concentrating on the stock fair value. As stated, a dollar will be worth a dollar sooner or later, so shares you hold which are traded in discount will ultimately go up to their fair price and yield the profits you wish for.
Disclosure: I am/we are long JPM WARRANT.
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.