10 Themes For 2016

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Includes: AET, BA, BXMX, DBA, DHLSX, DVY, DXJ, EDV, ETJ, EWJ, GD, GDX, GLD, HRS, HSGFX, IAU, IEF, LLL, LMT, LPNT, NOC, OTCRX, RTN, SCJ, SLV, SPTL, TLH, TLT, UNH, VIG, VYM, XLB, XLE
by: Kevin Wilson

Summary

Investors will experience a major market correction in 2016 and should act defensively now.

Bonds will have a great year as global deflation or a cyclical bear market cause a flight to safety.

Long/short, dividend growth, and buy-write strategies will outperform other equity strategies.

It's that time of year where prognostications are popular in the financial press and amongst advisors. We have our own take on things as well, and we think some of the themes we've identified may be of interest to investors. On a macro level, the developing economies of the world are facing a dire crisis involving capital flight due to the recently rising dollar and a credit crunch due to the collapse in commodity prices and massive debt. At the same time, the developed or advanced economies of the world, especially the European Union, Japan and the US, are still facing deflationary pressures, the probable end of the credit cycle, problems with banks, and sovereign debt issues. Monetary policy in these countries remains super-expansionary in spite of the fact that the U.S. Federal Reserve just raised rates for the first time in nine years.

Major economic players like China, Russia, Italy, Brazil and Japan are already in, or just entering, recessions. So far, this is a near-replay of the financial crisis of 1998; however, we believe there is more risk of contagion this time around. Will the huge rally that followed the crisis of 1998 be repeated in some form in 2016? Maybe or maybe not, but either way, we are convinced that markets will remain volatile around the world in 2016, in part due to the economic stress and uncertainty prevailing around the world. All in all, it will be another interesting (and demanding) year for investors. What follows is a list and brief explanation of each of the ten themes we've identified for 2016. Please note that there is considerable uncertainty surrounding most of the themes on the list.

  1. US markets will experience a significant correction beginning as early as the beginning of January 2016 or perhaps as late as the end of the third quarter of 2016. This will occur because as I write this, US equity markets are overbought, overvalued and extremely narrow in breadth; also, junk bond yields have been rising strongly to levels comparable to those seen during recessions, and given low liquidity, a credit crisis is possible. The Treasuries yield curve is actually flattening in the days since the Fed's move to raise rates, suggesting the markets have deep concerns about growth prospects in 2016. Indeed, the year-long period of flat-trending stock indexes has not led to improved valuations, because earnings rates have fallen over the same time frame, and profit margins appear to be mean-reverting from their all-time highs. Inventory/sales ratios have risen quite dramatically as well, and are potentially additional harbingers of recession. Finally, risk tolerance has plummeted in recent months, as shown by many different measures such as market breadth, junk bond yield spreads, etc.

    It is not yet our base case that a recession is coming in 2016. But a cyclical bear within the secular bull is very likely. The long list of combined factors mentioned above has historically been quite deadly, according to fund manager John Hussman. For example, similar conditions existed in July 2011 before a 19% decline, in October 2007 before a 57% drop and in March 2000 before a 49% drop. We shouldn't forget either that there were cyclical bears in 1987 and 1998 in the midst of huge secular bull markets. In each case, investors would have been wise to dial back their risk and wait for a recovery. The length and relative severity of the correction (or bear market) will depend in part on market perceptions about the sustainability of profit margins, the projected mid-term trajectory of the dollar (and by implication, Fed rates) and the path taken by oil prices.

    But a correction is baked in the cake, as Hussman says, and can no longer be delayed by monetary gymnastics at the Fed. Any gains in 2016 will probably depend on how early in the year the correction (or bear market) occurs, and on the markets' continued childish faith that the Federal Reserve and government deficit spending are going to save us. If that faith continues or is rejuvenated, we would expect a big rally after the market bottoms, perhaps turning 2016 into a decent year for those who stick it out. However, if that faith in the Fed comes into question, as it did in 2000-2002 and 2008-2009, then we are in real trouble. Long/short funds make a lot of sense here, and we favor those with good track records, such as the Diamond Hill Long-Short Fund Inst (MUTF:DHLSX) and the Otter Creek Long/Short Opportunity Fund Inv (MUTF:OTCRX). Another alternative fund that should do well if a bear market has begun is the Hussman Strategic Growth Fund Inv (MUTF:HSGFX).

  2. Prolonged global deflation, or a cyclical bear market, and/or an actual recession will probably galvanize the Fed into new action, and a whole range of silly and ineffectual Fed interventions will follow. First, of course, there will be jaw-boning about what might be done. Then, when things are perceived to be pretty bad and Wall Street is throwing tantrums, the Fed will probably reverse their rate tightening decision and perhaps even start a QE 4 program. If a recession is recognized (long after it starts, of course), the Fed will then probably feel they have to move to negative bank rates, since they will have insufficient conventional ammo for stimulus (not that stimulus works in this strange environment).

    Home mortgage rates will soar (counterintuitively) in response as banks react to non-existent net interest margins for other asset types, as they already have in parts of Europe. We will remain caught in a classic liquidity trap, where efforts to stimulate borrowing or lending fail because there is simply no demand. The blind, nonsensical adherence by central banks and governments to totally ineffective Keynesian interventions will not change until new elections bring in leaders who actually understand capitalism, and who also understand how to get sustained growth by promoting savings and investment. The old saying is, "Don't fight the Fed," but that may not apply later in 2016.

  3. Bond investors in the US will enjoy a very good year as the steep yield curve flattens on the long end and fears of deflation increase. This is a contrarian view, obviously, in light of the prevailing opinions about interest rates, jobless rates and wage inflation. We believe stock market volatility will also drive short bursts of intense bond buying. Recession fears, which have been on the back burner of late, may come back into focus later in 2016, as the global recession indicated by researchers like David Levy spreads to more countries.

    Potential downside risks for the economy (and positives for bonds) include: 1) a severe slowdown in Asia and other emerging markets, accompanied by capital flight due to the rising dollar, a weak Chinese growth engine and already steeply declining exports; 2) continued severe debt and banking problems in parts of Europe (e.g. Italy, Greece), with risks of contagion; and 3) falling US profit margins, a looming potential credit crisis, a junk bond implosion and rising recession risk based on nearly stagnant wages, rising healthcare costs, rising housing costs, high inventories and falling exports, etc.

    When deciding how to allocate when, and if, a bear market begins (not our base case, but increasingly possible), investors would do well to remember that 10-year bond yields fell by 3.65% from top to bottom in the worst part of the 2000-2002 bear market, and then fell 2.65% in the worst part of the 2008-2009 bear market. If long (30-year) bonds fall to 2% and the 10-year to 1% this time around, as market observers like Jeffrey Gundlach, Lacy Hunt, and David Levy have suggested could happen, then big money will be made on trades using the Vanguard Extended Duration Treasury ETF (NYSEARCA:EDV), the iShares 20+ Year Treasury Bond ETF (NYSEARCA:TLT), the iShares 10-20 Year Treasury Bond ETF (NYSEARCA:TLH), the SPDR Barclays Long Term Treasury ETF (TLO), and the iShares 7-10 Year Treasury Bond ETF (NYSEARCA:IEF).

  4. The US dollar is likely to end its strengthening trend, as postulated by bond wizard Jeffrey Gundlach, as weakness in Europe, China and Japan is surprisingly offset by a possible reversal in the Fed's plans to raise rates amid US economic weakness. US industrial growth will begin to recover a bit later in the year or early in 2017 as the dollar stabilizes or even declines. The surprise trades would then be to bet on brisk, short-covering rallies in the SPDR Gold Trust ETF (NYSEARCA:GLD), the iShares Gold Trust ETF (NYSEARCA:IAU), the Market Vectors Gold Miners ETF (NYSEARCA:GDX), the iShares Silver Trust ETF (NYSEARCA:SLV), the Energy Select Sector SPDR ETF (NYSEARCA:XLE) and the Materials Select Sector SPDR ETF (NYSEARCA:XLB). For the longer term, though, see below.
  5. Global food, oil, iron ore and other commodity prices will stay low long term, and some will collapse to depression levels. This will happen in the long run because malinvestment due to cheap money has caused enormous global overcapacity in many commodities, and it will take years to bleed off the excess. Significant potential supply problems will eventually result from the collapse of capex going on right now, but it will take years for cotton, copper, nickel, zinc, iron ore, rare earth minerals, oil and natural gas to fully recover. OPEC's stand against high-cost producers will eventually collapse as budget deficits soar within the cartel; however, this is not expected to make a difference until late in 2016. One bright spot may be agricultural commodities, which are farther along in the cycle, as pointed out by commodities guru Jim Rogers. So, at some point, a trade in the PowerShares DB Agriculture ETF (NYSE:DBA) may make sense.
  6. The Japanese stock markets, especially small caps, will probably outperform, mainly because they are unloved, but also because the government is buying equities and has a set policy of destroying their own currency over time due to their crushing debt overhang. The fundamental reasons for favoring Japanese stocks is that they are very cheap, many companies have low debt, high cash flow, high cash reserves, and the profits are steady. Good bets would probably include the WisdomTree Japan Hedged Equity ETF (NYSEARCA:DXJ), the iShares MSCI Japan ETF (NYSEARCA:EWJ) and the iShares Japan MSCI Small-Cap ETF (NYSEARCA:SCJ).
  7. Gold prices may actually bottom out and rally strongly at some point as fears about economic growth, widespread negative bank rates, and currency devaluation drive a flight to safety. Bullish factors include the massive global deficit spending in advanced economies and the uncertainty and fear associated with geopolitical events in places like Iran, Syria, Iraq and North Korea. The threat of major acts of terrorism may also be a factor. Again, if gold bottoms, we would favor IAU, GLD, GDX and SLV.
  8. Dividend-paying stocks with decent growth, strong balance sheets and good free cash flow will outperform in the US, as investors continue to seek safety and alternative sources of income in reaction to growth fears, low or negative bank rates and low bond yields. This is probably a longer-term theme, since retired households are still starved for yield on their investments and younger households are wrestling with debt. Some effective trades might include the Vanguard Dividend Appreciation ETF (NYSEARCA:VIG), the iShares Select Dividend ETF (NYSEARCA:DVY) and the Vanguard High Dividend Yield ETF (NYSEARCA:VYM). Some liquid alternative ideas, such as a buy-write strategy using the Nuveen S&P 500 Buy-Write Income Fund (NYSE:BXMX), might do very well if markets remain relatively flat. Also helpful might be equity closed-end funds (CEFs) such as the Eaton Vance Risk-Managed Diversified Equity Income ETF (NYSE:ETJ).
  9. The healthcare industry will go through big changes as Obamacare gradually moves towards collapse. This process has already started, with a number of companies closing shop or withdrawing from the program's exchanges because of perverse incentives that promote adverse selection and promised government subsidies that have failed to appear. Companies lost over $2.5 billion in 2015, and this will continue in 2016. Expect this problem to worsen if there is a recession. One of the largest health insurers says they will probably withdraw from the program in 2016 due to mounting losses and the failure of the so-called risk corridors to receive adequate federal funding.

    The new omnibus spending bill provides a partial reprieve in 2017, but soaring costs to consumers are going to drive even more adverse selection going forward. Increased penalties for non-participation will slow the impact of adverse selection down, of course, but as mentioned before, a recession, if it happens, would cause a catastrophe in falling participation rates. Obamacare is deeply unloved by middle class payers and well loved by Medicaid recipients, as consumer costs have soared and government interventions into healthcare decisions have continued to escalate. This will cause Democrats to propose a single-payer system at some point (which will not pass Congress), and it will cause Republicans to do all they can to hasten Obamacare's demise (with the President vetoing any significant new legislation). There will be winners and losers, but we think shorting insurance companies (e.g. UnitedHealth Group (NYSE:UNH), Aetna (NYSE:AET)) and going long hospital networks (e.g., LifePoint Hospitals (NASDAQ:LPNT)) might make sense.

  10. The US administration's restrained, or (some would say) half-hearted approach to the "war on ISIS" will fail miserably in the face of continued acts of terror inspired by or actually perpetrated by ISIS in many developed countries. Attempts will continue to be made by weak governments to use the fear of terrorism for internal political purposes, but nothing effective will really be done about it. Iran will freely violate almost all of the terms of the so-called nuclear agreement, which they never even signed anyway. They will also continue to violate various UN and US sanctions without meaningful constraint as the West takes appeasement to its ultimate extreme pathology. US allies will act on their feelings of betrayal, and it will not be pretty. All of this will promote a global arms race in which many nations forget the lessons of World Wars I and II. Defense stocks should do very well indeed (Boeing (NYSE:BA), General Dynamics Corp. (NYSE:GD), Lockheed Martin (NYSE:LMT), Harris Corporation (NYSE:HRS), L-3 Communications Holdings (NYSE:LLL), Northrop Grumman Corp. (NYSE:NOC), Raytheon Company (NYSE:RTN)).

Disclosure: I am/we are long OTCRX, TLT, IEF, EWJ, VIG, DVY, VYM, BXMX, ETJ, BA, GD.

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: This article is intended to provide information to interested parties. As I have no knowledge of individual investor circumstances, goals, and/or portfolio concentration or diversification, readers are expected to complete their own due diligence before purchasing any stocks or other securities mentioned or recommended.