Year Ending Under Commodity Shadow

by: Stephen Biggar


2015 is on track to be the first year of negative capital appreciation on the S&P 500 since 2011.

How often will the Fed act through 2016?

Our 2016 EPS forecast is predicated on easier comparisons, as strong dollar and weak oil impacts are anniversaried, and on stabilization and recovery in the emerging world.

With two truncated trading weeks left in December, this year is on track to be the first year of negative capital appreciation on the S&P 500 since 2011. Investors will recall that the S&P 500 in 2011 finished within a point of where it started; thus, total return in 2011 was a positive 2.1% based on dividend payouts at that time.

With the market down about 2.3% entering the final few weeks of trading, 2015 is on track to be down both on a capital-appreciation and total-return basis. No trading year is complete until it is complete, and the market could muster a rally in the final weeks. But trading sentiment is sour and most investors appear to wish that the year 2015 would simply go away.

No firm should have seen it coming more than Argus. For years, we have sounded one consistent theme: as earnings go, so goes the market. While other investors and advisors have variously harped on money supply, quantitative easing, Fed policy or liquidity, we have been consistent in pointing to the reasonably tight correlation between the recovery in earnings since 2009 and the recovery in the market since 2009.

Recipe For A Soggy Stock Market

We were on record early in the year as predicting that the S&P 500 was positioned to record a gain in the high-single digits to low-double digits for 2015. That was predicated on our view that earnings would also rise in high singles to low doubles. Our prediction of high single-digit to low double-digit earnings and stock gains might have worked if not for a much worse than anticipated weakening in commodity demand and prices. As the year progressed, the failure of oil and commodities to find a bid caused deep EPS declines for about 10% of the market. But this weakness not only weighed on the energy and materials sectors, industrial stock investors found out the hard way that much of the activity in industrial stocks, from building oil & gas infrastructure to shipping crude and pipe by rail, was tied to prosperity in the oil patch.

Confounding expectations, conditions worsened rather than improved. After plunging from summer 2014 into January 2015, oil prices appeared to have stabilized in the region of low-to-mid 50s per barrel for Brent and high-to-mid-$40s for WTI. But as the El Nino effect warmed up the Northeast and Midwest, energy prices embarked on a new round of weakness. Halfway through December, WTI was close to an 11-year low and fighting to hold at $35 a barrel. If you're wondering why the Santa Rally was grounded, it's likely because reindeer chow is much pricier than gasoline.

Whereas oil late in the year failed to hold midyear strength, the decline in commodity prices has been a more prolonged affair, stretching across most of the year and worsening into year-end. Weakness in agricultural commodities and in gold has been long-standing; this has impacted mining equipment and farm machinery. Key industrial commodities such as iron ore and copper have recently weakened to new lows, as investors acknowledge that the Chinese industry is not going to ride to the rescue.

The Chinese leadership is committed to transitioning to a consumer-driven economy; the smokestack economy could already be fading in China. Energy and commodity prices might have fared slightly better in 2015 if not for the stronger than anticipated dollar accompanied by deeper than anticipated weakness in key currencies such as the euro and Yen. Even as strong U.S. nonfarm payrolls reports in October and November were practically compelling the Fed to hike rates, Mario Draghi - Janet Yellen's counterpart in the European Central Bank, or ECB - was crooning an ultra-dovish tune.

On 12/14/15, as the final full trading week of the year was getting underway in the United States, Mr. Draghi stated that the ECB was "ready and able" to intensify quantitative easing in the Eurozone. Earlier in December, the ECB recalibrated its policy tools, including extending its huge 60 billion euro per month QE program at least until March 2017. Europe's central bank believes that a structural recovery requires raising not just current growth but potential growth. To do so will require investment, and flat to negative interest rates, the ECB believes, are required to stimulate investment.

With the Fed going one way and the ECB (and Japan and China, to a lesser extent) going the other way, the dollar could conceivably stabilize. But it is unlikely to back down anytime soon. We expect global currency exchange rates, along with weak demand and abundant supply, to sustain this perfect storm that is keeping all commodity prices underwater.

Fed Finally Does It

At its latest meeting on Wednesday, December 16, the Federal Reserve Open Market Committee finally decided the time was right for the first rate hike in 10 years. The federal funds rate is now 0.25%-0.50%. The move was widely expected in the markets, and stock prices rallied on the news.

The case for increasing rates was based on the view that the U.S. economy has recovered from the Great Recession, unemployment has fallen to 5% and the Fed risks falling behind inflation trends. Further, a Fed rate hike could be seen by investors as conviction at the central bank that the economy is finally healthy.

The more important question now is, how often will the Fed act through 2016? We think they will move cautiously, given global economic trends and fits-and-starts in the U.S. economy. We would be surprised to see more than four fed funds rate hikes in 2016. In fact, global crosscurrents such as oil price volatility and currency trends could mean that the Fed only raises rates once or twice.

From an asset allocation standpoint, we think that bonds remain more overvalued and recommend that fixed-income securities account for a relatively low 35% of diversified Moderate portfolios. We see more value in corporate bonds than Treasuries, particularly if investors can hold financially sound corporates to term. Select short-term foreign government fixed-income securities also offer relatively high yields, though local inflation and currencies are a problem for many of these nations and a real risk for investors.

In terms of duration, we favor the short and intermediate term as opposed to the long end. Proceeds from newly matured notes can be reinvested at higher rates, assuming our interest rate outlook is on target. Within equities, we favor dividend growth stocks over high dividend stocks such as Telcos, Utilities and REITs. Preferred stock issued by financially strong companies may also be relatively attractive, as the equity component can benefit from an improving domestic economy, which is presumably the core reason for the Fed's latest actions.


Globally, stock market performance has been predictably mixed. Mature, weak currency economies are leading. Based on a snapshot taken on the final trading of November, Japan's Nikkei has delivered total return of 16% year to date, while the Eurozone in aggregate is up 14.9%. U.S. investors will recall that U.S. stocks also rallied in the Fed's easy money periods of quantitative easing.

Amid the collapse in energy and materials prices, stock markets in most resource-based economies are negative year to date, led by Brazil (-10%) and Canada (-5%). Russia, coming off its 2014 collapse with a 16% gain, is an outlier among resource economies. After Canada, our second largest trading partner China is down 6%, while our third largest partner Mexico is, like the S&P 500, up in the low-single digits.

We see a high likelihood that this pattern will be in place as 2016 dawns. But we are also feeling better about earnings next year. We look for a 10% earnings recovery for 2016, to the $132 range for S&P 500 earnings. Our forecast is predicated on easier EPS comps, as strong dollar and weak oil impacts are anniversaried, and on stabilization and recovery in the emerging world. Assuming earnings recovery, and assuming our formula of earnings trend = stock market trend proves correct in 2016, stocks could get back to winning ways in 2016.

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.