So okay, the market is down a couple of points for 2015, and it had the worst start for a long time in the first week of 2016. Is this all that surprising after the bull run we've already had?
The main driver of the market is earnings, and these are stagnant to even mildly declining, so together with the fantastic run from March 2009, the disappointing 2015 can hardly be a surprise.
The quality of earnings isn't really top as much of it is driven not by increasing sales, but by share buybacks. Here is CNBC:
Excluding recession years 2001 and 2008, dividends and stock buybacks have represented on average 85 percent of corporate earnings since 1998, according to analysts at S&P. And stock repurchases worth almost $2 trillion have helped buoy the bull market since March 2009, according to FactSet data compiled for CNBC.
What's more, as Bank of America Merrill Lynch argued, there are other reasons earnings are suspect:
The proportion of companies beating on EPS (60%) was the highest since 3Q10, while the proportion missing on sales (59%) was the highest since 3Q12 - with the gap between the two surprise ratios the widest since 1Q09. Only Health Care and Tech saw both top and bottom line beats. While companies have been nimble about managing earnings to expectations, demand continues to weigh on sales...
Another trend worth watching: since late last year, pro forma S&P 500 EPS has exceeded reported (GAAP) EPS by more than 30%, well above the ~10% gap for most of 2013 and 2014 and the widest gap since the Financial Crisis.
The buybacks and other types of financial engineering have propped up the market. What's more? It can be argued that while good for share prices, it's bad for the economy:
- Buybacks means companies do not spend that part of earnings on stuff that actually helps sales and productivity, that is, on capital, equipment, technology, employees, training, etc.
- It reinforces the sales problem as it redistributes money from low savers to high savers, leading to a little vicious cycle, as lack of sales growth is one of the drivers of share buybacks in the first place.
The lack of investment also leads to hysteresis effects, less adoption of new technology and an increasingly older capital stock. CNBC again:
While a good low-risk bet for the C-suite, the reluctance to boost capital investment in operations, people and product has left companies with the oldest plants and equipment in almost 60 years. The average age of fixed assets reached 22 years in 2013, the highest level since 1956, according to data compiled by the Commerce Department, as reported by Bloomberg and S&P.
Then there is this:
As it turns out, the indices' performance is largely based on the extraordinary performance of just a few big stocks, like Amazon (NASDAQ:AMZN), Netflix (NASDAQ:NFLX), Facebook (NASDAQ:FB) and Google (NASDAQ:GOOG), but Microsoft (NASDAQ:MSFT) has also shown a very strong performance last year.
There is good and bad news in this. The good news is that these stocks are actually driven by increasing sales, and these increases are likely to continue for some time to come.
The bad news is that the rest of the market has done considerably worse than the indices suggest. The breadth of the market is really very small, in fact close to historic lows:
Energy and materials are obviously already in a bear market, but, especially adding the amount of financial engineering, the rest of the market isn't far off, if not already there.
The overall market is down some 10% from the highs, that's correction territory, but most stocks are down much more. In the light of that, one wonders how much further they can fall.
The big risk driving the selloff is the specter of a Chinese devaluation. No doubt, if and when this happens, this sends a deflationary shockwave through the world economy, but many stocks have already sold off to such an extent that one wonders how much of this isn't already discounted.
While there is a bit of a selling frenzy going on that can easily feed on itself, we think that rationality will return in due order. In the meantime, one has to look at what's driving this panic. That's:
- The daily yuan settlement by the PBoC (the People's Bank of China).
- The spread between the offshore (Hong Kong) yuan and the domestic yuan.
It's fairly simple, a lower settlement and a higher spread is likely to induce further selling. If they stabilize for some time, the selling is likely to dry up.
The latter doesn't necessarily mean we're home and dry, as next month we will get a figure on how much forex reserves the PBoC had to use in order to achieve such stabilization.
In December, they used well over $100B, which really is a pace they cannot sustain indefinitely. Of course, there is other Chinese data that's important. If the economy weakens further this is likely to accelerate the capital outflow.
So it's all eyes on China until further notice, and until things stabilize there, we are likely to go down further, but we feel plenty of bargains are coming up. A substantial Chinese devaluation, while rather bad news, is unlikely to produce a crisis of similar magnitude as the one in 2008.
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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.