Desperately Seeking Capitulation: Our Monthly Survey Of The Economy, Interest Rates And Markets

Includes: DIA, QQQ, SPY
by: Stephen Biggar


The advance reading on 4Q15 GDP confirmed what investors feared: the U.S. economy is not immune from the turmoil impacting global commodity, energy and currency markets.

Deterioration has been significant of late in high-beta and growth-oriented indexes.

Traditional capitulation (which requires 90% or more downside participation) seems out of reach because defensive sectors are relatively outperforming.

In the immensely popular "Game of Thrones" books and TV series, the Stark family from the cold northern country has a dour family motto: Winter is coming. In the real world, or at least in the U.S. Northeast and Midwest, December and January were unseasonably mild. February's cold and snow have brought back some of the shiver, and that is usually enough to send energy prices moving higher - but not this year.

In 2015, stocks sold off in January only to rebound in February. This year, the stock-market misery has intensified in the second month. Energy prices cannot catch a bid; and until energy prices at least stabilize, investors seem determined to keep pressure on stocks. The economic environment, while showing challenges, seems out of whack with the intensity of negative stock market sentiment.


The advance reading on 4Q15 GDP confirmed what investors feared: the U.S. economy is not immune from the turmoil impacting global commodity, energy and currency markets. U.S. GDP grew just 0.7% in 4Q15, below our optimistic 1% call and the 0.8% consensus forecast. Slight growth in 4Q15 GDP was attributable to still-solid personal consumption expenditures, along with modest spending on housing and a positive contribution from the Federal government. GDP grew 2.0% in 3Q15. Growth slowed in 4Q from 3Q because of falling corporate capital spending, weak exports and higher imports, and reduced wholesaler inventories as distributors worked down their stockpiles.

The gulf between the consumer economy and the industrial economy remains significant. Personal Consumption expenditures (PCE) increased 2.2% in 4Q15, backing down from 3.0% growth in 3Q15. PCE growth in 4Q was led by goods, while services growth was modest. Residential investment was up a healthy 8.1% in 4Q15, as consumers continue to buy homes. Federal government growth, led by defense spending, overcame declines at the state and local level.

But outside of consumer and government, the industrial economy was weak in 4Q. Non-residential fixed investment, a proxy for corporate capital spending, inched up just 0.2% - after growing at an average mid-single-digit pace for most of 2015 and at high single digits across 2014. Exports declined by 2.5% in 4Q15, the first negative reading since weather-impacted 1Q15. Imports edged higher despite lower oil prices.

For all of 2015, real GDP increased 2.4%, similar to the growth rate attained in 2014. While the simple average of four quarterly GDP changes for 2015 would suggest growth closer to 1.8%, real GDP growth for the year is measured as the percentage change in the dollar value of U.S. GDP, which reached $18.13 trillion as of year-end 2015.

For 2016, and despite what will likely be an uncertain first quarter, we continue to model growth in line with recent year trends. That would put growth in the 2.5% range. But to get there we will need to see some stabilization in global currencies and commodities, and most likely in the stock market as well.

Although it seemingly took years for the U.S. Federal Reserve to adapt more restrictive monetary policy, investors now widely believe the Fed is no longer in tightening mode and that this really might be a "one and done" cycle. While it is too soon to determine if that is true, we certainly do look for the Fed to move in the near term.

When the Fed first hiked the funds rate and the discount rate by 25 basis points at the December 16 FOMC meeting, markets were shaky but still seemed to be in recovery mode from the August-September selloff. Now, investor fears of Chinese recession and further declines in energy and commodity prices are overwhelming any positives in the U.S. economic picture. Investor sentiment is so bad that you might have thought the Bureau of Labor Statistics announced an 8.9% unemployment rate last week, not a 4.9% rate.

As we noted a month ago, the short end of the curve is in a completely different space compared with the long end. The three-month bill yield is at 0.26%, up from 0.18% a month ago and zero a year ago.

Prospects for the first Fed rate hike in 10 years allowed longer-maturity bonds to stabilize. But as global fears have intensified, Treasury bonds have soared and long bond yields have tanked. From November through January, yields on 5-, 10- and 30-year Treasuries were higher than they were a year earlier. But long yields are now once again lower than they were one year ago.

The two-year yield, which was roughly double its year earlier level two months ago, is now level year-over-year. The yield on the 30-year bond is 40 basis points above its year-ago level. The 10-year yield has declined 40 basis points in one month and is now 23 basis points below where it was in February 2015.

At the beginning of 2016, Argus Investment Strategy forecast that the Fed would engage in four quarter-point hikes, with each occurring at every other of the eight FOMC meetings scheduled for 2016. Given worsening global concerns, however, the Fed will likely be much slower to act and may in fact have already moved to the sidelines.

This 4Q earnings season, companies are not just reporting challenging results. They are girding their loins for what looks to be a persistently turbulent operating environment. With about 64% of S&P 500 companies having reported, individual company earnings for 4Q15 are down about 4.5% on average compared with calendar 4Q14. Calendar 4Q15 EPS for companies outside the energy sector, on the other hand, are up about 2.3% year-over-year. And on a market-cap-weighted basis, overall S&P 500 earnings are positive both including and excluding energy earnings - signaling that investors are huddling in mega-caps.

The U.S. consumer has been a bastion of strength, and Consumer Discretionary 4Q EPS is up over 20%. Telecom Services has also been strong, while most other sectors are either up or down by a percentage point or two.

For calendar 4Q15 to date, revenue on averaged has declined 4.8% year-over-year. Most companies with meaningful overseas exposure have reported repatriation-related currency headwind of 5%-15%, with a median of about 8%. That suggests that the bulk of the top-line decline for 4Q15 can be explained by unfavorable currency repatriation.

As expected, energy earnings are dragging down an otherwise slightly positive earnings environment. The surprise is not that bad Energy earnings have been joined by bad Materials earnings, but that any company at all can grow EPS in this fraught environment. While we look for a 10% earnings recovery for 2016, that outlook could prove problematic if spring does not bring signs of recovery and growth in emerging economies. 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.


Stocks also declined in the January 2015, by 3%. But they bounced back in February 2015 and at this time a year ago were down just 1%. That seems a distant memory. Our aggregate of equity indexes is down 10% year-to-date. Bluechip stocks are in correction mode, having declined at least 10% from their recovery highs of October (following the August-September selloff). While January was bad, February is turning out worse for stocks in general and for growth names in particular.

Deterioration has been significant of late in high-beta and growth-oriented indexes. The Small-Cap Russell 2000 is officially in bear territory, and Nasdaq is knocking on the door. Wilshire Large-Cap Growth is now in line with Wilshire Value, with both down more than 9.5% year-to-date.

Fixed income has experienced accelerating safe-haven momentum, primarily for Treasury bonds and investment-grade corporates. Speculative grade bonds continue to fall, particularly in the Energy sector.

Last year a down January presaged a down year. Investors are hoping stocks can avoid a repeat this year. There are bargains among the wreckage, but no one wants to find out the hard way that stocks are still a falling knife. Negative sentiment in the stock market has been so intense that wishful bulls are calling it a sign of capitulation. The problem is that not every stock is being sold, which usually is considered a requirement for classic capitulation. Telecom Services and Utilities are both positive year-to-date. Unfortunately, these sectors represent less than 6% of total S&P 500 market capitalization.

The worst sectors are the growth stars of recent years: Healthcare, Technology, and Consumer Discretionary. Financial Services, which was finally getting a lift on prospects for higher U.S. interest rates, is now one of the worst sectors year-to-date.

If bulls are looking for any sort of consolation, they can start with what have been the worst sectors since oil started falling and the dollar started rising: that is, the Energy, Materials, and Industrial sectors. In just the past month, the four economy-sensitive sectors cited above (Healthcare, Technology, Financial Services, and Consumer Discretionary) have declined 7.4%. By contrast, the Energy, Materials, and Industrial sectors have declined just 1.8% in the past month. Investors are now systematically going through and selling everything left with value; pretty soon, there will be nothing left to decimate. More than some grand capitulation, this sector-wide selling may be a sign that the market is preparing to form a bottom.

Relentless downward pressure on stock prices is hitting every sector, but of course not hitting every sector equally. As expected in a scared market, defensive and income names - which were completely out of favor as the Fed prepared for its first rate hike late last year - have cycled back into favor. The 180 degree turn in investor risk appetite is reflected in monthly changes in sector weights, and is even beginning to turn up in annual changes in sector weights.

One of the more notable changes in stock investing in 2016 has been sudden loss of appetite for Healthcare stocks. The Healthcare sector weighting is down 50 basis points just in the past month, to 14.7%. Another sector that has fallen from grace is Financial Services, with a weighting within S&P 500 of 15.9% - down from 16.5% a month ago.

Where did that sector weight go? Consumer Staples was the chief beneficiary, gaining 50 basis points of sector weight to 10.6% in just the past month as investors hunkered down in familiar mega-cap names such as PepsiCo and Kimberly-Clark and Campbell Soup. Utilities also added 30 basis points - a huge move for a sector with just a 3.0% weighting and lately less than that. Telecom Services, another income sector, is also rallying.

Year-over-year, major themes continue to prevail, with Energy losing weight and the Consumer sectors and Technology gaining weight. Healthcare, notably, is no longer growing year-over-year; the bull run in this sector may finally be exhausted after seven years.

Every index in our global survey is negative. At the same time, and similar to our sector observations, national stock markets that were weakest in 2015 are now relatively outperforming the markets that were strongest in 2015.

For example, a persistent theme last year was weakness in BRICs and in resource economies relative to mature, industrialized economies. While energy prices remain weak, relative stock market performance has flipped over. So, for example, mature stock markets are down 9% year-to-date. That is worse than the 6% decline for resource economy stock markets. And last year, Americas underperformed because of Canada and Brazil. In 2015, Americas is down less than 5%, as resource economies (particularly Canada) show relative strength. Unless commodities and energy really fall hard from current levels, we would expect this relative outperformance to persist.


When stocks rise, they tend to rise in all different markets differently, with stock and sector gains sometimes showing no real correlation to other sectors and stocks with similar economic sensitivity. When stocks fall hard, unfortunately, they tend to correlate to the downside. At the same time, traditional capitulation (which requires 90% or more downside participation) seems out of reach because defensive sectors such as Utilities, Staples, and Telecom are relatively outperforming.

But what if another kind of capitulation, more systematic and piece-meal, were taking place? The market crushed certain resource-sensitive regional markets and sectors last year, all impacted by falling commodity and energy prices. This year, many of those regional markets and sectors are relatively outperforming while Mr. Market crushes formerly strong sectors and mature economy markets.

Optimistic bulls interpret this to mean that soon, there be nothing left to crush. Our technical work indicates signs that a bottom could form. But until the selling stops, few want to stand in the bear's way.

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.