As We Enter 2016 Investors Seem To Be Assuming The Worst

January, 2016
S&P 500: 2044
OUTLOOK MEMORANDUM
As We Enter 2016 Investors Seem To Be Assuming The Worst

Since last spring, investors have had to sort through the implications of a tightening Fed in the face of an easing European Central Bank, a strong dollar, falling oil and commodity prices, and the perceived slowing growth in China. All this uncertainty has produced an investor consensus that is fearful of a deflationary spiral, based on expectations that the dollar will keep rising in 2016, the Chinese economy will keep slowing, and the price of oil will keep falling. While the consensus may be right, we think other more positive outcomes are at least as likely. As we discuss, the dollar may decline over the course of this year, oil prices may rebound, and Chinese economic growth may accelerate. Each of these would boost US corporate earnings and investor psychology, and thus help to produce a more favorable year for US stocks than many now expect.

Many years ago, contrarian investor David Dreman wrote a classic book titled “Contrarian Investment Strategy” in which he detailed the psychological reasons investment markets work the way they do. He explained that human brains are quite efficient at doing linear, or sequential, reasoning; most people can easily figure out that when they are building a house they need to put in the foundation before they construct the frame of the house. But he went on to argue that our brains are not well-equipped to perform what he called “interactive reasoning”, by which he meant we have difficulty determining likely outcomes when there are multiple independent or inter-related variables. Unfortunately, most investment decisions require this type of reasoning, and investors understandably feel insecure about many of the investment decisions they make. Dreman then described how even when simple linear reasoning is involved, humans are very susceptible to having their opinions affected by the actions of those around them. So, when they are faced with interactive decisions about which they already are insecure, investors are especially susceptible to the herd mentality that often characterizes markets.

2015 was a very complex and difficult year for investors as they tried to sort through the implications of changes in US and foreign monetary policies, currency changes, falling commodity prices, developments in China, and the effects of these on the emerging economies. Each of these is a complex subject, and how they are interacting to affect economies, markets, and companies are very difficult calculations. It is conventional market wisdom that “markets hate uncertainty”, and there has been more than enough uncertainty to go around. The frustrating aspect as we proceeded through 2015 was that it seemed as if investors were dealing with the uncertainties by assuming that the worst case, or near-worst case, outcome would result in each situation while ignoring the positive developments. Conse-quently, a consensus formed around the exaggerated fear of a return to worldwide deflation.

As we enter 2016, all of these important issues remain with us, and there is little to suggest that the uncertainty will lift anytime soon. Yet, we question whether the Fed’s expected tightening soon will push the US economy back into recession as so many seem to fear. Similarly, is this US monetary tightening in the face of European monetary easing destined to push the US dollar to even greater heights in 2016, thereby further hurting US exports and US corporate earnings, depressing oil and other commodity prices further, and threatening financial crises in emerging economies? Will oil prices remain under extreme pressure, or will the self-corrective process triggered by falling prices that already has begun to reduce US oil production allow oil prices to rise during 2016? And, will the growth rate of the Chinese economy slow further, adding to investors’ deflationary fears, or will its growth rate surprise investors and improve in 2016? If the current negative consensus is too bearish, then as the year unfolds, there is the potential for the stock market to perform better than the nominal gains most are currently forecasting. The remainder of this paper presents our views on each of these key issues.

On Fed policy, we think the Fed acted wisely in December in beginning to raise short-term interest rates. By our analysis, the recovery of our economy from the Great Recession had surpassed the historical point at which Fed tightening had begun in the past. With significant liquidity remaining in the system, a measured tightening should not do great harm to our economy and may even increase confidence by showing that we can continue to grow without special monetary assistance. Despite plunging oil prices, core inflation rose to a 2% rate in 2015, and with unemployment down to 5%, wage increases could push core inflation above 2% in 2016. We support Fed tightening despite our understanding that the strong rise in the dollar over the past eighteen months and the widening of credit spreads in the bond market represent other forms of restraint on the economy, and we do not see the Fed’s actions as likely to break the economy’s back.

We also note that despite constant concerns about US real economic growth, the US economy likely grew at a 2½% rate in 2015, slightly better than its 2.4% rate in 2014, in spite of the drags from collapsing oilfield investment and the strong dollar. And, while households did not spend as much of their savings from lower oil prices as had been expected, private consumption did improve to about a 3.1% growth rate in 2015 as auto and home sales improved. Given that employment should continue to rise in 2016, that wage increases should accelerate, and that interest rates will remain low, it is reasonable to assume our economy will continue on a growth path of about 2½% in 2016.

Although this economic recovery has gotten little respect, it has been significant. It is 6½ years old and soon will be the fourth longest in US history. US GDP and personal income are at record highs, about 25% above the peak levels in the previous cycle, as are corporate profits and household net worth. The 5% unemployment rate is lower than it has been two-thirds of the time since World War II.

A year ago, analysts forecast that S&P 500 earnings in 2015 would rise by 6.5% to $126.50. But, primarily due to the drop in oilfield earnings and the strong dollar, 2015 earnings likely fell by 1% to about $118. Consequently, at its year-end value of 2043.94, the S&P 500 finished 2015 with a Price-To-Earnings ratio (P/E) of 17.3. The media is filled with people pointing out that the long-term average PE of the S&P 500 is below 15, and therefore, that stocks now are “overvalued”. We see such statements as misguided for several reasons. First, as indicated above, the $118 of earnings were depressed by short-term factors such as the dollar and the oil price. On a “normalized” basis, S&P 500 earnings likely were about $125. Markets generally look through short-term factors and on this basis the S&P 500 had a year-end PE of 16.4. In addition, in every economic cycle in the post-World War II era, S&P 500 earnings have risen above their long-term 7% growth trend-line prior to the end of that cycle. Currently, they are 10% below this trend-line. While it is not a certainty that this pattern will repeat during this cycle, this pattern provides strong historical support for viewing 2015 earnings as “depressed”, especially when we know the oil and currency drags can reverse over the next few years. Second, and most importantly, the S&P 500 PE historically has ranged widely between 8 and 25, depending on a variety of factors such as inflation, interest rates, and the returns being earned by corporations. Thus, the long-term average PE generally has been an unreliable standard to use in judging stock market valuation, especially now when most of the factors underlying the PE point toward the PE returning to the upper portion of the historical range.

The trade-weighted dollar has appreciated by more than 20% over the past eighteen months. This has had very significant economic and investment market effects. First, since oil and other commodity prices generally move inversely with the dollar, the rise in the dollar has been very much interrelated with the drops in oil and other commodity prices. It also has made US exports, and those of other countries like China that had their currencies tied to the dollar, less competitive in world markets. We witnessed an example of this when one of our companies had to stop selling its US-made x-ray equipment in Japan last year after the dollar’s 23% rise versus the yen made this product too expensive to sell in Japan.   In addition, a strong dollar causes the foreign earnings of US corporations to be translated into fewer dollars, depressing reported earnings. Last April, following a 14% rise in the dollar over the prior nine months, we wrote that the strong consensus that the dollar would continue its rapid rise led us to think that the bulk of the dollar’s rise might have been behind us. While the dollar continued to rise during the last nine months of 2015, its appreciation was at a much slower 5% rate, signaling a loss of upward momentum.

Yet, most of the commentary on the outlook for the dollar in 2016 focuses on the interest rate increases the Fed is expected to implement against the interest rate cuts expected from the European Central Bank (ECB). These commentators state, as if it were fact, that with the Fed tightening and the ECB easing, the dollar must continue to appreciate in 2016. This is a significant part of the current deflationary “bear” case that is so widely supported.

The problem with this argument is that it is not supported by history. We looked back at the last five Fed tightening cycles since the early-1980s. Since the euro and the ECB did not exist in the 1980s, we used German monetary policy as a proxy for European policy. We found that there were two Fed tightening periods during which German monetary policy was being eased (1994 and 1986-1987). In other words, during these two periods US rates were rising while German rates were falling, just as is expected to be the case this year. During both of these periods, the trade-weighted dollar declined in value; so clearly, the dollar has not blindly followed relative interest rates.

Our study showed that oil price trends were far more important to the dollar than relative interest rate trends. In four of the five Fed tightening cycles, the dollar fell when oil prices rose, or rose when oil prices fell. Thus, we think the trend of the dollar during 2016 will be more dependent on what oil does than on the Fed’s tightening while the ECB eases.

Oil performed much worse in 2015 than we expected. Despite the price of a barrel of oil rallying from $43.88 in mid-March to $61.43 in early-June, it finished the year at $37.04 as the glut continued. This was despite cutbacks in oil drilling that exceeded our expectations so that US oil production declined by about 300,000 barrels per day (bpd) from its peak rate in the spring, and a stronger-than-expected 1.6 million bpd increase in worldwide oil demand. The oil glut did not diminish in response to these developments because, unexpectedly, Iraq increased its oil production by about 800,000 bpd and Saudi Arabia raised its own production by close to 500,000 bpd.

This extreme weakness in the price of oil, and in the prices of other commodities, played a big part in fanning the deflationary fears of investors since last spring. But, we think investors may be proven wrong in seeing weak commodity prices as a signal that the world economy is headed for a recession. That might be true if the recent weakness in commodity prices were caused by falling demand. Currently, however, the major economies all are on growth paths and the demand for most commodities is rising. This cycle’s commodity price weakness reflects excess supply resulting from significant new productive capacity having been brought on line. We think investors who interpret weak commodity prices as an indication of approaching worldwide recession and deflation will be incorrect unless there is so much excess capacity that it results in major bankruptcies and financial crises.

One good sign is that even many bearish forecasters expect a small rebound in the price of oil during 2016. Such a rebound would be very meaningful in relieving some of the worst deflation fears as well as in reducing the likelihood of the dollar rising much further, or even in making a decline in the dollar likely during this year as per our discussion earlier on this page. Such developments would be viewed as providing boosts to the US economy and S&P 500 earnings. Thus, we think the current bearish consensus expectation that Fed tightening as the ECB eases assures a further rise in the dollar is far from certain. If the dollar does not rise, the negative implications that rise would have for our economy, corporate earnings, and commodity deflation may be avoided, and a more favorable set of developments may even occur.

Another focus of investor concern continues to be about the slowing growth in the Chinese economy. Over the past four years China’s reported real economic growth rate has slowed from 10% to 7%, and many think even the 7% figure is overstated by the Chinese government. The slowdown in Chinese growth accounts for much of the excess supply currently depressing commodity prices and fanning the fears of deflation. Furthermore, until last August, the Chinese yuan was pegged to the US dollar so that the rise in the dollar also had boosted the value of the yuan versus other currencies. This had made Chinese goods more expensive on the world market. Additionally, money was flowing out of China, and the government’s efforts to maintain the peg against the dollar had made it difficult for the Chinese government to produce the desired level of money supply growth. These problems led it to loosen the yuan’s peg versus the dollar in August.

Notwithstanding investor skepticism about the accuracy of Chinese economic statistics, it is worth observing that Chinese real GDP growth has run at a 7% year-to-year rate through the first three quarters of 2015, with the fourth quarter yet to be reported. Thus, according to official statistics, growth has stabilized at around a 7% rate in contrast to most commentary that talks about ongoing slowing growth. In November, Chinese President Xi Jinping announced a growth target for the 2016-2020 period of 6.5%, suggesting that the Chinese government expects some further slowing over the next five years. Although markets interpreted this growth goal bearishly, we think investors would be quite pleased if such growth were achieved over the next five years.

In addition, we think Chinese growth in 2016 may be better than the bears expect. The chart below shows that there has been a close relationship between the growth rates of Chinese real GDP (green line) and Chinese M-2 money supply (blue line), with Chinese real GDP growth following money supply growth with a lag of about three months. Note in the orange circle at the right that since the summer money growth has risen from a 10% rate to almost 14%, suggesting that an upturn in real GDP growth is coming. The black and red lines show two other monthly indicators of Chinese economic activity. The black line is the Citibank Chinese Economic Surprise Index, confirming that since money growth has picked up, a broad range of Chinese economic indicators have been coming in better than expected. Similarly, the Markit Chinese Purchasing Managers Survey (red line) has improved in recent months. These suggest to us the potential for Chinese economic growth to surprise positively as we proceed through 2016.

In summary, the markets enter 2016 with negative expectations for Fed policy, the dollar, oil prices, and Chinese growth, seeing these developments as dangerously deflationary. While we are respectful of these concerns, we have explained why we think the consensus view may be too bearish on each of these issues, and that 2016 may be a better year for investors than many now expect.

Graph