With five inbound lanes, including a state highway, a connector to an Interstate, and Main Street changing from two to one way, everyone passing through my hometown’s “five points” intersection needs to pay attention to the signals.
Likewise, the stock market is in an unusual situation. The news seems to be all over the place on its future, and there’s talk of an imminent global recession. However, most indicators of US economic activity remain positive, and there are signs that the European economy is following right behind.
Stocks can be a barometer of future economic conditions, and stock market declines precede most recessions. But they don’t always portend such trouble. Put another way, bear markets have predicted eleven of the past seven recessions.
So, is the market going up or going down?
Yes.
Increased volatility can signal a market top, a prelude to a major selloff in stocks. By one measure , volatility doubled last August when the Chinese announced their changed growth strategy. The same measure doubled again since the first of the year as global growth concerns increased on the back of falling oil prices.
Trying to make sense of all the divergent signals is like selecting a political leader. In what or whom do you trust? In a political year like this one, trust is often a criterion for voters. It’s also a concern for investors. Unfortunately, it’s often difficult to discern which news is relevant, fundamental and important versus that noise which is irrelevant, curious and distracting.
A good example of mixed signals: With over 85% of S&P Company earnings reported this earnings season, Revenue Growth and Earnings Per Share Growth are both negative, both sitting at -3.8%. It’s easy to make a negative case given these numbers, but is it truly relevant?
Two-thirds of all companies beat earnings estimates and almost half beat on revenues, too. Removing just one sector (energy) representing just 6.5% of the index, is like applying an absolute return to the growth numbers, flipping them to solid positives.
From an economic standpoint, the primary issues haven’t changed for over a year. Oil prices and emerging markets are the primary factors driving uncertainty. Oil and other commodities are intrinsically linked to the markets we call emerging: countries with economies still building infrastructure and a middle class society.
In the states, regional declines follow the oil and energy boom and bust cycle, with Alaska, North Dakota (18,800 jobs lost in 2015), West Virginia (11,800) and Wyoming (6,400) in recession. During the oil price collapse of 1985-86, energy states including Texas experienced local recessions. But Texas now has a very diversified and growing economy, in spite of the energy sector drag.
Globally, the economies selling energy and other commodities are also suffering. Brazil, Venezuela, Russia and others depend on exports of raw materials, and their biggest customer, China, is cutting back. Saudia Arabia, the world’s largest oil producer is capable of slowing the oil glut, but refuses to cede market share to others. (Click here for our recent Supply and Demand video discussing that issue.)
News related to oil prices is indeed relevant, fundamental and important in these areas. Elsewhere? Not so much. Low energy costs help almost every other market sector. Furthermore, I believe that new extraction techniques have significantly and permanently altered the world energy market supplies.
Less important, in my opinion, is all the central banker activity on which the markets seem to pivot dramatically. My contempt is not directed toward the specific monetary policy choices made by the FED or any other central bank. They have an important role, but in recent years their role expanded beyond banking, bordering on moral hazard.
Businesses and individuals alike are hoarding cash as a result of the 2008 financial crisis, and no amount of cheap capital is going to stimulate them to invest or spend it.
Even less important to businesses are the politicians. Politicians can change the rules of the game, but unless they shut down the game altogether, companies will figure out how to succeed in virtually any environment. It would be good for America if the next wave of political leaders includes some that have business backgrounds.
In prior periods of “sideways” movement, company selection, or what we now call active management, often proves its mettle. Investing in good companies at home is challenging. Index or passive investing does not differentiate between the good and bad companies within the index. When the signals aren’t clear, it is a good time to understand why each particular investment is included in a portfolio.
Do commodities have a role to play? Of course! At low prices, companies that produce the commodities earn less money per unit sold. They can even lose money and go bankrupt, which is what we expect will happen with the high cost oil producers. That’ll be one of the key factors indicating a bottom of the oil cycle, and possibly a turning point from a sideways and highly volatile market into a more consistently positive, climbing market.
In the meantime, the riskiest assets in a diversified portfolio are likely to experience high levels of volatility, while there is a possibility that even the most conservative investments are pressured.
I know my way through the five-points intersection, having entered and exited every possible way. But it is always a good idea to watch out for other drivers who might not be paying attention or miss the signals altogether. No point in getting blind-sided by a distracted driver!
Likewise, use caution: unanticipated outside forces might impact investment portfolios. Balanced, diversified portfolios, spread across several asset classes can help withstand the unexpected.
For our clients, we maintain a constant vigilance while steering them in pursuit of their financial goals.
Investing involves risk including loss of principal. Asset allocation and diversification does not ensure a profit or protect against a loss.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
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