“He alone is free who lives with
free consent under the entire guidance of reason.” (Baruch Spinoza 1632-1677)
Summary
A much needed breather appears after the early weeks
of 2016. Lower treasury yields, turbulent trading patterns, collapse of Oil
prices, and murky growth outlook all played out in the first month of the year.
As investors digest prior weeks’ events, January ends up leaving us with more
unanswered questions. Meanwhile, it is becoming a daunting task for the Fed to
defend their call of raising rates last year. The Fed’s ego /credibility
versus the soft growth reality is the illustrious debate that’s going on in
financial circles. In addition, the twists and turns of central bankers
and their desperate stimulus efforts trigger a mixed response.
Misguidance
Participants' heavy reliance on central banks (CBs)
has been well documented and clearly hits the core of the post-2008 market
behavior. At what point, are CBs going to lose their credibility or are
we at a desperate period where CBs are the ultimate last resort?
January 2016 illustrated some doubts about the Fed’s leadership, particularly
about raising rates in a less convincing economy. In fact, the health of the
economy is highly debated and contested in intellectual circles, but very weak
for pragmatic observers (early voters, as well). Others point to the Fed’s
inability to raise interest rates early, but that’s a subjective debate.
Nonetheless, if the economy is not viewed as unanimously strong and if earnings
are mostly shaky across multiple sectors (not only energy), then the markets,
participants, and the Fed need to acknowledge that reality.
Amazingly, the ECB already assured further stimulus
efforts in the desperate Eurozone economy. At the same time, negative interest
rates in Japan illustrate the ongoing desperation for finding yields and a gruesome
period of a lack of growth. Basically, investors have nearly given up on
policymakers creating growth, as that’s not an opinion but rather a fact.
Confidence building is not to be confused with real economy growth creation.
At the same
time, there is an over-reliance on CBs that are limited with their nearly
exhausted tools. During this insane period, it becomes difficult to analyze and
digest. Within this context, the Federal Reserve faces further scrutiny, mainly
for raising rates and over promising on the health of economic conditions. That
might be the ongoing theme during the rest of 2016. Interestingly, the next few weeks appear to
have less public relation appearances from CBs, which sets up a reality check
with less intervention:
“Leaving investors to their own devices for a few weeks could
also be in order given that some central bankers themselves have questioned the
potency of even more monetary stimulus. They also argue that it’s not their job
to prop up asset markets -- even if they have the reputation for doing
so….Policy makers themselves are the reason for the fewer gatherings this
month. The ECB last year decided to meet every six weeks rather than
monthly, while the BOJ cut its gatherings to eight from 14. That brought both
closer in line with the Fed, whose Open Market Committee meets eight times this
year.” (Bloomberg,
January 31, 2016)
Limited Relative Options
With yields so low, commodity cycles in shambles, and
growth rates anemic, the challenge remains for those looking to allocate
capital. Limited options have been a theme of markets as US equities looked
appealing on a relative basis. Innovation themes, such as technology and
biotech, have had a relative edge, but not all innovative ideas are seeing a healthy
appreciation of shares. With earnings' season upon us, the line between losers
and winners are being clearly defined.
In fact, the strength of the dollar, the demise of China and other
emerging markets, and collapse of oil should clearly impact most companies at
this stage. Thus, the macro events
that have played out viciously may not have been fully felt in the fundamentals
of various key companies. The
magnitude of recent macro movements should create further suspense and dictate
the narrative ahead.
Digesting Uncertainty
Much is being made about the correlation between crude
prices and the broad US stock markets. Perhaps, that is what caused a near-term
overreaction in January, where various key asset prices declined at once. This confused
the commodity cycle decline, which has taken place over four years, compared
with the stock market correction of few months is dangerous and misleading. At
the same time, the weakness in China is a bigger reflection of slowing global
growth. From Brazil to Turkey, the slowdown has been felt for several years;
thus, to claim China’s sell-off and panic as a surprise is not accurate. One
link that’s clear is between the soft demand for Crude and softer demand in
China. Surely, there is a strong link here and the markets were screaming of
this with warning.
Basically, Emerging Markets and Commodities have been
sinking together and sank even faster last month. Now the risk-reward has been
adjusted and energy companies are forced to reshape their business models.
Chinese regulators are in semi-panic mode, as investors are presented with new
opportunities and new paradigm for risk taking.
As long as investors accept the massive weakness in
Emerging Markets, then downside surprises will be limited. However, if
there is more denial about the severity of slowdown in global growth, then
downside surprises may amaze the optimists.
Article Quotes
“As such, a slowdown in the
economic growth rate of China implies a likely slowdown in increases to the
defense budget. China's military resources are somewhere between $150 billion
and $200 billion a year—far less than America's $600 billion, but far more than
any other country. When Chinese GDP growth rates approach 10 percent, so
typically have military budget increases. With a base of a $200 billion
military budget, 10 percent GDP growth translates into an annual real increment
in military resources of $20 billion each year. By contrast, at 5
percent growth, China might be expected to grow its defense budget from, say,
$200 billion to $210 billion this year, and wind up around $250 billion by
decade's end. That would leave the United States the unquestioned dominant
world military power well into the 2020s (and probably far beyond). Even if
China ultimately does approach American defense budget levels, the pace at
which it does so is important. A slow convergence gives time—for Chinese
political systems to mature, for Beijing to adjust to the responsibilities of
global leadership, and for America and its allies to respond and increase their
own defense levels if needed. Thus, annual growth rates closer to 5
percent are far less disruptive strategically than the recent norms closer to
10 percent.” (Brookings, January 29, 2016)
"During the month of January,
analysts lowered earnings estimates for companies in the S&P 500 for the
quarter. The Q1 bottom-up EPS estimate (which is an aggregation of the
estimates for all the companies in the index) dropped by 4.7% (to $27.76 from
$29.14) during this period. How significant is a 4.7% decline in the bottom-up
EPS estimate during the first month of a quarter? How does this decrease
compare to recent quarters? During the past year, (four quarters) the average
decline in the bottom-up EPS estimate during the first month of a quarter has
been 3.3%. During the past five years (20 quarters), the average decline
in the bottom-up EPS estimate during the first month of a quarter has been
1.9%. During the past 10 years, (40 quarters) the average decline in the
bottom-up EPS estimate during the first month of a quarter has been 2.2%. Thus,
the decline in the bottom-up EPS estimate recorded during the first month of
the first quarter was larger than the one-year, five-year, and 10-year
averages. As the bottom-up EPS estimate declined during the first month
of the quarter, the value of the S&P 500 also decreased during this same
time frame. From December 31 through January 28, the value of the index has
decreased by 7.4% (to 1893.36 from 2043.94)."
(FactSet January 29,2016)
Key Levels: (Prices as of Close:
January 29, 2016)
S&P 500 Index [1,940.24]
– Some signals of stabilization appear around 1,900.
Prior bottoms were 1,871.91 in September 2015 and 1,867.01 in August 2015. This
showcases that near 1,900 is where buyers and sellers continue to debate.
Crude (Spot) [$33.62] – January 20th lows of $26.19 are expected by some to be the
ultimate lows of this cycle. Meanwhile, in the near-term, reaching $40 would
set off some bullish optimist. Yet, in the big picture the demise of Crude prices
is alive and well. Below $40 still suggests distressed conditions.
Gold [$1,111.80] – A possible bottom around $1,080, but doubt remains if prices can climb
above $1,120. The multi-year bear cycle continues to stand out as multiple
false bottoms have not proven to be sustainable.
DXY – US Dollar Index [99.60] – Since November, the index has
stayed above 98, showcasing the Dollar's relative appeal that it seems to be
stable. Unless there is a major macro shift, the strength remains intact.
US 10 Year Treasury Yields
[1.92%] – Critically failing to hold above 2%, which
illustrates demand for safety as well as lack of US economic growth. The last
two months showcase increased volatility and lack of growth potential, which is
reflected in the yields.
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