A Wicked Wind Will Blow In 2016

money mazeMy Comments: Are you wondering about your investments going forward?

This will give you pause.

Dec. 4, 2015 by Bret Jensen

The market had a huge rally to end the week and clawed back Thursday’s large losses. The trigger for the rise was a better than expected November Jobs Report that also had an upward revision for October, which brought that number up to almost 300,000 jobs created in the first month of the fourth quarter. This brought certainty that the Federal Reserve will raised rates in less than two weeks for the first time since 2006. Investors, at least for Friday, seemed to be okay with this upcoming action.

SPY 2015

It would be nice to end what has been a challenging 2015 for investors with a nice Santa Claus rally. It would also give me a nice little rise to achieve my goal of a 30% cash allocation in my portfolio by the end of the year. I think the chance of a significant correction is higher in 2016 than it has been in many years. The obvious reason for this is the liquidity provided by the Federal Reserve over the past half dozen years has been a key driver of the market rally since 2009, how much of the rally it has been responsible for is anyone’s guess. As you can see from the chart above, the S&P 500 has done basically nothing since the central bank completed QE3 in October of 2014. There are three key reasons why I have this pessimistic outlook.

Lack Of Earnings:
2015 will go down as the first year since 2009 that profits within the S&P 500 will have declined year-over-year. The key factors to the lack of earnings growth are tepid global demand, the collapse of profits from the commodity & energy sectors and the strong dollar. With Japan back in recession, Europe muddling along while trying to deal with the largest migration wave since WWII, real problems in the emerging markets like Brazil, and with China growing much slower than it has in 25 years, it is hard to see worldwide demand being much more than it was in 2015, which were the lowest levels since 2009.

The dollar is up ~12% against the euro in the last year. It is up against other major currencies this year as well. This has severely crimped revenues and earnings for American multinationals. Given our central bank is just starting to tighten as European and Japanese central banks are still providing abnormal amounts of liquidity to their economies; this strength should continue into 2016.

It is also hard to see commodity and energy prices recovering with tepid global demand, a glut in capacity and a strengthening dollar. 2016 should be another year where the best case scenario sees earnings growth in the low to mid-single digits with the possibility that earnings will be flat or down slightly again next year. Given stocks are selling above historical valuations, this could make the market vulnerable to a significant pullback in 2016.

Key Signs Of A Top:
M&A activity by dollar volume has set a record in 2015. This is a classic sign of a market top. Peak previous levels of M&A activity occurred in 1999 and 2007, right before major breaks in the market. This level of M&A activity says companies do not have the confidence to use these funds to expand operations, build new capacity or are not finding good organic growth opportunities. Companies bought back almost $4 billion a day of their own stock in the third quarter. Stock buyback activity is also near record levels, another traditional sign of a market top.

In addition, TrimTabs recently came out with a report on insider selling in November, which saw some $8 billion in insider sales. This is $2 billion more than September and October combined. It also is the highest level since May of 2011, just before an almost 10% slide in the market over the next three months. Watching insiders engage in massive selling while their companies are buying back stock in record amounts does not strike me as a positive sign for the overall market or economy.

Collapse In Energy and Commodity Markets:
As my real-time followers that get my daily instablog know, my biggest worry for 2016 is the continuing collapse in energy and commodity complexes and their impacts on the credit markets. S&P put out a recent report noting that in November “Plummeting oil and gas prices pushed the percentage of junk bonds trading at distressed levels to the highest since the markets were recovering from the financial crisis”.

Further “The ratings firm’s so-called distress ratio increased to 20.1 percent in November, up from 19.1 percent in October and the most since September 2009, when it hit 23.5 percent. The ratio is calculated by dividing the number of distressed securities by the total amount of speculative-grade debt outstanding.”

Oil is struggling to hold $40 a barrel level. It is hard to overstate how ugly it is getting in commodity markets. Iron prices are at 10-year lows. The falloff in demand from China (steel production is down this year which one would not expect if its economy was truly growing at the “official” seven percent GDP figure) is the primary factor along with new capacity coming on line. Copper is also at multi-year lows.

If oil & commodity prices stay at these levels, we will see significant bankruptcies in small and mid-tier energy producers. Mining concerns could be become a graveyard given their high debt levels. Commodity based emerging markets like Argentina, Brazil and Russia will also come under additional distress and increasing default concerns. Any turmoil in the credit markets tends to impact the equity markets and this is my “black swan” for the New Year.