As unrelentingly negative as this January has been, the prevailing sentiment appears to be weary resignation rather than panic. The typical pattern we have seen over the course of this recovery is for a sharp and swift drawdown followed by an equally swift recovery. That pattern probably drew its strength from complacency that the Fed put remained firmly in place. A kind word from Bullard here, dulcet tones from Evans there and presto! No need to focus on pesky things like earnings and free cash flow when Bernanke’s got your back.
The current climate seems driven by different considerations. The put, for all intents and purposes, is over. Would the Fed consider its options if this pullback descends into bear territory? Possibly, but in our opinion an emergency rescue could quite plausibly inject a higher dosage of fear into the market and make things worse. A more likely outcome, we believe, is that stocks will lurch both ways with higher than usual volatility – a slow burn scenario rather than a collapse-and-recover event.
A Tale of Two Pullbacks: 2015-16 vs. 2011
There are some useful insights to be drawn from a comparison between the current environment and the last US market correction, in the summer of 2011. The chart below compares the two pullback events.
The 2011 event was deeper than the present event (to date). It was also shorter. Most of the damage was done in the space of ten trading days from July 27 – August 10, during which time the index gave up 15.9 percent (see rightmost area of the chart above). Stocks then lurched sideways in a concentrated series of relief rallies and selling waves until a final spasm in early October closed out the event at minus 19.4 percent from the April 2011 peak, just shy of a bear market. During the height of the pullback in August there was genuine panic trading: the index lost more than four percent in a single trading session four times between August 4 – August 18, and there were also four relief rallies of four percent or more in the same time period.
The most interesting thing about the current pullback – or to be more precise the current stage of what is now an extended single event pullback beginning last August – is the lack of breathing space for a relief rally. As we write this on Friday morning the index futures signal a large jump at the open, which may or may not translate into a rally by the close. Sentiment has been unrelentingly negative. But – and here is where we draw the key distinction between today and 2011 – there is no panic in the streets. Sure, there have been several days of two percent or more down, and intraday volatility has been wider still. But there is a world of difference between a close of two percent down and one of four or five percent down.
For that matter, the magnitude of the event is more contained than 2011. While other equity asset classes have moved into bear territory, the S&P 500 remains in mild correction territory, 12.7 percent below the all-time high set last May. And volatility has not spiked to the same degree it did in the earlier event. The chart below shows the trading pattern of the CBOE VIX index from 2011 to the present.
VIX spikes in the current pullback have yet to reach the peaks attained in 2011. It is also interesting that volatility during the recent phase of the pullback is far short of the brief spike last August. This again points to the idea that what we have now is a slow burn of negative sentiment rather than panic. We do expect, though, that volatility is likely to stay at elevated levels relative to what it was in 2014 and the first half of 2015.
But volatility swings both ways. This observation brings us back to the point we made in the second paragraph above. Higher volatility and periodic swings up and down make a more plausible scenario for 2016 than the collapse-and-recover pullbacks of recent years. Without the Fed as a backstop the market should be driven by corporate earnings as well as X-factor events around the world. Currently we see a negative tilt to X-factor risks, but that relates only to the ones clear and present in today’s environment. “Unknown unknowns” could fan the negative flames or turn them positive. Time will tell, and the ride will probably be bumpy.
Credit is due to the Yellen Fed for setting clear expectations and then delivering on them. Markets expected a 25 basis point increase in the target Fed funds rate, accompanied by an accommodative policy statement, and that is just what they got. “Monetary policy remains accommodative” was the key phrase in that statement, underscoring the reality that data trumps calendar when it comes to the size and timing of policy actions in 2016.
Nonetheless this is something of a brave new world, a definitive coda in the policy-driven economy of the past seven years. There are plenty of risks as well as opportunities in the year ahead. Here are five observations informing our thinking as we see out 2015.
#1 – Sell the Rumor, Buy the News
Counter-intuition was a theme in many asset markets in the immediate lead-up to and aftermath of the 12/16 announcement. Asset classes that typically fare poorly in rising rate environments, such as precious metals and high dividend stocks, were strong outperformers on the day. The dollar was mostly muted against other major currencies. Most likely, expectations were largely baked into prices well in advance of Wednesday and thus the news itself gave little reason for further action. If anything, the trading dynamic Wednesday afternoon was characterized by some holiday bargain shopping in recently oversold corners of the market.
#2 – Ignore the Short Term Noise
We expect to see higher than average volatility prevail through the remainder of the year, and we attribute this to little more than the residual noise following a major policy event. The S&P 500 opened Wednesday morning at 2043 and closed Thursday afternoon at 2041, with this net return of zero punctuated by an aggregate spread of three percent over the two day period. The two year Treasury yield is at a five year high, while the ten year still sits below its average over the same period. We do not see much in the way of meaningful trend signals coming from the market until this residual froth settles, and recommend riding out the volatility to the extent possible.
#3 – Inflation is the New Jobs
The big event on macro calendars for the past several years has been the jobs report – “where for one brief moment the interests of Main Street, Wall Street and Washington align” as the Wall Street Journal likes to say in its first Friday of the month live blog. We’re not sure that the mid-month Consumer Price Index report will earn its own following of econo-journalist fanboys and fangirls next year, but it should. Assuming that the prevailing employment trend doesn’t go into sharp reverse, we expect that prices will be the key variable influencing the size and timing of future Fed action. The FOMC policy statement released Wednesday made repeated mention of near-term and long-term inflationary readings and progress towards the 2 percent target. Although reasonably balanced, we give somewhat more weight to the possibility for a faster than expected pickup in prices (outside the volatile energy and food sectors). It may be time to dust off those TIPS for portfolio inclusion.
#4 – The Fed and the Spread
While the Fed has occupied the spotlight for much of 4Q15, the real action in 2016 may be less in future rate hikes than in risk spreads between Treasuries and other fixed income asset classes. It is always worth remembering that risk spreads have a direct effect on household financial decisions through mortgages, personal loans and the like. High yield spreads have taken a hit recently, in part due to another wave of commodity price slumps, but we would be more concerned about investment grade spreads as a wild card that could inflict collateral damage on other asset classes. The Office of Financial Research (OFR), an independent office of the Treasury Department whose annual Financial Stability Report should be required reading for anyone invested in global asset markets, calls out “elevated and rising credit risks in the US nonfinancial business sector” as a key area of potential weakness. US companies have benefitted greatly from historically cheap borrowing costs in the past five years, serving up dividends and buybacks and other things investors hold near and dear. Those good times may be nearing an end.
#5 – Commodities: More Pain, but Stable
Speaking of commodity price slumps, we have listened to a number of quarterly earnings calls from energy companies over the past couple months. In expressing their views on 2016 the dominant theme is an impersonation of Rocky 2’s Clubber Lang: “My prediction? Pain”. The supply-demand imbalances that have sent crude prices down to seven year lows this year will not work themselves out overnight. Nonetheless, the impact of US E&P downsizing should start to be felt and inventories should gradually recede from their recent record levels. Demand should improve as well, with China a likely buyer of more oil at lock-in price levels for its strategic petroleum reserves. While we do not see a return to fortune and favor for commodities in the near term, we also do not necessarily see commodity prices as a key risk story for 2016. In our most-likely scenario model we have modestly narrowed our crude price range to $40-55 from $40-60.
There are plenty more blips on our radar screen: emerging markets, corporate earnings, geopolitics and US elections – among others – are all in the mix, set to surprise, befuddle, delight or antagonize investors in the year to come. We will have plenty more to say about all of them. Happy holidays.