Chicken Little and the Second Quarter Outlook

 

At the very beginning of 2016, it was as if someone flipped the “risk off” switch. Everything except gold and high-quality bonds retreated. Oil prices fell to $26/barrel and credit concerns came to the fore. And for the first time in quite a while, the word “recession” was thrown around with abandon in the financial news media. The sky was falling, of course.

We wrote to our clients on January 20th that investor fears were driven by four factors: currency, China, commodities and current earnings. But we asserted that an economic recession was not at all likely. And this piece bears repeating:

"Our view is that the stock market is in the process of testing support. We're guessing it will bottom at current levels or perhaps several percentage points lower. As evidence, we note a huge turnaround in stocks during today's session. The Dow, which was initially down 565 points, touched a key support level and rallied back to close down only 224 points. This bottoming process will continue over the next couple of weeks."

As it turns out, the S&P 500 Index bottomed on January 20th, although it would subsequently re-test that low on February 11th. This day also marked the bottom in oil and junk bond prices. To recap the damage, the major market averages had fallen 10-15% since the beginning of the year. By mid-February, the stock market’s all-time highs—set back in May 2015—looked pretty far away.

Since then, however, risk assets have been in recovery mode. The S&P 500 and Nasdaq are up something like 14% and 18%, respectively. The Dow Jones Transportation Average, which really struggled last year and was thought to be a harbinger of future declines, is up 16%. Ditto for the iShares High Yield Corporate Bond ETF (i.e. “junk” bonds), up 9%. Oil is trading back over $40/barrel. All this reminds us that panic isn’t an investment strategy, it’s an emotional response.

So what now? Let’s assess the four risk factors discussed earlier.

1.      Currency. The US dollar has weakened (finally) against a basket of foreign currencies, and it is now lower than it was a year ago.

2.      China. At the same time, the Chinese stock market and currency have been more stable. In other words, the worrying trends we saw in the last half of 2015 have reversed. In addition, the most recent trade-related economic data were more positive.

3.      Commodities. Perhaps the most important factor is rising oil prices. We recognize that oil is constantly pushed around by speculators. But consider the fact that the Int’l Energy Agency (IEA) predicts the global oversupply of oil will almost disappear in the second half of the year. The fact is that oil demand isn’t falling, whereas US oil production is falling.

4.      Current earnings. The combination of modestly higher oil and a weakening dollar should take some pressure off of corporate earnings as we move through the second quarter. Remember, plunging oil decimated energy sector earnings and the strong dollar hit industrials and consumer staples sectors especially hard. In addition, as pessimistic as Wall Street analysts have been over the past few months, note that corporate earnings for S&P 500 companies are expected to return to positive year-over-year growth in the third quarter. With less of a drag from external factors (i.e. geopolitics, slow economic growth in Europe), maybe we can focus on the fact that the US housing & job markets are fairly strong.  

It is our view that stocks will continue to trade with volatility because risk factors are still present. And the stock market is likely to trade in a range over the next few months as we wait for more clarity on corporate earnings, economic growth & inflation, the presidential election, etc.). But again, our research does not suggest recession is around the corner. So we offer some time-tested advice: one should avoid panic, and asses one’s investment time horizon. Those have always been good methods of fighting volatility. And once again, the sky remains intact- for the time being. 

 


*The foregoing content reflects the author's personal opinions which may not coincide with the opinions of the firm, and are subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that these statements, opinions, or forecasts provided herein will prove to be correct. Past performance is not a guarantee of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. All investing involves risk. Asset allocation and diversification does not ensure a profit or protect against a loss. Finally, please understand that–as with other social media–if you leave a comment, it will be made public.