Carl’s Corner – 2016

Carl Perthel Alt Text

Carl Perthel, CMT

Disclaimer: The views expressed are those of Carl Perthel, CMT. These views are subject to change at any time and The American Asset Management Group, Inc. (AAMG) disclaims any responsibility to update such views. These views may not be relied upon as investment advice and, because investment decisions for AAMG are based on many factors, may not be relied upon as an indication of trading intent on behalf of AAMG.

 

*** Carl’s Corner for October 2016 ***

A few months ago in the August Notes, we commented that the August-October stretch was seasonally the three worst consecutive months for equity performance. August eked out +0.14% gain, while September has eked out +0.02%, with dividends. The presidential debates, the Federal Reserve process and economic data continue to rile the financial markets as we “wait and see” on all these fronts. Volatility is back for the time being.

Besides the “name calling” during the presidential debates, it appears the candidates agree on a few platforms that should positively affect certain sub-industry groups within the stock market: (a) infrastructure build-outs should support energy, materials and information technology, while putting money in new worker’s pockets for (b) discretionary spending, while (c) a beefed- up U.S. defensive posture should support the aerospace/ defense industry sub-group and its components, along with cyber-security and homeland security.

The Federal Reserve chose to hold rates steady at the September meeting in a 7-3 vote. We’ve not had a rate hike since December 2015. Many are beginning to wonder if the Federal Reserve is still open for business. A December 2016 rate hike is likely since the presidential election will be over, and if not for anything else, to let America know that the Federal Reserve’s monetary policy “normalization” is still viable. Odds for a December rate hike are now at 58.5%.

Even with a rate hike or two over the next six months, given the absolute values on historically low interest rates, the stock market remains an attractive alternative to the bond market for securing yield. A choice between the 10-year bond yield of 1.6%, versus a dividend paying equity yield of 2.0% (SP500 average yield), will likely support stock prices for a while longer.

The flat to falling U.S. Dollar (-3.39% year-to-date) should favor dollar based commodities, like oil, while providing a positive currency translation for U.S. multinationals, helping these multinationals to boost their earnings in the quarters ahead.

Contributing to a weaker U.S. Dollar are the lowered rate hike expectations from the Federal Open Market Committee (FOMC). Going forward, the FOMC just announced these revisions: median projections for fed funds rate at 0.6% in 2016, 1.1% in 2017 and 1.9% in 2018. By my calculations that might translate to one rate hike by year end 2016, two rate hikes in 2017 and 3 rate hikes in 2018. That gradual path, along with the lower FOMC expectations, leads me to believe that the economy will be growing slowly over the next few years.

Crude oil got a boost over this past week on the news that OPEC would come to a production cap agreement, cutting output to between 32.5 and 33.0 million barrels per day. Current production is approximately 33.2 million barrels per day. OPEC meets November 30 to finalize this decision. Was it only a matter of time, that Saudi Arabia would decide to put money back in their pockets, rather than take it out, as we postulated in our January 2016 Notes, “Right now, Saudi Arabia chooses to be a loss leader to keep market share. My take, given time, greed will bring back higher oil prices. In the meantime, let’s enjoy the sub- $2.00 a gallon at the gas pump.” Looks like the House of Saud will try to give itself a raise. The fall in oil prices, which Saudi Arabia perpetrated back in the fall of 2015, has left the Kingdom low on cash, forcing them toward austerity measures and payment delays. The International Monetary Fund in its July 2016 report painted a grim economic picture for Saudi Arabia.

Deutsche Bank (DB) was originally fined $14 Billion by the DOJ for its improprieties regarding its lending practices. Recent rumors indicate that the German government is considering taking a stake in the bank to assist. Yet, last week, Angela Merkel, chancellor of Germany, rejected a compromise with Deutsche Bank. The use of German taxpayer money for a bailout, in light of a 2017 re-election bid for Ms. Merkel, would be akin to political suicide for Merkel. Still, it’s hard to believe DB will “go under,” given the systemic risk to the global financial system if non-payment should occur. In the meantime, between Merkel, a bailout and a possible DOJ revision in fines (down to $5.4 Billion), DB will have to find a way to raise capital, which will be tough given the demise in its share price.

Carl C. Perthel, CMT

 

*** Carl’s Corner for September 2016 ***

From the BREXIT low on June 27 to the end of July, last month, the SP500 moved +8.65%. This past month, August, saw price momentum coming to a screeching halt, relatively speaking. August eked out +0.14%. As we mentioned at the end of the July Notes, “Historically, the August, September and October seasonal time frame represents the worst performing three month consecutive block of time throughout the year for U.S. stocks. “Caveat emptor.” It might not be just the seasonal tendencies in the stock market that have given the market pause to reflect.

Janet Yellen’s messages from Jackson Hole made it clear (once again) that the Fed wants to hike rates, under opportune circumstances. Yet, after so many instances communicating this same message, there are more than a few doubters. And who can blame them?

Nevertheless, when looking at the best performing sectors over the past month, price has rewarded a pro interest rate sensitive group; financials. For August, the financial sector has bolted to #1 out of the nine sectors we study for monthly price performance. The specter of a rising interest rate environment (somewhere out there) may have been the catalyst that helped push this sector to the top of the August list.

Economic data will be the deciding factor for higher rates. Where’s the strength? Q2, 2016 GDP (second revision) growth has been downgraded slightly. Consumers have been stronger but CAPEX and corporate earnings were weaker. Durable goods rose 4.4% in July, erasing a 4.2% decline in June, while new home sales rose 12.4% in July, coming in at strength not seen since October 2007. August non-farm payrolls are expected weaker by month-end.

Like Bernanke, Yellen does not want to upset the (tepid?) pace of the current economic expansion. The likelihood of rising rates would most likely not happen until December, given the November presidential elections. The financial odds-makers give a December hike a 51% probability. This number compared to the 93% chance of a December rate hike back in January of 2015. Things can change quickly.

According to a Bloomberg Survey of earnings estimates going forward, valuations in healthcare, telecommunications and utilities still remain “cheaper” than the SP-500 in defensive groups. On a valuation basis, according to Bloomberg, financials and industrials are “cheaper” on a relative basis vs. the SP-500. Bloomberg contends that technology, materials and consumer discretionary will match the SP-500 valuations over the next 12 months.

Valuations aside, it bears repeating from last month’s Notes, “Even though the equity market is stretched to the upside, there are no hard and fast rules that state it cannot move higher. Given investment choices around the world, relative to the U.S. equity market, and the premise that money seeks yield and capital appreciation, let me introduce you to TINA (There Is No Alternative). TINA is capturing everyone’s attention for the time being. TINA’s alias is the U.S. stock market. She exists thanks to a low interest rate environment.”

Carl C. Perthel, CMT

 

*** Carl’s Corner for August 2016 ***

What has been most striking about 2016, especially up until the end of last month, has been the outperformance of “defensive” sectors relative to the SP500 benchmark. The stock market had fallen under the spell of STUB (Staples, Telecom, Utilities and Bonds). Given the low interest rate environment, compliments of the U.S. Federal Reserve, money has sought yield in something else other than bonds. That “something else,” in a nutshell, has been “defensive issues” in the U.S. equity market.

We stated in July’s Corner, given BREXIT, the sluggish European Union economies, volatility in the Chinese markets, as well as negative interest rate environments in Japan, Switzerland and Europe, that “For political stability, arguably, the U.S. ranks highly, relative to other developed political systems. Political and economic stability should count for something given the events in Europe this past week. The U.S. still looks like the best house in the global neighborhood.” That “something” proved correct as U.S. investors were rewarded with a +8.65% jump in the U.S. equity markets (as represented by the SP500) since the BREXIT low on June 27th.

Inflows of global money are rewarded with a relatively high yield of 1.5% (10-year yield) in U.S. bonds, compared to the rest of the “global bond” world. Those willing to invest in U.S equities get the added benefit of dividend income from those equities; averaging +2.4% in the SP500, nearly double the yield in 10-year bonds. Bond proxies, such as utilities, drug makers and consumer staples, averaging even higher yields, have been the beneficiaries of “yield hungry” global and domestic investors. Consequently, “bond proxies” have appreciated, giving them the new moniker of “growth stocks,” for now anyway.

In all likelihood, a Fed rate hike may be “off the table” for 2016. The U.S. Federal Reserve will continue to coordinate with their global central bank brethren, and therefore, support “easy money” policies abroad by not raising interest rates here at home. After last week’s Fed Notes release, Fed “odds makers” reduced the likelihood of a rate hike by year end down to 46.8%, from the 51.5% prediction the day before Reserve minutes were released.

With the likelihood of a Fed rate hike not appearing until next year and a continuation of historically low rates, it would seem “more of the same” is in store for the U.S. financial markets. Let’s not forget though, that “more of the same” may not be just new highs in the equity benchmarks, but also, more volatility. Last August’s drawdown of more than -12%, something investors had not witnessed in 4 years, was followed by other “volatile” down moves in the equity markets in September 2015 (almost -6%), January 2016 (approximately -11%), February (about -6%), and finally, another downdraft in late June (around -6%), following BREXIT. Having gotten use to a tranquil, rising equity curve between 2011 and 2014, investors will now have to accept more of a “normal” stock market environment, sans Federal Reserve “easy money” intervention. Let’s embrace the volatility and recognize it for what it is…a move back to normalcy.

An important fact, not touted by many on Wall Street, is that new bull markets begin when stock valuations in the equity benchmarks (going all the way back to the turn of the 20th century) start in the single digits. Valuations on the SP500 currently range from approximately 17 incorporating traditional P/E calculations, to almost 27, if using the Robert Shiller CAPE P/E valuation model; a valuation measure usually applied to the US SP500 equity market. Shiller’s P/E is defined as price divided by the average of ten years of earnings (moving average), adjusted for inflation. Either one of these valuations should alert us to current equity levels being higher than the historical mean.

Even though the equity market is stretched to the upside, there are no hard and fast rules that state it cannot move higher. Given investment choices around the world, relative to the U.S. equity market, and the premise that money seeks yield and capital appreciation, let me introduce you to TINA (There Is No Alternative). TINA is capturing everyone’s attention for the time being. TINA’s alias is the U.S. stock market. She exists thanks to a low interest rate environment.

Historically, the August, September and October seasonal time frame represents the worst performing three month consecutive block of time throughout the year for U.S. stock market “bulls.” Caveat emptor.

Carl Perthel, CMT

 

*** Carl’s Corner for July 2016 ***

From our last edition of Carl’s Corner in April we postulated: “Looking beyond this coming month, the May-October seasonally “unfavorable” six-month time frame exerts itself. Couple negative seasonality with these fundamentals: (a) a June Fed meeting and a possible tightening before the election season begins, (b) an already advertised weak earnings and profit outlook for U.S. companies in the coming quarters, (c) a vote by Britain on June 23 to consider exiting the Eurozone (BREXIT) and you have the likelihood of summer volatility.” Let’s take a look at these possible market movers now that we’re in July.

The British Exit referendum from the Eurozone (EU) is endemic of a “grass roots” movement against big bureaucracy, big central banks and George Orwell’s “Big Brother.” In the U.S. we see this message in our current election process with candidates Donald Trump and Bernie Sanders. In Britain, last week’s majority of disenfranchised and frustrated Brits, in an effort to win back their independence from Brussels, now have to deal with a new economic reality that may not be as simple as they thought, before their “exit” vote. On an economic level, cross-border agreements and new trade pacts will have to be re-negotiated with existing trading partners and their immediate future will generate increased levels of anxiety and uncertainty in the financial markets. Look for summer volatility (and beyond?) as Britain, the Eurozone and outside trading partners jockey to understand and execute free trade after this historical decision.

The immediate question that comes to my mind is this: Will the jilted party (EU) decide to throw its companion’s (Britain) clothes out the window in the rain or will they choose to be amicable and allow their “ex” to come “pick up (your) things” from (my) house at a time convenient for both of us? The EU may want to set a “hard line” and let the neighbors know that a “break up” has harsh consequences. Some existing members of the EU will want to throw Britain’s clothes out the window to set a precedent in the likelihood that other Eurozone countries may want to break away from their 40 year union. To quote William Congreve, “Hell hath no fury like a woman scorned (Angela Merkel?).”

Investors around the world have rotated money into bonds, precious metals and other “safe haven” investments. Look for global central bankers to rally around the flag pole with more “easy money” solutions in an effort to calm the market’s jitters. Looks like global central banks are still “kicking the can down the road” with quantitative easing. Will it ever end?

With further coordination among global central banks, it is highly likely that the U.S. Federal Reserve will not raise interest rates in 2016. The likelihood of a stronger U.S. Dollar as a result of BREXIT should do just fine for those Fed “hawks” looking for higher rates. It’s not in the best interest of the global central bank “brotherhood” to have the U.S. raise rates while the Eurozone and other nations are trying to overcome economic sluggishness, and now BREXIT. Some of the economic odds-makers are projecting no rate hikes until 2018 and there was news on Bloomberg of an eventual rate cut in the United States. Hmmm…

Low rates may mean more of the same for U.S. equity markets. If the U.S. is seen as a safe haven and bond’s interest rates are at all-time low levels (and may have more room to fall), won’t dividend paying U.S. equities still look attractive, as they have since 2009? Remember, money seeks yield and safety. The U.S. equity market, relative to other domestic and global investments still looks attractive. For political stability, arguably, the U.S. ranks highly, relative to other developed political systems. Political and economic stability should count for something given the events in Europe this past week. The U.S. still looks like the best house in the global neighborhood.

70% of the U.S. GDP hinges on the consumer. The effects of BREXIT should have minimal impact on U.S. GDP. Even after BREXIT the value of the U.S. Dollar is lower than the beginning of the year, although it has risen in the past week. The Dollar has been range-bound the past few years. History has shown us, in general, a stronger dollar is likely to be both an economic and market positive. Since the late 1970s, the stock market has performed twice as well during dollar bull markets than during dollar bear markets.

According to June earnings insights from FACTSET, earnings for Q2, 2016 are estimated to decline -5.2%. If this “fact” holds true, then it will mark the first time the index has recorded 5 consecutive quarters of year-over-year declines since Q3, 2008 through Q3, 2009. Still, given alternative investments for investors, stocks should remain attractive.
Even with the BREXIT decline on June 24 (the 7th largest session decline since 1987), investors still found themselves in the middle of a trading range in the SP500 benchmark; bounded by the May 21, 2015 high of 2,134 and the February 11, 2016 low of 1,810. The June 30, 2016 close on the SP500 of 2,098.86 represents the upper third of the trading range (2,000 to 2,100). Until market participants break above the 2,134 high with renewed vigor, the preponderance of evidence continues to support a “range bound” market for the time being. The closing BREXIT low of 2,000.54 on the SP500 has acted as a price magnet since late 2014. We are not too far from that level right now. Therefore, market participants have not seen appreciable gains in the stock market for the past 20 months. Much like the ocean tides, expect price moves up the shore line to be followed by price tide declines, should supply overtake demand at the 2,130 level; especially now, through the “Low Tide Calendar Season,” that occurs in the stock market between May 1 and October 31.

Carl Perthel, CMT

 

*** Carl’s Corner for April 2016 ***

What a difference a month makes makes…especially if you are a Wall Street bull! Historically, March ranks as the 4th best month for overall performance in the calendar year. This March did not disappoint. For the bulls, April historically brings even better news. April, since 1950, is one of the top performing months in the equity markets. Equity benchmarks are back to within 3.5% of their all-time closing highs. Should we expect full steam ahead in April and beyond? Let’s examine the evidence.

The two market breaks of January and February seem like distant memories. The February reflex rally punished the “shorts” that were looking for price to continue below the January lows. When those lows held and prices moved higher, the shorts covered, providing fuel for higher stock market prices. Higher prices pulled “underperforming” money managers off the “side-lines” while emboldening investors to get “back in” so they will not miss out on potential, future profits.

What about the investors who purchased stocks between SP500 levels at 2,050 and 2,130 from January-August and from November-December 2015? Having experienced two market declines of 10+% in January and February of 2016, will these past purchasers be eager to “unload” their stocks in hopes of getting back to “break-even” if the market continues higher? These market participants may provide the “overhead supply” that might stall the market in the historically non-performing months between May and October.

Last week brought back the specter of rising interest rates. Four of the Fed regional presidents, separately and in the aggregate, communicated that future meetings were “live” and anything could happen. This “about face” follows Fed news from early March. The news then was the likelihood of the Fed waiting longer before making a decision. Conflicting signals, “flip-flopping” and lack of guidance seems to be the hallmark of Janet Yellen’s Fed. Can’t say I blame them given the unevenness of the U.S. economic recovery. As we stated a few months back, look for another Fed hike this year, but NOT four, as previously communicated by the Federal Reserve in December of 2015.

U.S. economic data is mixed. It’s difficult for the Fed to “hang their hat” on a consistent economic data set. And don’t forget, it’s not just a U.S. economic story. The Fed has to coordinate its interest rate policies in conjunction with our global trading partners. It’s an inter-connected world and global central banks are trying to stay on the same page.

On the U.S. economic front (see last month’s Notes for our global commentary), Q4, 2015 GDP growth was revised up +0.4 to an annualized 1.4% from the prior quarter. But, this report showed slowing corporate profit growth which is a concern for business fixed investment growth while consumer spending growth slowed to just 2.4% from 3.0% in Q3 and 3.6% in Q2. Estimates by the Atlanta Fed for Q1, 2016 GDP are for +0.6%. Employment growth, low energy prices and rising consumer confidence may mitigate this negative trend by year end.

New orders for durable goods fell 2.8% in February following a larger than average gain of 4.2% in January. The U.S. dollar was weaker this past quarter. If this trend continues, we could see better returns for U.S. multi-nationals and a stronger U.S. manufacturing sector. Three benefits to a weaker U.S. dollar: (a) U.S. goods look more attractive to global customers because they are cheaper, (b) U.S. profits in foreign currencies are “translated” back to the U.S. in dollars, boosting overseas profits and (c) since most commodities are priced in U.S. dollars, the production and consumption of commodities are more palatable since they cost less.

In Q1, 2016, U.S. investors sought refuge in “defensive” issues. Utilities, telecommunications and consumer staples led all sectors. Additional bright spots this quarter were the U.S. Industrial and Transportation sectors, helped by the weaker U.S. dollar and a rebound in commodities.

This quarter’s commodity rally may be “short covering.” Industrial metals & materials, agricultural chemicals and select energies have been scraping bottom (Stage 4) on our STARS analysis since January 2015. “Bottom Fishers” found their way into the Basic Materials sector this quarter, boosting beaten down stock prices. Patience is suggested here. Fundamentally, where will global demand come from to stoke the production and purchase of raw materials? With most of the world on a slow growth path, it’s difficult to imagine the uptrend in the commodity patch continuing in the near term. Then again, this price action may be a reflection of European QE and global central bank negative interest rate policies producing their desired effect by stimulating global demand.

The U.S. and global markets showed resiliency in March, given the tragic events in Brussels; a sign of strength.

Looking beyond this coming month, the May-October seasonally “unfavorable” six-month time frame exerts itself. Couple negative seasonality with these fundamentals: (a) a June Fed meeting and a possible tightening before the election season begins, (b) an already advertised weak earnings and profit outlook for U.S. companies in the coming quarters, (c) a vote by Britain on June 23 to consider exiting the Eurozone (BREXIT) and you have the likelihood of summer volatility. Remember, the stock market is within 3.5% of its all-time highs and price will have to overcome possible eager sellers that have been waiting to get out since the January-February 2016 sell-off. These fundamental and technical concerns are directly ahead throughout the summer.

As a suggestion, for you stock pickers out there: Look for companies with low valuations, low debt, and those that are buying back their shares. Stay away from companies that are taking advantage of low rates and borrowing, if their primary goal is only to buy back shares with their newly borrowed money. Traditional value factors like low price-to-sales and low price-to-book historically do well if your time frame is more than five years.

Until next time…

Carl Perthel, CMT

 

*** Carl’s Corner for March 2016 ***

The stock market will often “test” price levels before deciding which way to go. The August 2015 low was tested in September 2015 before the market moved higher. Next, the September 2015 lows were “tested” in January 2016 before the market moved higher. Once again this month, the January low was tested to within just a few S&P points before the stock market moved higher. These tests off the bottom of the channel (1820-1870) multiple times, and the ensuing moves higher, indicate buying interest. The frequency of these “touches” builds a case for strong buyer interest at these “support” levels. Please view last month’s Carl’s Corner regarding equity market price ranges and fundamental reasons why this range may continue.

In just 13 trading days from the recent February 11th low, the stock market has risen + 6.74%; nearly 4 times last year’s annual return. Volatility, as we discussed in last month’s Corner, is back! The uncertainty surrounding the fundamental news will take time to resolve itself. On our plates are the global central banks inability to help “goose” global spending; an oil glut, albeit good for consumers, but creating fear of a global slowdown; fear of possible bankruptcies, personnel cut-backs and diminished cap-ex in the energy patch; a China slowdown; a slower growing U.S. economy that was not anticipated a few months ago and an up-coming U.S. election where choices range from the “far right” to the “far left.” Where did the “center” go? P.T. Barnum for the GOP?

You’ll see that most of the “uncertainties” in the above paragraph have the word “slow” associated with them. To borrow from William Shakespeare in Hamlet’s soliloquy, “there’s the rub.”

Global central banks face slow recovery in their respective countries; low inflation (weak growth/spending) and higher debt than before the 2008 Great Recession. Expanding their respective money supplies does not appear to be working. This month we witnessed the Japanese central bank joining the ranks of various Eurozone countries and Switzerland by instituting negative interest rates to spur borrowing. The idea is for banks to lend. After all, who wants deposited money sitting idle with no profit to be made? Will this spur the banks to lend is the question.

The United States appears to be the “best house” in the global neighborhood. Of course, the U.S. has been through numerous Federal Reserve monetary stimulus maturations since 2008. Relatively speaking, the rest of the world is just getting started on their quantitative easing (QE) programs. One can only hope those countries can stimulate their economies. But, I do not remember the U.S. having to resort to negative interest rate policies after the 2008 real estate bubble. Perhaps cutting taxes is a solution? Is that even politically palatable in the European framework? Perhaps a “helicopter drop;” a page out of the Milton Friedman and Ben Bernanke playbook, whereby printing large sums of money and distributing it to the public are in order to stimulate an economy? It may take some imagination outside of traditional QE policies to stem slow growth in these countries. Time will tell.

The U.S. economy received stimulating news last week. Second estimate of Q4, 2015 GDP pointed to an expansion of 1.0%, up from 0.7. In addition to this favorable economic news, better than expected Personal Income (+0.5) and Personal Spending (+0.5%) supports the case for more rate hikes, although we stated last month we doubted the Fed would be able to carry out its stated December objective of 4 hikes in 2016.

To support our case, James Bullard, President of the St. Louis Fed and an FOMC voting member, stated “declining market-based inflation expectations” as a possible reason for putting off further tightening. President Bullard is widely considered the most “hawkish” Fed President. For him to make this statement clearly puts the Fed off its previous glide path for rate increases. Stock market bulls will embrace this kind of news.

Although the Saudis won’t cut crude production, their oil minister, Ali al-Naimi stated it is “easier to freeze production and let demand rise and some inefficient supplies decline.” He will present this to the OPEC voting members in March. Longer term, it is not expected that Saudi Arabia will allow oil to rise above $50 a barrel, a price that would put U.S. drills back into the ground. Iran will likely agree to a freeze after it boosts daily production to 4 million barrels a day, approximately its output before its sanctions. Gasoline prices moved higher this past week.

See you next time.

Carl Perthel, CMT

 

*** Carl’s Corner for February 2016 ***

By the 12:30pm hour on January 20, 2016, the equity market (SP500) was down -11.3% for the year, before a dramatic turnaround of +65 (SP-500) points (+3.6%) in the next 2 ½ hours on heavy volume. That turnaround occurred at the prior October 2014 low (1,820) and validated our premise from January’s Carl’s Corner that investor’s would find themselves in a trading range between the 1,820-1,870 lows and the SP500 mid-point at 2,000. On the last trading day of January, an impressive move higher helped to partially salvage what has become the worst start to a new year in the equity markets since 2009. Currently, 1,950-1,975 will represent “resistance;” where we are likely to see overhead supply (sellers) come into the market. Please review January’s Corner for reasons why we believe a trading range will continue in 2016.

Fundamentally, the reasons for the January selloff might be enumerated like this: (A) over production of oil, leading to supply out pacing demand, concerns the markets because there is a fear that global growth is slowing. Rising energy prices correlate to global growth, while falling energy prices instill a fear that growth is declining. Fact: global demand is not shrinking, it’s just that over production by Saudi Arabia and Iran (soon to happen) is causing the oil glut. (B) China GDP slowdown to 6.8% annually (wish U.S. had that) instills fear for those who believe that without China the rest of the world is doomed. Don’t believe it. The Chinese are pragmatic communists and they’ll figure it out. (c) SP500 earnings are off 4.3% overall in 2016. The earnings shortfall is due primarily to weak energy pricing and had been expected since last quarter. Weak earnings instill a fear that corporate America is doomed. Don’t believe it. A moderating U.S. Dollar in 2016 and stable to rising energy prices in the second half of 2016 will enhance earnings by year-end. Nevertheless, for the time being the economy may not be in recession, but we’re in an earnings recession. (D) The collapse in energy prices may lead to debt re-structuring and potential defaults in the energy patch. Financial institutions holding energy “paper” may be at risk of not being re-paid. This is a concern and something to keep our eye on.

Overseas, the ECB’s continuing efforts toward quantitative easing (QE) should prove successful in stimulating growth in the European region. Economic data, earnings and sentiment in the region are improving. In mid-January, ECB president, Mario Draghi gave global investors’ confidence that European policy makers will remain committed to QE and are even willing to extend and expand that program if necessary.
Emerging market benchmarks are telegraphing a challenging environment as a result of currency, commodity and interest rate risks, even in the midst of decreasing valuations in those regions. But price action the past few weeks (+8.21%) have signaled a temporary “turn-around” which may lead to higher growth prospects by year-end.

On Friday, the Commerce Department reported that the gross domestic product (GDP), the broadest measure of economic output, expanded at a 0.7% seasonally adjusted annualized rate in the fourth quarter. The economy had advanced 2% in the third quarter and 3.9% in the second. According to the Wall Street Journal, despite weak first and fourth quarters to bookend the year, growth in 2015 was steady overall. The economy expanded 2.4% from 2014, a little better than the 2.1% average since 2010, the first full year of the expansion. Steady job gains, an improving housing market and high auto sales helped support growth through much of the year. But rapidly falling oil prices and the strong dollar in 2015 had a mixed impact on businesses and consumers. Lower energy prices, creating an instant “tax break” at the gas pump should continue to aid consumer discretionary spending in 2016. Personal consumption remained fairly strong in this report. Full-year consumer spending in 2015 advanced 3.1%, the fastest pace since 2005.

Last week the Federal Reserve Open Market Committee (FOMC) released a policy statement. The latest directive from the FOMC demonstrated more “hawkish” undertones than market participants may have been expecting. The statement partly acknowledged that growth had slowed and that inflation is expected to remain low in the near-term. It’s the Fed’s belief that inflation is expected to rise to 2.0% (likely a response to decreasing unemployment numbers possibly signaling future wage inflation). Now, for the FOMC saying this in the face of declines in energy and import prices creates doubt as to whether the central bank will back down on its statement that they will raise rates four times in 2016. Let’s add this “fear” to the list under bullet point #3 above. The market still detests any notion of higher interest rates.

But, with last Thursday’s employment cost index not as strong as consensus, the Fed gets some breathing room if they want to take their foot off the pedal for a rate increase in the near term. Equity markets like this kind of news. Stocks ticked up immediately after the release. This concern raises the question of how can the Fed raise rates four more times in 2016. They’ll need to see a stronger economy before this happens.

In summary, the fundamental and technical picture has changed from the QE years (2010-2014). As the economy “normalizes” without the assistance of Federal Reserve stimulus, we should expect the equity markets to take on some of its historical precedents; like corrections. The slow, smooth rising equity curve, a consequence of “easy money” policies, now returns to a more volatile price path as the market digests the news events we’ve related in this piece. These events will continue to act as a catalyst for increased volatility in 2016.

This change in market temperament should not be viewed in a fearful fashion. It’s best to recognize the change and know that equity markets historically move (more often than not) in a volatile manner, where 10+% price swings (up or down) are the rule, rather than the exception. There are a lot of uncertainties to work through in the coming year. The equity market will reflect these concerns in price volatility.

Stick to basic tenants like investing in quality companies and groups with profitable business plans. Focus on earnings, revenue and dividend growth. If an investor can find issues trading below their “intrinsic” values, this alone will act as a hedge during market downturns. For index investors, be aware of the equity market’s seasonal cycles. Certain times of the year are better than others. But as this January just proved, a “typical” favorable January does not happen 100% of the time.

Carl Perthel, CMT

*** Carl’s Corner for January 2016 ***

Looking back over the financial markets in 2015, I am struck by two observations, the tight trading range on U.S. equity market pricing and Saudi Arabia’s decision to keep oil production loose.

Observation #1: First, the tight trading band in U.S. equity market pricing: After three straight years of upward price action (2012-2014), on a relative basis, investors witnessed “supply-demand equilibrium.” The buying pressure from 2012-2014 stalled. Absent the market break between August and September, the SP-500 equity benchmark traded within a + or – 5.0% band for most of the year. Why the change? “Easy money” U.S. Federal Reserve policies, which the stock market loved for so many years, are now absent. In their place is a “tighter money” policy, after the first Fed rate hike. Even though the Fed rate hike did not happen until December, the stock market had been telegraphing a change in temperament throughout 2015. The U.S. equity market, as represented by the SP-500, was discounting “tighter” Fed policies all year long.

For 2016, here’s the case for a trading range environment in the U.S. equity market: Any kind of positive economic news will bring the likelihood of the Fed continuing to raise interest rates. This scenario will put a lid on rising equity prices. Equity market pricing does not reward rising rates. On the other hand, because interest rates are low on a relative basis, equity prices could find a floor. Low relative rates, even in a slow rising rate environment, will continue to force investors to seek higher yield. The bastion for higher yield, relative to bonds, will be found in the U.S. equity markets; no different from previous years. Higher dividend yields relative to bonds should put a floor under equity prices as investors continue to purchase stocks that pay dividends. In between this ceiling and floor we’ll likely find ourselves in a protracted trading range in the stock market for 2016.

Opportunities in this trading range environment may be found in high quality; dividend paying stocks should fare well. Look for issues with strong balance sheets, revenue growth, earnings growth and dividend growth.

Observation #2: Saudi Arabia’s decision to keep oil production loose: Expanding oil production in the summer of 2014, causing lower oil prices globally, stopped Mr. Putin’s armies from crossing into NATO occupied territory.
High oil prices fed Mr. Putin’s popularity at home and his desire to expand Russia’s borders. Falling oil prices put a crimp in Russia’s balance sheet and sent Mr. Putin’s armies back to Moscow in short order. Higher oil production, causing lower energy prices was good news politically for the West by the end of 2014. What followed was startling; Saudi Arabia decided not to cut production after Mr. Putin returned home. Oil fell to $53 a barrel by the end of 2014. Global oil producers lost billions of dollars with the declining value of a barrel of oil. The decision by Saudi Arabia not to tighten supply was bad news economically for oil producing nations in 2015.

Global oil producers like the United States, Iran, Venezuela, Russia and others are losing billions of dollars because of the Saudi decision; their country’s balance sheets are suffering, along with their economies and social services. Global energy employment has declined, rig counts are down, and capital-expenditures have shrunk, while oil supply is plentiful. Technology is making it easier to extract oil and natural gas. Demand cannot keep up with supply at this juncture. Why does Saudi Arabia choose not to cut oil production, when they could be lining their pockets (and OPEC’s) with profits from higher oil prices? It would appear that Saudi officials feel that if they were to cut production and prices were to rise, Saudi Arabia would lose market share, giving other oil producers an opportunity to pump and profit because of higher prices. Right now, Saudi Arabia chooses to be a loss leader to keep market share. My take, given time, greed will bring back higher oil prices. In the meantime, let’s enjoy the sub- $2.00 a gallon at the gas pump.

It bears repeating from our February 2015 issue: According to www.InflationData.com and www.PlainsAllAmerican.com, the inflation adjusted barrel of crude oil (1946 to present day in 2014 U.S. Dollars) is $44 a barrel. Oil closed 2015 at $37.04 a barrel. 2016 just might present an opportunity for a transition and a move to relatively higher energy prices.

A tax cut for America at the gas pump, an improving economy, and job growth, gave the U.S. consumer something to smile about in 2015. “Consumer discretionary” spending and the issues that accompany positive consumer psychology were the “tale of the tape” in 2015. The Consumer Discretionary sector led all SP-500 sectors in 2015. Here at the beginning of 2016, consumers continue to spend their discretionary income on food, soft drinks, cleaning products and sin.

Other pockets of strength are staffing and business management services. In the financial sector, under the cloud of rising rates, historically, regional banks and insurance companies are rewarded. With the aging of America, healthcare should continue to fare well. Look for opportunities in U.S. multi-nationals as the U.S. Dollar stabilizes, while keeping an eye on a possible rebound among the major integrated oil companies.

In the energy sector, the large major integrated oil companies, because of their strong balance sheets and cash positions, fare the best in a low price per barrel environment. Historically, the large major-integrated oil companies will take advantage of this environment by purchasing smaller and financially weaker energy companies that cannot bear the brunt of cheap oil. An investor’s patience will be tested before the energy patch turns “bullish.”

As a reminder, the November-December edition of Carl’s Corner can be found on the www.aamg.com website under “Past Market Views.” Within that link please go to “Markets Unplugged Series” with the title: “The Markets – Unplugged XIV Conference Call Transcript (November 18, 2015).”

Happy New Year, until next time…

Carl Perthel, CMT