Escalator UP....Elevator DOWN!

Chapin Hill Advisors Market Comment 1-25-16

 Escalator UP but Elevator DOWN!

Wild Week on Wall Street…

By Wednesday, January 20th, markets were two-thirds of the way to “bear territory” as the large cap U.S. indices fell 15% from their May 2015 highs. The Dow was off over 500 points by mid-morning trading on Wednesday. Oil continued to plunge falling below $27 a barrel, lower than even most oil-bears predicted. Concerns that Iran was going to continue to increase production adding to a global glut of supply weighed down crude and equities followed.

The markets were oversold and rallied almost 5% from the lows to finish the week up just about 1%. The Dow added 105 points to finish up 0.7% while the S&P500 gained 27 points to close up 1.14%. Nasdaq led the charge rising 2.3%. Energy stocks rallied 2% overall. The worst stocks rallied the most. Crude made a big reversal rallying 9% to end the week at $32.16.

Michael Purves, chief global strategist for Weeden was quoted in Barron’s stating that there was a “coiled spring of short positions which released an upsurge”. The stocks which suffered the most over the past few weeks were the biggest winners. Shorts raced to cover their positions driving up stocks and crude.

Adam Sarhan, CEO of the Sarhan Group, called last week’s recovery a “relief rally” from an oversold position. Sarhan expects the market to enter bear territory noting that small caps, banks and commodities are already there. He feels that the rally was a technical one from oversold levels.

While last week’s rally in U.S. stocks added 1.3% or $300 billion for the week, Wilshire Associates points out that we have given up $1.8 trillion year to date as the S&P is down 7.4%  An article in ZeroHedge used the analogy of bull markets heading up escalators while bear markets seem to  take the express elevator down. That is certainly how many people feel as the plunge in equities has been steep over a short period of time compared to the six-year rise of the bull with very little volatility.

WIT…

Draghi announced that Europe was prepared to do “Whatever It Takes” (WIT) to boost inflation. That statement, along with the imbedded promise of more QE globally as both Europe and Japan seem committed to continuing to adding liquidity was the spark which ignited the rally. Draghi stated that “there are no limits to our action”. At the same time, the BOJ (Bank of Japan) is being pressured to boost stimulus to counter the appreciation of the yen.

China is attempting to balance the contradictory forces of providing liquidity (especially in light of the pending Chinese New Year) while restricting the yuan to steady its price. China reported Q4 GDP at 6.8% - the lowest in 25 years! Goldman Sachs, in a sobering note, stated that the CIA (Current Activity Indicator) may be as much as 230 basis points lower than the reported GDP growth. If Goldman is correct, China is only growing at 4.5%, a huge slowdown for that country. Repercussions of slowing growth in China will reverberate around the globe.

Kyle Bass was also interviewed by Zero Hedge stating that “a lot more pain to come” is heading our way. He noted that China will continue to devalue their currency. And he is watching their non-performing loan growth for signs of increases. Citibank Global also jumped on the bear bandwagon predicting that the earnings revision index is dropping to 7-year lows and that the “spread between emerging markets and mainland markets is alarming”. They lowered their Q1 2016 earnings estimates from 1% to a -1.7%

Search for Yield…

While many investors moved their bond allocations into dividend paying equities over the past few years, they may have received yield but trailed overall equity returns. In 2015, the i-shares Select Dividend ETF (DVY) trailed the S&P by -3%. Comprised of 99 stocks with healthy dividend payouts, it is a good proxy for overall dividend-paying equities.  Year to date, the DVY is -3% but outperforming the S&P by 4%.

However, Barron’s wrote a cautionary column this weekend about relying on dividend-paying stocks. They pointed out that S&P companies are paying out 41% of earnings to dividends, the highest since 2010. Convergex’s strategist, Nick Colas, says this could mean trouble as the expansion is getting “long in the tooth”. While energy is being blamed, he says energy only comprises 6.5% of the S&P with 50% of that allocation in just 5 stocks. Colas points out that over the past 5 years, dividends have increased 91% while earnings have grown just 27%.

Overall, Barron’s notes that reinvesting dividends enhances returns. Since 1969, reinvesting dividends in the S&P500 stocks provided investors with 4 times the return of price appreciation alone. Last year, the S&P finished the year with a -0.7% return. However, adding in dividends brought the total return to 1.4%. This 2.1% may seem small but if you compound it over time, it really adds up.

Where junk goes, equities will follow…

So says Stephanie Pomboy, CEO of MacroMavens. Ms. Pomboy has been bearish since 2010, advising her largely institutional clients to be wary of the risks in equities. She felt that the fundamentals lagged stock performance and when QE stopped, it would have failed to benefit the economy. She’s also been bullish on gold and Treasuries.

Her view if that credit is a precursor to equities. She has been warning her subscribers that the credit markets were set up for a sharp correction and that equities would follow. She refers to junk and equities the “twin barometers of risk”. Pomboy does not feel the Fed will raise rates this year and the dollar is likely to give back some of its gains.

Bespoke Investment Group noted that while equities outperformed high-yield in 2015, equities have quickly “closed the gap” as we have entered 2016. The energy sector is front and center as a concern in high yield for many. Moody’s just placed 120 oil companies under review. The list included some big guns such as Royal Dutch, Statoil and Total. Barclay’s warns that $155 billion of corporate debt is “down-grade able” and followed with a note that said “valuations do not seem to fully reflect the downgrade risk in energy”.

Energy is a big concern for banks as many were all too eager to lend to the oil patch. While the Wall Street consensus is looking for oil to trend up to $40-50 a barrel, a 50% increase from present prices, it is a far cry from the $107 price last June. Many oil companies are losing with every barrel they pump at present prices. How long can they continue to produce with losses adding up each day?

Looking ahead…

Bespoke Investment Group noted that the S&P closed two standard deviations below the 50-day moving average 11 days in a row. This is a rare occurrence and only happened in October 2008 and September 2001, both of which were followed by more turbulence and significant downside performance.

Bank of America said that if 1867 gives out on the S&P500 ( which closed at 1877 on Monday, January 25), the next stop is 1820 which is the October 2014 lows. If 1820 fails to hold, they say we are headed for 1600-1575. That’s a hefty “correction” from the 2100 levels we saw at the end of 2015!

Bloomberg pointed out that 40 markets with $27 trillion in market cap are in bear market territory already. These include China, UK and Canada which have each fallen 20%. India was only 1% away from that 20% mark and that’s considered one of the better emerging markets. Emerging markets accounted for 19 of the 40 markets.

Many on Wall Street are calling this a great buying opportunity, with better valuations than just a few weeks ago. Even if the Fed does not raise rates again this year, they have little room to add any additional QE. Earnings season is underway and so far, many stocks are not reporting rosy numbers.

We have had six years of rising prices with little volatility. It is very likely that volatility will increase and if oil does not recover, we shall see bankruptcies in the oil patch leading to write-off’s on bank balance sheets and further damage to their stock prices. Energy stocks have been hit hard but they can still fall more. Be careful to evaluate the risk in your portfolio and take prudent action.

As always, feel free to reach out to us with questions or comments. [email protected] or 212-583-1992.

This quantitative approach can help one construct a portfolio which is more in keeping with one's downside risk tolerance. We are happy to offer this complementary to anyone who would like to try it. Please email me at [email protected] if you would like to take the questionnaire and quantify your risk tolerance.

As always, feel free to send questions or comments to us at [email protected].

This information is provided for general information only, and is not intended as personalized investment advice. Reading the above is in no way intended to be a substitute for individualized investment advice, and no conclusions should be drawn from this information regarding any potential investment. All readers should contact their professional investment, legal and tax advisors before entering into any investment or investment agreement.  Past performance of any index, market, sector, or investment is not necessarily indicative of future returns.  Any index referenced herein references historical results.  They are also unmanaged and cannot be invested in directly.  Some information in the above is gleaned from third party sources, and while believed to be reliable, is not independently verified. Please contact Kathy Boyle for more information at [email protected].