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Update and Analysis of Equity Markets
By Sam Sweitzer, CFA
Last week was a difficult week for global equity markets, to say the least. The U.S. stock market got off to its worst January ever. The Dow Jones Industrial Average dropped 6.2%. The S&P 500 lost 6% and the Nasdaq Composite index lost 7.27%. Many clients have asked if the U.S. is in a recession and if the next bear market has begun. I have compiled some brief analysis to attempt to answer these concerns:
Last week’s sell-off was primarily driven by concerns about China’s economy and stock market. Why is China’s stock market slipping? Manufacturing in China has been slowing for months. The country’s credit markets have also become turbulent with defaults. Finally, the Yuan’s exchange rate has been unstable. Most analysts agree that China will have to devalue again, but when and by how much is an open question. Finally, a wave of small Chinese investors has been caught up in margin trading and playing the market “like visitors to the dog track,” as reporter Evan Osnos wrote in the New Yorker. More than 38 million new retail brokerage accounts opened in China in a three-month period in 2015, shortly after the Communist Party spurred households to invest in stocks. Less than 10 million new brokerage accounts had opened in China in all of 2014.
Other factors have also contributed to instability in global stock markets. Declines in oil prices have created economic instability in many middle eastern countries. Diplomatic relations have quickly eroded between Iran and Saudi Arabia. Adding fuel to the fire, North Korea tested a nuclear device last week and proclaimed that its arsenal now includes the hydrogen bomb.
Investors have also become concerned about weakening corporate profits, as several analysts have lowered their 2016 earnings estimates for U.S. companies. Wall Street is contending with other headwinds. The oversupply of oil continues: According to Yardeni Research, world crude oil output rose 2.4% in the 12 months ending in November to a new record of 95.2 million barrels a day.
Additionally, the pace of American manufacturing is a worldwide concern. In December, the Institute for Supply Management’s manufacturing PMI showed sector contraction (a reading under 50) for a second straight month. Factory orders were down for a thirteenth consecutive month in November (the first time a streak of declines that long has occurred outside of a recession) and the November durable goods orders report also disappointed investors.
But positive economic data has been largely ignored. Germany’s economy expanded in December more than analyst estimates had predicted. US employment continues to grow and consumer confidence is high. Mortgage delinquency rates in the U.S. are extremely low and—despite the Fed’s modest .25% increase in rates—interest rates continue to be very low for U.S. households. Vehicle sales were slightly lower than expected in December, but November’s sales were blockbuster. 2016 should see a record number of vehicles sold in the U.S.
We continue to watch numerous economic and market factors, but three specific indicators are signaling caution: First, small-cap stocks are underperforming large-cap stocks in the U.S. This phenomenon has marked other market tops, though not with pinpoint accuracy. Second, high-yield bond interest rates have increased significantly—and not just in the Energy sector. This tells us that credit is tightening for low quality companies and may slow growth in those sectors most in need of additional capital. Third, multiple transportation indexes such as the Marine Transport Index, Airline Transport Index, and Trucking Transport Index are all continuing to decline. Although manufacturing has become less important than services in our economy, declines in these indexes still warrant caution.
Our hope is that this early January sell-off is met with a solid rebound in late January and early February. We do not believe that the economic data have warranted such a steep decline. When the Federal Reserve raised interest rates above zero in December, they essentially took the training wheels off of the economy. We can expect some wobbliness going forward and we urge investors to show caution but not pessimism, balanced with factual data about world economic growth.
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