Is it a Bull or is it a Bear?

4/9/2016 - Is it a bull or is it a bear? The past 18 months have left a number of investors asking this very question. Since October 2014, we have experienced 3 dramatic selloff only to have the market bounce back. But the problem is that the S&P 500 has not been able to rally beyond its summer 2015 highs. And this leads us to the question: where do we go from here?18 mos SP500

We began the year in a short-lived, but sizable bear market when the S&P 500 fell nearly -15%. Not surprisingly, the 10-year Treasury rate fell from 2.24% to 1.64% during the same time period! From the February 11th market lows, the S&P 500 roared back and printed positive returns for the year before moving sideways and showing weakness again.

For most, the recent market volatility has left investors scratching their heads. There has been a lot of conflicting data (e.g. China is slowing down, the unemployment rate is at historic lows, the Fed has recently raised interest rates, housing prices are skyrocketing, etc.).

The trillion dollar then becomes, "where does the market go from here?" I don't have a definitive answer, of course, but I think the data suggests abnormal market risks and it tips the scales to the bears. But, like anything else in life, there are plenty of uncertainties and unknowns out there. This is an ongoing thesis as the market evolves and conclusions are almost certainly going to change. Nonetheless, I think it is worthwhile for me and for those reading this newsletter to present both sides of the current bull/bear argument.

The Bear Case

  • Stocks are not cheap and they could easily be argued as being expensive. The current S&P 500 trailing P/E (Price/Earnings) ratio is 22.59! (the historical average is 15.58). The current CAPE (Cyclically Adjusted PE) ratio at 25.86 doesn't paint a better picture (the historical average is 16.66). According to this ratio, we are currently in the 91st percentile when compared against its historical self...

PE10-percentiles

  • We are currently in an earnings recession. Profits have been declining for the past 3 quarters.
    • Wall Street is expecting a -7.9% plunge in first-quarter profits in S&P 500 companies as earnings season kicks off next week. This decline would be the deepest decline since 2009.
    • It is important to note that an earnings recession doesn't always predict an economic recession, but they often coincide. The last time earnings turned negative without the economy experiencing a recession was in 1998.

Earnings recessions

  • More and more companies are using accounting tricks to manipulate their earnings. This is particularly troubling as these companies are essentially telling their investors that they are making more money than accounting statements suggest. See GAAP (Generally Accepted Accounting Principals) earnings vs. Non-GAAP earnings (adjusted earnings that the company states is more reflective of their true earnings):S&P PE GAAP non GAAP
  • China, the second largest economy in the world, is slowing. China, in large part, has been the growth engine of the world, especially since 2008 as Europe, Japan, and the U.S. growth has lagged. 2015 was the first year that China's GDP has (officially) expanded less than 7%. With Europe and Japan struggling to grow, where is global growth going to come from? I believe a lot of this stems from changing demographics, which I wrote about here. The U.S. seems to be the only bright spot among large economic countries. Though, a projected 2% annual growth rate here in the States doesn't invoke much confidence.
  • Corporate buybacks are likely keeping the U.S. stock market propped up. As we already know, a stock goes up if there are more buyers than sellers. Bank of America Merrill Lynch recently published a study that shows that 93% of all US net stock purchases can be attributed to corporate buybacks. These buybacks have accounted for $12.5 billion of the $13.4 billion of the net buying activity this year. Is this the only thing holding up the market?

buybacks

Other bearish examples include a waning investor appetite in Silicon Valley, interest rates are set to increase this year, and this is a presidential election year.

The Bull Case

One of the biggest themes supporting the bull case is that the U.S. consumer is quite strong. Our economy continues to show strength despite the global economic slowdown. U.S. economic growth is positive, but it is slow (projected to expand at only 2% this year).

  • Total nonfarm payroll employment rose by 215,000 in March and the unemployment rate was little changed at 5.0 percent. Employment growth is close to the best since the 1990s.
  • The ISM manufacturing index indicated expansion in March after five months of contraction. The PMI was at 51.8% in March, up from 49.5% in February. The employment index was at 48.1%, down slightly from 48.5% in February, and the new orders index was at 58.3%, up sharply from February.
  • Finally, the Federal Reserve decided to take an extremely dovish tone this past month and chose NOT to raise interest rates, despite improving economic data here in the United States. This is a short-term boon for stocks. The Fed cited global weakness as its primary reason for the decision and signaled fewer rate hikes for 2016. This is in sharp contrast to previous recent statements where they declared that interest rates will likely increase if U.S. economic data supports it (which it does, at least under their own guidelines). Only 3 weeks removed from the March 16th decision, there is now talk from Fed members that a rate hike will occur "sooner than markets imply."
    • Predicting the Federal Reserve is akin to predicting daily stock movements; it is nearly impossible. In my opinion, by not increasing interest rates in March, the Federal Reserve is essentially providing monetary easing for those emerging markets that are struggling (e.g. China). The Yuan appreciated versus the Dollar on the heels of the Fed announcement, providing a much needed relief to the battered currency. The Fed has repeatedly said that the the Global Economic Slowdown is one of the biggest threats to the U.S. economy. It makes sense that the Fed would adopt a monetary policy that is accommodative to China. I would expect this to continue for the foreseeable future.
  • Inflation has finally started to show signs of life. Core CPI grew at 2.3% in march, the highest since 2008.

CPI

  • Housing starts and sales in the U.S. remain near an 8 year high.

US Housing Starts

The U.S. consumer is currently the envy of the world. With such a healthy, strong, and expansive demand base, I don't think there is a reasonable chance of a U.S. recession in 2016. That being said, outside and unforeseen shocks can certainly change this viewpoint. As things currently stand, the U.S. consumer will likely be a large factor as to why the U.S. markets will continue its outperformance when compared to the rest of the world.

Conclusion

I believe that the United States is the only major economy contributing any real global economic growth. While China has repeatedly stated that they are growing near 7%, I find it difficult to trust their data.Global GDP 2014

If China isn't growing near 7%, but rather closer to 0%, then this would help explain the dramatic drop in commodity prices (China has been a large consumer of commodities) and the devaluation of their Yuan.

Despite the fact that the U.S. consumer is strong, stock valuations are extremely high, especially as earnings growth has been turning negative. Investors continue to purchase equities because, quite frankly, there doesn't seem too be anywhere else invest. Of course, this will not end well for those investors. The price risk to equities is too high, especially as economic headwinds persist. As such, Bull Oak continues to be defensive to risk assets until the price of those assets more accurately reflect those risks.
 

Ryan Hughes
Bull Oak Capital
Bull Oak Newsletter
4/8/2016


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