One Bull and Ten Bears Go Walking in the Woods, Guess What Happens…

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Niels Bohr, the Danish physicist and Nobel laureate once said, “Prediction is very difficult, especially if it’s about the future.”  Niels would likely turn in his grave if asked about the direction of equity markets for the second half of 2016.  We don’t know what happens when one bull and ten bears go walking in the woods, but we’ve got an idea what is statistically likely.  Here are ten reasons to be bearish and one reason to be bullish for equity markets in the second half of 2016.

 

On the first business day of 2016, we published an article titled, The Top Ten Reasons Why The Stock Market Will Tank in 2016. Over the first six weeks of the year, the S&P 500 fell by as much as 11.5%.  We looked smart, but then, fresh rounds of central bank steroids in the form of ever decreasing interest rates and quantitative easing caused a dramatic rebound in equity prices.  However, the reasons for the swoon in stock prices have intensified, and now we are facing an equity market that looks even more fragile than it did at the very end of 2015.

 

As we have said before, we think this is a time to be extremely cautious with capital.  Given extended valuations in equities, bonds and real estate, the risk is to the downside.  Investors should consider risk investment strategies such as our Smart Wealth Indices, with embedded risk management, as capital can quickly be eroded in these types of market environments.

 

In spite of every reason to be bearish, there is one reason to be bullish and that is because interest rates are at record lows and may go lower.  As we write this article on July 6th, 2016, today the US 10 Year and 30 Year Treasury bonds hit record lows of 1.32% and 2.10% respectively.  Record low yields are the one reason we can conjure to be bullish on the stock market, as they continue to drive equity prices, especially yield driven names.  For example, the utilities exchange traded funds XLU and IDU have gained 14% and 24% year to date respectively, while the broader market has been relatively flat.  If rates continue to fall, which is the current trend in the US and other parts of the world, equities could continue to rally.  But record low interest rates could also be the harbinger of bad things to come.  Thus, we present ten reasons to be bearish in the second half of 2016.

 

1. Interest rates are at record lows. The Fed controls short term rates. The market controls long term rates (unless quantitative easing is involved).  It is our belief that the bond market tends to be smarter money, as it is dominated by institutional players, whereas the equity market is more like a casino.  In almost all previous recessions the yield curve has gone inverted (meaning short dated yields exceed long dated yields) prior to recession.  We do not believe this will happen this time as the short dated yields have been held abnormally low by the Fed.  However the fact that the US Ten Year yield has fallen from 2.27% on December 31st, to 1.39% as we write this article, should have many investors worried.

 

2. The Fed has no more bullets. The Fed has made only one short term rate increase in the last nine years, when it raised the short term rate from zero to .25% last December. At the time the Fed stated it would increase rates throughout 2016.  We noted in this piece (Goldman Doesn’t Get It On Rates) from February 5th, that we expected no rate increases in 2016.  So far we have been spot on with this analysis.  Unfortunately, this is a major reason to be bearish.  Normally in a recession, or as we near a recession, the Fed reduces short term rates by 3-4% in an effort to stimulate the economy.  This is no longer possible.  There is only one decrease in rates possible to hit zero.  Thus a major stimulus factor is no longer available in the Fed’s arsenal.  We do not believe the Fed will reduce rates below zero, as similar efforts in Europe and Japan have proven unsuccessful to stimulate economies.

 

3. Brexit. The British exit from the EU will likely cause a recession in the UK with spillover effects throughout the EU as the EU is a major trading partner for Germany and other countries. No one knows exactly what will happen as new treaties are negotiated, but due to the increased risk and uncertainty, a reduction in investment and spending look inevitable.  Just yesterday it was announced that three U.K. property funds with 9.1 billion pounds of assets suspended redemptions.  A slowdown in Europe will impact business in the US and this will impact our equity markets.

 

4. Anti-European political parties are likely to gain ground in Europe. The strain on the euro currency continues to increase, and Brexit could trigger the departure of other nations from the Union, or at least the common currency. The refugee crisis continues to cause nationalistic movements to gain voters.  A deterioration of the E.U. or Eurozone breakup will cause tremendous recessionary pressures on the world economy.  Investors surely remember the stock market impact in 2011 when the Eurozone almost broke apart.  Nothing has been fixed other than the ECB is now papering over the problem.  Europe has been an economic basket case for years and now the system is showing cracks with the exit of the United Kingdom.  The ECB is likely to add more liquidity to the economic system, which will just add more fuel to a bubble that is ready to pop.

 

5. Housing gains are slowing. There are signs that the rebound in the housing market is hitting a ceiling once again in 2016. Low and medium priced homes bought by wage earners are very expensive and latest reports indicate that prices are holding but not moving higher substantially higher. We expect this summer will mark the peak in residential US real estate.  Additionally, high-end properties are in decline over recent months as buyers have retreated and sellers have begun lowering prices.  We discussed housing more extensively in this article from May 26th.

 

6. Asian Contagion. The latest economic data out of China has looked weak, but has been countered somewhat by stimulative central bank policy. We believe China is slowing, but it is difficult to know exactly since government statistics are manipulated.  In Japan things look worse.  Japan suffers from an aging population dependent on social programs without immigration to counter its decline.  In spite of massive central bank stimulus, the yen continues to strengthen as a ‘safe-haven’ currency which is yet another negative factor as Japanese exports become less competitive on world markets. In Japan, a vicious cycle of economic deterioration has caused the central bank to continue to push rates negative; all the while the yen has increased in value.  The weekly chart of Japanese yen futures highlights the more than 16.5% increase in the value of the currency so far in 2016. We expect further bad data out of Asia could hurt US equity markets.

 

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7. Business activity in the US continues to slow. Moderate growth in the U.S. economy was the reason that the Fed finally increased interest rates last December. However, the latest employment report shocked markets, and although the jobless rate remains at 4.7%, the latest numbers are a sign that an economic slowdown has commenced.  Additionally, our sources in private equity corroborate this slowdown based on what they see from their portfolio companies.

 

8. Corporate earnings are down year over year. In the first quarter of 2016, corporate profits in the United States were down by 7.5% on a year-on-year basis. The dollar had been under pressure in Q2 until it recovered in the wake of the Brexit vote and a stronger dollar will continue to have a depressive effect on corporate earnings. When earnings start to decline, this is usually a signal that the market will turn.  Second quarter earnings season should start next week so stay tuned for more action on this subject.

 

9. Valuations are already very high. Low rates have held equity prices up with accommodative juice, in spite of declining earnings. The spike down last August when the Chinese shocked world markets with a surprise devaluation of the yuan and the plunge at the beginning of the year as Chinese stocks cascaded lower, were signs of how fragile markets really are.  One could argue that valuations are justified because rates are so low.  However, we believe the valuation of U.S. stocks remains too high in the current environment.  The CAPE ratio, a good indicator of long term valuation, remains far above normal.

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10. The stock market is no longer making new highs. The monthly chart of the E-Mini S&P 500 highlights that the market has not hit a new high since May 2015. Typically, when a market goes over a year without making a higher high, it tends to signal a downside reversal. There is a wall of resistance dating back to February 2015 that has held despite many tries and a continuation of accommodative Fed policy that should have caused new highs. Markets can be highly irrational, but in this case, they seem to be telling a pretty consistent story.

 

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It is a genuinely dangerous and uncertain time in the world and markets reflect world events. Equity prices are close to highs, but the evidence points to an accumulation of risk factors.  We don’t know what happens when one bull and ten bears go walking in the woods, but we believe it is highly likely the bull gets eaten.  Consider the risks in the months ahead and ways to protect your portfolio in an upcoming bear market.

 

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