Market Surveillance: The Force Awakens … in China … on the Wrong Side of the Bed

Sun, JAN 10th, 2016

It was a bad week for stocks. The S&P 500 suffered a -5.96% drop in 5 days. This sounds horrible … and it is. But a dose of perspective is warranted: Back in August – the last time China fears infected US stocks – we had an -11% sell-off in 5 days! OK, so maybe this current sell-off isn’t quite as violent as originally perceived.

But what do we make of it?

What’s going on?

Continued chaos out of China (PBOC cut Yuan reference rate 8 days straight; reports suggests more to come), global growth concerns (See: oil, commodities continuing to fade), geopolitical scuffles (North Korean H-bomb test?, Saudi Arabia + 3 cutting off diplomatic ties with Iran), pre-earnings jitters (Q415 results begin next week), valuation (still lofty, to many), concerns over the path and pace of Fed policy normalization in 2016 (John Williams, Loretta Mester and Stan Fischer all suggested this week that the pace may be quicker than markets would like to see) … all amid carryover bearish momentum from December 2015 resulting in the worst 5-day start to the year. Ever.

Just about everyone is now bearish (5-month low in bullish sentiment, per recent AAII data), and this has created a large and swift market response. Meanwhile, Friday’s NFP jobs report came in at +292K net new jobs added for December with little signs of accelerating wage inflation. A Goldilocks report on the Fed and US economy, indeed.

Regarding China – likely the 800-pound gorilla on the trading floor – the big question now is how much of the turmoil reflects rule changes and other policies at the Chinese stock market, and how much is based on broader economic fundamentals that might have a further impact on global growth leading to a nasty outcome? Paul Krugman opined on this in Friday’s New York Times. Paul seems more worried about a “hard-landing” than I am (though he caveats financial linkages – i.e., global contagion).

What’s my best-guess short-run outlook?

I think present market action feels similar to August … where we saw 5 or 6 nasty distribution days in a row that took the market down into official correction territory (-11%, very quickly).

From the beginning of that sell-off on 8/18/15 until it double-bottomed in late September it took 5-6 weeks to wash out. Will it run the same course this time? Maybe. Maybe not. Nobody knows for sure. But before last August we had traveled roughly 3 years without an official market ”correction”, and when it finally hit it was amid a period of seasonally poor returns (September is historically the worst month of the year for stocks). I suppose what’s different this time around is that we recently had a steep correction (the aforementioned late-summer period) that moderately refreshed the market, and January is typically a good month for stocks. This could lead one to logically conclude that the selling may be more condensed in this episode.

There’s a good chance that we’re oversold at current levels; for example as of Friday’s close only ~15% of S&P 500 stocks are trading above their 50-day moving-averages (and the majority of these are in defensive sectors, like utilities and consumer staples). The last time we saw similar internals was, you guessed it, August 2015. In addition, when lifting the hood on the S&P 500 index we see that nearly 20% of stocks in the index have been knocked down twice as much, or more, as the broad market to start the year, and over 50% of stocks in the index are -20% or more off from their 52-week highs. So, again, there are signals to suggest that this move may be a bit overdone. But that doesn’t mean the sell-off won’t continue. In fact, for now anyway, the path of least resistance seems lower; it may get a bit worse before it gets better.

Bigger picture, the month of January is purportedly a reliable directional barometer for the rest of the year, per the Stock Traders Almanac. Going back to 1938, if January ends higher the full year should be positive too, with a positive correlation about 75% of the time (and vice-versa to the downside). But keep this in mind, this barometer has essentially broken down over the past decade. Since 2005 there have been 4 years where the market had negative returns in January yet ended the year higher (2005, 2009, 2010, and 2014). Conversely, 2011 saw a strong start to the year only to end exactly where it began. More recently, the past two Januarys have looked like this:

2014, -3.56% (S&P ended the year up +11.4%)
2015, -3.10% (S&P 500 -0.73%)

In the aggregate since 2005 that’s a success rate of just about 50%, which is what you’d except from a coin toss.

For a slightly different perspective, I came across two data tables on Twitter from Ryan Detrick, CMT that I found useful in providing additional context (see bottom of page). The first one highlights that going back to 1900 there have been 14 instances of awful returns in the first 5 days of the year. In 7 of those 14 periods the market ended the year higher (50% of the time), and down the other 7 (50%): we’re just tossing coins again. So, should we read too much into this terrible start to 2016? Probably not. The second table plots 19 other times where we’ve seen steep 5-day sell-offs (across various months, and years), which admittedly makes the current -5.95% drawdown look tame by comparison. I suppose it’s a bit like having a cold and seeing someone suffering from a bad case of the flu. Your day just got a little better after seeing that.

Medium-term

I remain fairly bullish. We have just worked our way through perhaps the toughest 2 or 3 quarters – broadly speaking – for companies in this recovery (i.e., mid-to-late 2015). A decline in oil and the strong dollar has paused profit growth, but I think as we lap these moves the outlook for earnings into 2016 looks OK. And stocks against this background are not expensive, particularly when one considers very low interest rates and inflation. That said, the easy gains have likely been made for the foreseeable future, correlations are lower, and stock selection is therefore important. I continue to believe that at this stage in the bull cycle a true bear market will not engross stocks without a US recession. And here, I just don’t see this in the card for 2016 given the robust, durable, and rather broad-based economic substructure with few signs of excesses building in either the economy or financial markets.

The bull market may not be not over yet, but amid the existing volatility I am sure glad our portfolios are holding some cash.

Happy New Year!

Jason L. Ware, MBA / Chief Investment Officer
Albion Financial Group
jware@albionfinancial.com
(801) 487-3700

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About Albion Financial

Established in 1982, Albion Financial Group is an independent, fee-only financial planner and investment manager located in Salt Lake City, Utah.