The following commentary was originally sent to Action Alerts PLUS subscribers on Jan. 8, 2016, at 11:36 a.m. ET.
The start to the New Year has been nothing short of dreadful for the global markets, with the "when it rains, it pours" convergence of geopolitical, macroeconomic and commodity risks -- headlined by (but not isolated to) a complete and utter structural breakdown in the Chinese markets -- sending vicious shockwaves across each and every global market. While the damage of the past several days cannot be unraveled, 51 trading weeks remain in 2016, which is why we would like to take the time to provide our subscribers with our outlook for the balance of the year.
We will present our overarching outlook with a "puts and takes" approach, as we believe each positive theme is balanced by (potential) negative implications.
Sentiment is low. Very low. Valuations have come down from when we published our first "bearish" piece back in early November, with S&P 500 trailing price-to-earnings (P/E) ratio 1.25 turning lower in the two months following the report. While it is impossible to forecast the market P/E ratio going forward, the downside rerating provided some valuation relief. Fear, panic and anxiety have defined recent market activity, with emotion at times overriding cerebral analysis.
Offsetting this is the reality that valuation expansion going forward is unlikely. The S&P 500 valuation expansion cycle that began over four years back drove P/E multiples 60% higher (which, according to Goldman Sachs, persisted more than three times longer than the typical 16-month expansion). Incremental Fed interest rate hikes blunt the potential for further P/E expansion. The median S&P 500 stock trades at 17x forward earnings, well above the five-, 10- and 35-year median of 15.5x, 15x and 13.5, respectively.
While S&P 500 companies are forecast to return more than $1 trillion to shareholders this year, the majority (60%) of these capital returns are expected to come in the form of buybacks, which we strongly disfavor compared to dividends. Since much of the buyback activity last year (roughly $570 billion across S&P 500 companies) was funded through debt rather than existing cash, we believe the rising interest rate environment diminishes the impact/accretion from buyback programs going forward. Although capital devoted toward buybacks may have a powerful short-term impact on a nominal basis, it may be in lieu of using that cash for investing in the company's core business (which ultimately leads to long-term value creation).
Next, the strength and resiliency of the U.S. consumer are intact. Job creation remains strong, with the economy adding an average of 221,000 jobs each month through 2015 and 284,000 in the last three months of the year. The December employment report released this morning -- in which 292,000 jobs were created, above consensus estimates for 210,000 -- validates what we have been seeing and saying for the past 12 months. Consumers are also working more hours per week and making more money per hour than they were a year ago. Beyond this, the housing market is improving, household debt is down (with consumers using savings at the pump to deleverage), and consumer confidence is up. Interest rates remain historically low -- even after the Fed's latest hike -- providing consumers cheap access to credit, enabling a robust cycle of mortgage refinancing.
The main counterpoint to this is that the "savings at the pump fuels consumer spending" argument has yet to play out, with consumers having pocketed -- rather than spent -- their savings at the pump throughout the entirety of last year. Further, lower gas prices -- while a boon to the car-owning consumer -- are a drag on the 200,000 energy workers who lost jobs last year as a result of the energy market's historic collapse. We expect more energy jobs to be slashed this year, as historically low oil prices (Brent crude oil trading at 11-year lows) will not only force the smaller companies (lacking scale and access to capital) to turn off their lights but larger companies to further cut production while simultaneously slashing variable expenses -- jobs being the most malleable target -- to cover fixed expenses/overhead (equipment, property, etc.). Disappointing manufacturing data (which weigh on industrials, especially those with a global presence) and arguably a cyclical peak in the semiconductor industry also give us pause.
Third: The rest of the world is easing. Europe, Japan and China are all expected to exercise varying degrees of fiscal stimulus in 2016, providing a decent offset to the economic headwinds pressuring each respective economy. Offsetting this is the aforementioned reality that our own central bank is tightening, with 100 basis points of incremental rate hikes expected for the balance of the year. Prior to the December meeting, it had been a decade since the Fed last raised rates. For 10 years, investors and companies alike were served free money on a platter akin to a gambler being served free alcohol in a casino; the punch-drunk love inevitably distorted judgment and in many cases drove decisions that would have otherwise made little sense in a rising rate environment.
For instance, take a construction company that has based its investment decisions in property, plant and/or equipment using a <I>de minimis </I>"discount rate." While the return on investment may have exceeded the hurdle in a zero-rate environment, the return on that same investment diminishes significantly when that "discount rate" is adjusted upward.
Finally, let's address the stronger dollar (which is further driven by rising rates). On the positive side, domestic consumers have more buying power and imports are less expensive. This is a positive for domestic companies selling their products exclusively (or mostly) in the U.S. On the flip side, a strong U.S. dollar makes U.S. exports more expensive internationally, which can lead to declining sales and profits for companies selling outside the U.S.
All in, we have mixed expectations for 2016. The honeymoon period for stocks is decidedly over, and many outstanding uncertainties remain cloaked in mystery. We have confidence in our domestic economy, however, and hope the Federal Reserve approaches its coming rate decisions with a heightened sense of caution. Given the unprecedented nature -- and sheer magnitude -- of its seven-year quantitative easing program, it is absolutely crucial the Fed understand the weight of its future decisions. Job creation should be just one of many considerations, not the least of which include persistently low inflation, geopolitical instability, a structural breakdown in the world's second-largest economy (China) and collapsing commodity prices.
We believe a selective, active and thought-intensive investment approach is considerably more important in today's uncertain environment as compared to the prior cycle -- marked by a Fed-fueled 300% return between 2009 and 2014 -- which required zero thought or analysis in order to make money hand over fist.
As for our Action Alerts PLUS portfolio, we will stick to names that are both undervalued and possess strong balance sheets (AAPL, CSCO, JACK, GOOGL); misunderstood (AGN, BIIB); have powerful restructuring stories (DOW, KHC, WBA); offer stable, diversified and scalable business models that throw off cash in spades (COST, LMT, TMO); as well as two bank names levered to rising rates (BAC and WFC).