article 02-17-2016

Wild Swings and Black Swans

Charlie Dreifus looks at the underwhelming 2015 and the wild, bearish start to 2016, which have frightened investors already anxious over weak commodity markets and sluggish global growth. What might be next for careful stock pickers?

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For the market overall, 2015 was a wild ride to nowhere. The S&P 500 averaged the highest number of intraday swings since 2008. It was a particularly bad year for penny-pinchers and bargain hunters—U.S. growth stocks trounced value stocks.

As we have seen recently, the market wants higher commodity prices, as does the Federal Reserve. That would certainly help the distressed sectors of the world economies and currencies in emerging markets while also harnessing the strength of the U.S. dollar.

Frankly, though, it is still difficult to see why commodity prices should advance on a sustained basis. The subpar growth rates from the only major economies (U.S. and China) make it likely that commodities remain weak. In fact, China’s situation also makes further currency turmoil more likely as it weakens its currency.

The market’s overall flattish results in 2015 belie the fact that a tiny handful of big names—Facebook Amazon, Netflix, and Google, now collectively grouped as FANG—pulled the market out of overall negative territory. The majority of stocks actually finished the year in negative territory. This narrowness was not a new phenomenon. We saw it in the “Nifty Fifty” market of 1972-1974 and in the 1999-2000 Tech bubble.

This time, however, it was even narrower. The premium paid for growth in an increasingly revenue starved world is understandable, but only to a point. One has to wonder, though, if that was really what motivated the buyers of these anointed issues—it may have been merely mindless momentum players.

Growth at any price, does not persist forever. In addition to the “Nifty Fifty” and Internet bubble, we appear to be seeing it in early 2016. Nonetheless, it can take time for the laws of economic logic and reality to resurface.

The possible test for this year, and further out, is whether current P/E multiples are sustainable without aggressive monetary policy. If not, can earnings growth compensate for declining multiples? The answer to these questions will determine the investment rate of return going forward. Given the background of tepid demand for equities, particularly from individual investors who have endured two major market declines in the past 15 years, it will be very difficult for the entire market to undergo multiple expansions.

This suggests that stock picking will become increasingly important. We are closer to our day. We strongly believe granular security selection, that is, stock picking, will soon shine again.

No doubt we all are finding it difficult to properly value stocks in light of the fact that central bankers have manipulated the risk-free rate to such lows. Stocks are inexpensive compared to their risk free benchmarks, but really only to that. The Wilshire 5000 Index relative to U.S. nominal GDP has come back close to its 2000 Tech bubble peak.

Perhaps it is okay because of the T.I.N.A. principle (“There Is No Alternative” to equities), as the Fed funds rate was 6.25% in 2000. Has central bank easing front-loaded returns over the past five years? Should we curb our enthusiasm? Is demand for stocks satiated or, even worse, more than satiated?

Consumption is doing all right. A new phrase—secular rejuvenation—is being used to describe the improving consumer situation in the U.S. Real incomes, as well as expectations, have risen, and perhaps most important household formations increased in 2015 and are expected to rise again this year.

The 2016 economy also got a boost late in December when Congress increased spending and cut taxes. This often happens ahead of elections. These actions could add 0.7% to U.S. GDP in 2016.

"With volatility returning, it should come as no surprise that dividend payers have become more popular again as they have provided a steadier return over long periods of time. The macro backdrop also seems to be encouraging investors to seek yield.'

The appetite for junk bonds and leveraged loans has waned. In some cases Wall Street banks can be left funding what others will not. There is no mistaking what is happening in the credit markets there is more selectivity regarding credit quality—even if this has not yet been fully reflected in the equity market.

Some have started to question the health and liquidity of the corporate debt market. We still believe it would take a 10-year Treasury yield north of 4% to be competitive with equities; we doubt that can occur for many years. The Fed would need to aggressively sell their holdings accumulated during quantitative easing for that to occur.

Are equity markets addicted to massive central bank accommodation? Since the Fed ended quantitative easing in October 2014 and the expanded its balance sheet later that same year, U.S. stocks have basically gone nowhere.

Obviously, valuation and other factors also come into play. In a climate of modest growth, geopolitical conflicts, overall uncertainty, and elevated asset prices, it is hard to make the case for total returns above their historic 8%+ range.

With volatility returning, it should come as no surprise that dividend payers have become more popular again as they have provided a steadier return over long periods of time. The macro backdrop also seems to be encouraging investors to seek yield.

All does not seem right. Sentiment is hardly positive, with many market participants now watching for Black Swan events. The main concerns revolve around economic conditions in China, Brazil, Russia, and other energy markets, as well as geopolitical issues, particularly in the Middle East.

This sets up the opportunity for another strong advance as shorts are covered if the Fed’s comments become more dovish before its March meeting. As of now, of course, most would consider a March rate hike a policy error.

Perhaps we are at the point where fiscal policy initiatives should be leading the charge to improve economic growth. This need becomes more and more critical given ever more limited monetary options as the global economy seemingly slides further into a spiral of deteriorating growth. The financial strain is intensifying.

We have witnessed 22 consecutive quarters in which the trailing 12 month EPS for the S&P 500 has been up more than the trailing 12 month’s sales. While we are big believers in being lean and mean and in the power of incremental margins, this trend is growing long in the tooth. Without a pickup in revenues, the earnings improvements will fade out.

Did the Fed move too soon in raising rates in December? Is the global risk asset mood crossing over from simple noise into something more serious—even game changing? Time will tell.

Wild swings in the ruble and double-digit inflation are complicating Vladimir Putin’s job. Russia is already in its longest recession since Putin came to power more than 15 years ago. He is also fighting in two wars. We should expect the unexpected from him.

History teaches us that the kind of price declines we have seen in oil and other commodities causes some type of crisis—and what we have endured so far would not qualify. Some of the market’s volatility woes are due in no small measure to quantitative models and robotic trading that may not have been programed to account for the current environment— because it has no historical precedent.

The lack of any positive developments resulting from recent quantitative easing and/or forecasts around the world was disturbing. Certainly if the market took the kind of steep nosedive that led to widespread financial losses, it would help push the economy into a recession.

Let’s hope that outperformance for many active small-cap approaches so far in 2016 continues. The market makes it feel like it should.

Important Disclosure Information

Charlie Dreifus is a Portfolio Manager and Principal of Royce & Associates, LLC, investment adviser to The Royce funds. Mr. Dreifus's thoughts and opinions expressed in this piece are solely his own and may differ from those of other Royce investment professionals, or the firm as a whole. There can be no assurance with regard to future market movements. No assurance can be given that the past performance trends as outlined above will continue in the future.

The S&P 500 is an index of U.S. large-cap stocks selected by Standard & Poor's based on market size, liquidity, and industry grouping, among other factors. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.

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