Market Risks Increasing

Market risk has risen substantially over the past month.  October’s reflex rally was driven substantially by an apparent basing in the energy markets, the subsidence of concerns surrounding China’s economic situation, and the lack of action by the US Federal Reserve.   The energy markets have again destabilized over the past month, concerns about emerging markets and China have resurfaced, and more knowledgeable analysts are highlighting the market dislocations that are emerging as the Federal Reserve’s monetary policies may diverge from the rest of the world.

The Bank of International Settlements in their BIS Quarterly Review is clearly quite concerned about not only market fundamentals but also deep structural issues that might emerge in the markets from divergent US monetary policy, to wit:

“…the positive and negative effects of a rate hike are perceived as broadly balanced for equities.  On the one hand, higher rates would be positive as they would confirm the strength of the US recovery.   But higher rates would inter alia increase interest expense for corporations.  Low rates have helped bolster high profit margins despite low earnings growth for US corporations in recent years.   Earnings in fact fell in the third quarter, by -0.6%.  Historically, earnings shrinkage has signaled recessions, although few analysts now forecast such a development.”

“Markets also continued to be propped up by leveraged positions, which may be vulnerable to higher interest rates.   Although down from its August peak, margin debt in the US equity market remained within reach of previous record highs seen in the run-up to the dotcom bust more than 10 years ago.”

“…such a large negative basis indicates potential market dislocations.   And this may call into question how smoothly US dollar funding conditions will adjust in the event of an increase in US onshore interest rates.   Similar pricing anomalies have also emerged in interest rate swap markets recently, raising related concerns.”

“Such volatile movements in euro area interest rate derivative markets raise questions about smooth pricing responses in the face of possible transient order imbalances.  Of question is liquidity in hedging markets and the capacity of tradition options writers, such as banks, to provide adequate counterparty services to institutional hedgers.”

I have reported for some time now US operating earnings have now dropped for four consecutive quarters.  With 98% reported for 3Q15, S&P 500 operating earnings are now 14% below their peak in third quarter 2014, and at levels not seen since first quarter 2013.   The primary explanation for why analysts are ignoring this fact is the dramatic fall in energy sector earnings.   However, as I have pointed out in the past, the markets are more than fully valued even excluding the energy sector.   Large cap stocks, excluding the energy sector, have an average PEG ratio (operating PE ratio divided by 5 year projected earnings growth rate) of 1.87; midcap stocks (also excluding energy) have an average PEG of 1.59, and small cap stocks (excluding energy) have a PEG of 2.09.    Excluding the energy sector, large cap stocks have an average trailing 12-month PE of 18.3x, midcap stocks 20.5x, and smallcap stocks a whopping 25.1x.    I continue to see the state of earnings and valuations as a fundamental risk to the markets at this juncture.

After a ten-year downtrend, the US dollar index has now rallied 33% from its Summer 2011 lows, breaking out of the downtrend in December 2014.   The US dollar index was up 12.5% in 2014 and is up another 10% year-to-date in 2015.   This is dramatic volatility for the world’s reserve currency and dominant trading currency for crude oil.    If the Federal Reserve does diverge from the rest of the world with its monetary policy, it will likely propel the US dollar index higher.    How high is debatable, but some analysts feel that it could reach its 2001 highs in the 120 range, or 23% higher from today’s levels.    While the Fed focuses its public comments on the US economy and employment, the effects of a much higher US dollar index, particularly if the rise is as mercurial as it was in 2014 and 2015, would cause more market dislocations with systemic risks.  If the Fed fails to raise rates in their meeting next week, these observations will certainly have been a major contributing factor.

Crude oil prices and the US dollar index generally move in opposite directions, which has been extremely clear since 2014.   Oil is now down -60% from its June 2014 highs; after a false breakout in May-June 2015, crude oil has continued to plummet and is now trading within a few dollars of the February 2009 lows.   While there are certainly currency forces at work here, there are also supply/demand forces.   OPEC’s November monthly report noted output of 31.695 million barrels per day, the highest production rate in 3.5 years.   Iraq had the largest percentage output gains, reaching 4.3 million barrels per day in November.    The US renaissance in oil production has contributed to swelling supplies – US crude oil output has grown from around 5 million barrels per day in 2011 to 9.3 million barrels per day.   Meanwhile, growth in global demand for crude has been below forecast.   It seems likely that this massive dislocation in the energy markets will continue for some time, presenting additional market risks.

US equity market breadth has continued to be weak, even as we trade with a few percent of the all-time highs.    One analyst noted that since 1970, the US equity markets have traded within 3.5% of its all-time high on 5500 days.  In only 15 of those 5500 cases were net new lows more than 10% of all stocks traded in the NYSE.   Yesterday was one of those 15 cases.    In fact, 4 of the 15 cases occurred in 2015, 2 occurred in July 2007, and 4 occurred in December 1999.   Only 47.6% of stocks in the S&P 500 are currently trading above their 200-day moving average.   The narrowness of market participation continues to be concerning.

Russia, Brazil, and Argentina are in recession.  China just reported its lowest GDP growth rate (third quarter) since the first half of 2009.  The Economist poll of economic forecasts shows that expectations in 2016 are modest at best; Austria, Belgium, Britain, Canada, Denmark, France, Germany, Italy, Japan, South Africa, Netherlands, and Switzerland are all expected to have GDP growth under 2% in 2016.   And, economic forecasters have been overly optimistic for some years now.   There continue to be analysts that believe that the US (Economist forecast of 2.5% GDP growth in 2016) will enter recession in the second quarter of 2016.    Currency volatility, dislocations in fixed income markets, dislocations in energy markets, and expanding terrorism present downside risks to these muted forecasts.

The general meme that the Fed is raising rates in the US for positive reasons, the performance of the economy and employment, has played unchecked for the last several months.    However, it is my opinion that there will be a reset of expectations as we receive fourth quarter economic and earnings data in January.   While this may only have the effect of perpetuating the sideways action we have seen in the US equity markets since early 2014, at these valuation levels the possibility of a more serious correction is clearly present.