Published by Raymond James & Associates Michael Gibbs, Director of Equity Portfolio & Technical Strategy, (901) 579-4346, Michael.Gibbs@RaymondJames.com Joey Madere, (901) 529-5331, Joey.Madere@RaymondJames.com David Hydrick, (901) 579-4812, David.Hydrick@RaymondJames.com August 24, 2015 Weighing the Known vs. the Unknown By Michael Gibbs The abrupt 6.3% four-day decline from the Monday August 17 th close to the Friday August 21 st close has left in its wake a technically damaged market and damaged investor emotions. The market was vulnerable and global growth fears were the trigger: The equity market has been stuck in a sideways trading pattern for approximately nine months. The inability to push higher has been due to slowing earnings trends, the rallying dollar, the collapse in the price of crude, issues with Greece, uncertainty regarding the impact of the move to tighten by the Fed (whenever it happens), and, now renewed fears over global growth especially in the emerging markets. After a 220% price gain off the 2009 bear market bottom, which coincides with the S&P 500 s P/E multiple climbing from under 10x to 18x (i.e. stocks are not cheap), the inability of the market to move higher is not a major surprise with all the headwinds. The loss of momentum and challenges left stocks in a vulnerable state with elevated odds that any shock item could lead to sharp pullbacks. Global growth fears proved to be such a shock item. Much uncertainty has arisen and the one thing equity markets detest is uncertainty. The rapid sell-off and the reasons for the sell-off suggest a rocky ride ahead in the coming months for equity investors as they search for answers. As the summer turns to fall, the equity market enters a period that has historically produced some of the most trying times for investors. Absent a quick defusing of the uncertainty, the odds are elevated for fireworks as the equity market moves through these months this year. Yet, just as the fall of the year has coincided with market declines, the weakness has also set the table for what has been historically the best period of the year (November- April). Even during the credit crisis the S&P 500 gained 17.67% from the low point on November 20, 2008 to the close on April 30, 2009. Granted there were some violent back and forth moves along the way during that period. Luckily, a repeat of the type of price swings of that period is a low probability now. So, based on our belief that this bull market has yet to run its course, any weakness ahead should present opportunity. In preparation for what might lie ahead, it is best to weigh the known versus the unknown to set your course of action. International Headquarters: The Raymond James Financial Center 880 Carillon Parkway St. Petersburg, Florida 33716 800-248-8863
The Issues to monitor in the months ahead: The main market influences, in our opinion, in the coming period will be China (economic, currency, impact on its neighbors and the world), global economic growth, impact of any Fed action (or inaction), collateral damage from the fall-off of energy prices, and earnings (especially in the U.S.). For investors, assessing how these issues may transpire, and the ramifications on the equity market, can help set a risk vs. reward scenario. Monitoring the progression of the issues of the day will alter the risk vs reward and influence portfolio moves. The Knowns vs. the Unknowns China: Economy Known: China s economy has weakened. This is a big deal and is one reason the market reacted so violently on the downside. Unknown: How bad the economy is and what the impact will be on the rest of the world. Thoughts: Although last quarter reported GDP growth in China was 7%, few believe the number. Also, recent data suggests the economy continues to weaken (PMI data on Friday August 21). At this point, it is too soon to pronounce the economy dead. The weaker yuan could help exports in the period ahead. Also, although the economy has not reacted to policy response by the PBOC as of yet, the central bank is likely to attempt additional measures before they let the economy collapse. New measures are likely to get a favorable equity market reaction. 11 10 9 8 7 6 5 4 Chinese Real GDP (YoY%) 2008200920102011201220132014201520162017 Global Economic Growth China s impact on the rest of the world: China has grown to the second-largest economy in the world. It has also been responsible for a great deal of global growth in recent years. Known: The direct negative economic impact on the developed world, as a whole, should not be dramatic. Certain key economies, such as Germany and Japan, will likely be negatively impacted to a greater degree. Yet, as of now, the weight of the evidence continues to point to global growth in the developed world. Source: Equity Portfolio Strategy, FactSet. International Headquarters:The Raymond James Financial Center 880 Carillon Parkway St. Petersburg, Florida 33716 800-248-8863 2
The impact on the emerging world is greater as substantial trade occurs between China and its Southeast Asia neighbors. Many other developing economies, reliant on natural resource exporters, will also feel the impact. Unknown: Same as above, a lack of clarity on how severe the economic weakness in China really is remains in question. We simply need more time and data to assess the extent. Summary: More time must pass and each data point assessed. The equity market will react to every data point. It will then settle and await additional data. The developed world still appears positioned to grow. Although pockets of weakness in the emerging world may slow overall growth, a return to recession in the developed world appears less likely, for now. The vast majority of bear markets have coincided with recessions. Known: Yuan has weakened. Unknown: What will be the impact on China s Southeast Asia neighbors? Investors have not forgotten the 1997-1998 impact currency issues in Southeast Asia had on the world financial markets (the U.S. declined 20%). Known: A repeat of 1997-1998 seems less likely. Most of these countries currencies are not pegged to the US dollar as they were then. Currency reserves (ability to fight attacks on currency and pay back debts) are much larger now vs. then. Also, the currency market of these economies are deeper than they were in the previous period Known: After the move by China many of their neighbors have devalued their currencies to remain competitive The Unknown: Economies in the region have external debt balances especially debt denominated in U.S. dollars. As their currencies decline especially vs. the U.S. dollar the amount of debt they must pay back increases. With many of these economies suffering from capital flight and slower revenues from falling exports, (the main export of many are commodity products energy being the largest) the inability to pay back debts will increase. A default, or fear of default, could trigger angst resulting in declines in U.S. equities. Summary: The risk of financial issues in the emerging world is elevated. If multiple blowups occur around the globe as a result of external debt issues, currency issues, or civil unrest, there is a high potential for sharp declines in the equity market. We highlighted that most bear markets coincide with recessions. Yet, there have bear markets when no recession occurred. One such bear market was in 1998 as the Asian currency crisis eventually triggered a 20% decline in U.S. stocks. We don t feel such a decline is a risk currently. For what it is worth, the equity market returned to a new all-time within four months of the previous alltime high in 1998. The Fed: Known: The Fed is going to move at some point International Headquarters:The Raymond James Financial Center 880 Carillon Parkway St. Petersburg, Florida 33716 800-248-8863 3
Unknown: When and by how much they will move. What the impact on the financial markets will be. Thoughts: If the financial markets remain under-pressure, and if additional data points suggest questionable economic growth, the Fed will be less likely to move on rates in September. Regardless of when they do move, the higher probability of slower, rather than faster U.S. growth, suggests a slow rate of tightening. In this scenario, the likelihood of rapidly rising interest rates (bad for stocks and bonds) are much less likely. Earnings: Earnings are the key driver of stock prices over the long term Known: Earnings trends have weakened. 1Q and 2Q for 2015 produced year-over-year declines. Expectations are for earnings to decline again year-over-year in 3Q. Unknown: When earnings will stabilize and resume growth. Known: Energy has been a big reason for the decline in earnings, as has the rise in the U.S. dollar. For example in 2Q15, earnings for the Energy sector declined 56.4%, according to FactSet. Also according to FactSet, if energy were removed, earnings actually increased by 5.7%. The impact of the dollar is tougher to quantify, but based on general company guidance currency is having a significant impact. The recent resumption in the sell-off in crude oil prices will continue to weigh on activity in the Energy sector. Also, the recent move higher in the dollar (and potential for a continued climb) will weigh on earnings. Yet, the future impact of both of these items should be less in the periods ahead than in the most recent periods. Current expectations call for a return of earnings growth as early as 4Q15. For 2016, current expectations are for earnings growth to return to double-digit levels. This may be tough to envision, but even a resumption of half that growth rate will lessen the negative impact the slowing trend will have on stocks. Summary: As of now, we are comfortable believing the market is going through a normal correction of what remains a bull market. Yet, we acknowledge the issues of the day could alter this belief if a larger threat to global economic growth develops, or if a financial event occurs. Regardless of the outcome, it is wise for all investors to prepare for various what if situations. Previously, we highlighted the issues we feel are most important above. The following is a suggested course of action. Set Your Course of Action The big issue for long-term investors will be a determination if the issues are great enough to trigger the next bear market. Given that most bear markets coincide with economic recessions, make macro data the most important variable to monitor. This class of investor also needs to decide if they are adequately diversified to ride it out or do they need (or desire) to make moves along the way, if a bear market does develop. If you are diversified enough to ride it out, don t over think it and attempt to avoid getting caught up in the emotion of the day. If you desire to make some changes along the way, monitor the items we highlighted above. As each data point presents a challenge (or is proven to be less problematic) make your moves accordingly. Try not to make moves as a International Headquarters:The Raymond James Financial Center 880 Carillon Parkway St. Petersburg, Florida 33716 800-248-8863 4
reflex reaction to your emotions. Remember, even in declining markets counter-trend rallies occur quite frequently and are often quite large. During the last bear market, we count numerous counter-trend rallies that produced price percentage gains in the upper single digits to low double digits. In the final phase of the move, in late 2008 and early 2009, we count two 20% rallies. In other words, making moves (if you chose to lighten positions) is better done during the reflex rallies as opposed to cascading sell-offs. For investors with shorter-term time frames, become familiar with the issues of the day and monitor the progression. Set an expectation for a potential trading range for the market, or you can use the ranges we suggest (see below). Re-evaluate the ranges with each progressive data point on the issues. Widen the range as the data flow becomes more negative and vice-versa on positive flow of data. Follow a disciplined approach to make your moves as the market trades within your expected range. Aggressive types can make moves as the market hits extreme levels of the expected range. Less aggressive types should wait for confirmation the market will hold (the downside) or fail (at the upside) before making moves. Confirmation is often as simple as a follow-though move to the initial rally off the low or follow-through decline to the initial failure at resistance. Current Range Expected for the S&P 500: Combining fundamental, psychological, and technical rationale. Fundamental: Currently, we are maintaining our expected S&P 500 P/E range of 16.5x to 18x. This results in a range of about 1950-2150 over the next five or so months (assuming current year-end projected earnings of $119 come to fruition). Over the next 16-18 months our current range is about 1950 to around 2250. We are using $125 for 2016 year-end earnings vs. current consensus of $131. Earnings data is from FactSet and may differ from earnings reflected by other services. A word of caution, drawing a line in the sand at these absolute prices is foolish. Use them as a guideline of an area near where the S&P 500 is fairly valued. During volatile markets, equities are likely to overshoot realistic fair values. As calm returns, the proper value is typically found. Psychological: Investor mood dictates the P/E they assign to current earnings (see chart below). When issues of the day are few (or generally more positive) the P/Es assigned in normal market gyrations are sometimes more narrow. When issues are heightened, or if the issues are potentially more problematic, the gyrations will become larger. Our current tight range of 16.5-18x is rapidly approaching a point where we believe it needs to be widened. But for now, we will stay with the range. Technical: The S&P 500 sliced through obvious support levels as it moved down last week (8/18-8/21). As each level of support fails, turn to the next level to see if it will provide support. This is one reason we suggest those more disciplined less aggressive types wait for the market to supply some evidence a support level becomes more likely to hold. Next levels to watch: Horizontal support near the close of trading on Friday the 21 st (1970) should be monitored. This is near the reaction low prices on December 16, 2014 (1972) and February 2, 2015 (1980). As a reminder, don t become overly focused on the exact number because somewhere near the level still qualifies it as support. International Headquarters:The Raymond James Financial Center 880 Carillon Parkway St. Petersburg, Florida 33716 800-248-8863 5
The main level of our focus for this decline is near 1940. This would be a 61.8% retracement of the October 2014 low to the May 2015 peak. We will not go into great detail other than to say we find using retracement levels a useful technical analysis practice. More importantly, the level is near a 16.5x P/E, which is our current base case low P/E. For what it is worth, the S&P 500 bottomed last October at 15.85x P/E. That decline was also caused by global growth worries due to China. If the market returns to a similar P/E, due to the current global growth worries, the S&P 500 would likely trade at about 1880. In summary: The heat has turned up and equities have hit a rough patch that may carry forward in the coming months. Despite the risk, we continue to believe the current bull market has not runs its course. For this reason, the potential volatility in the weeks and months ahead is most likely a good opportunity. Although this is our expectation, we are fully aware that if the current issues in China (economic and currency byproducts) continue to grow, a much more problematic outcome might occur. Yet, if this turns out to be the case it will be a building process with time. The market will go through declines then counter-trend rallies as the process unfolds. See our report: Bull Market Tops for illustrations of how the last five bull market tops developed. For now, monitoring the situation as it progresses is the most appropriate course of action. For all investors, decide what you wish to accomplish and analyze how you are positioned. Consider all the possible outcomes, good or bad, and plot a plan of action. Lack of preparation will result in emotional moves a recipe for disappointment. International Headquarters:The Raymond James Financial Center 880 Carillon Parkway St. Petersburg, Florida 33716 800-248-8863 6
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