Thursday, January 14, 2016

January 10, 2016

After an unsatisfying 2015, markets both here and abroad ushered in the New Year with a sharp sell-off.  You can see below that the key indexes fell between 6% and 8% in just 5 trading days.  For those who are historians, both the Dow Jones Industrial Average and S&P 500 had their worst first week performance of a year ever.  Ouch.

Time Period
Dow Jones
Industrial Average

S&P 500

Russell 2000

Week 1, 2016
Source:  The Wall Street Journal (Past performance is not indicative of future returns).  As of market close January 8, 2016.

International markets shared in the selloff as well with most global indexes down around 6%.  China suffered the most with the Shanghai Composite losing 10%.

Time Period

Global Dow xUS

Dow Jones
Devel Mkt Region
Total Stock Market
Dow Jones
Emerg Mkt Region
Total Stock Market
Week 1, 2016
Source:  The Wall Street Journal (Past performance is not indicative of future returns).  As of market close January 8, 2016.

The 5-day decline of 6% in the S&P 500 this past week is eerily similar to the 11% 6-day decline in the S&P 500 from August 18th to August 25th last summer.  Now as then, most analysts and commentators place much of the responsibility squarely on the back of China and that country’s slowing economy and weakening currency.  Similarly, oil prices fell 10.5% last week compared to 9.6% over the six-day stretch last August.  What is new this time around is the Federal Reserve has raised interest rates a quarter of a percent, and I would argue the geopolitical threat from terror has increased.

A fair question to ask is whether US investors should be worried about a Chinese slowdown.  I will address this topic and my outlook for 2016 in the next section.

Before turning my attention to 2016, I would like to do a quick look back to some 2015 data. 

The best performing sector in 2015 was Health Care with a nearly 6% gain followed by Consumer Discretionary (+4.8%) and Information Technology (+3.6).  Energy (-25.5%) was the worst performing sector by far followed by Materials (-12.3%) and Utilities (-8.2%).  Avoiding or under-weighting these sectors was important for portfolio performance in such a lackluster year.
The Federal Reserve raised interest rates for the first time in seven years increasing the overnight lending rate by a quarter percent (25 basis points) the third week in December.  Speculation about the Fed’s move was one of the dominant topics in 2015, yet after the move, little changed.  Interest rates finished the year marginally higher in a year when rates meandered about.  The benchmark 10-year US Treasury closed up 0.1% to 2.27%.  The Bond asset category was a disappointment in 2015.  The Barclays US Aggregate Bond index was up just 0.6% and only five of the sixteen taxable bond sectors tracked by Morningstar® were positive in 2015.  The best performing taxable bond sectors were Preferred Stocks (+3.2%), Intermediate Government (+0.4%), and Short-Term Bond (+0.2%).  The worst performing sectors were Emerging Markets Bond (-6.0%), World Bond (-4.1%), and High Yield (-4.0%).

Commodities continued their downward free-fall in 2015.  The Dow Jones UBS Commodity index, which captures a broad swath of key commodities, fell 25% last year after falling 17% in 2014.  WTI Oil, a key component of the commodity sector and US economy, fell 30.5% in 2015.  Since oil’s most recent peak in July 2014 ($93.85), the price has fallen over 60% closing last Friday at $37.04.  The impact on falling oil prices both here and abroad has been profound.  According to the research firm FactSet, earnings in the Energy sector are estimated to decline 59% in 2015.  FactSet is also estimating that earnings across the S&P 500 will fall 3.3% in 2015.  However, if the decline in Energy earnings were stripped out of the estimate, the other nine sectors are expected to post a net increase of 1.1%. 

The US Dollar continued to gain in strength in 2015.  The US Dollar index, a comparison of the US Dollar against a basket of the other major currencies, gained 9.3% in 2015.  The US Dollar was up 10.3% against the Euro and up nearly 1% to the Japanese Yen.  The impact of a stronger US Dollar helped contribute to lower US corporate earnings, poor international stock and bond performance at home, and a decrease in demand for oil overseas.  Currency fluctuations play an important role in global economics and I believe will continue to do so in 2016.


Early last year (January 25, 2015) I talked about four big themes to watch in 2015:  Greece, the US Federal Reserve raising interest rates, geopolitical risks abroad, and the uncertainty surrounding US domestic politics.  While Greece created all sorts of trouble for the markets early in the year, the Europeans managed to stabilize the European Union.  The Fed did raise rates a quarter percent at their last meeting in 2015 and the sun still came up the next day.  Geopolitical challenges came and went.  Terror attacks continued and stability in the Middle East deteriorated without significant impact on markets.  However, oil prices fell during the political turmoil in the Middle East and that is a new twist on global economics.  Finally, my prediction that growth-oriented policies coming from Congress would be minimal has unfortunately turned out to be true.

While I did not feel like the economy was likely to grow at a rate greater than 2.5% in 2015, I thought equity returns would be better than they were.  I believe that the energy sector was responsible for much of what has challenged markets.  However, I also believe that the anti-growth fiscal policies via law and rulemaking, has much responsibility for lackluster growth as well.  Finally, a stronger US Dollar has diminished earnings of US companies that have large overseas earnings.

My outlook for 2016 is MORE OF THE SAME resulting in lackluster economic growth (less than 2.5% real gross domestic product (GDP), more volatility in the markets, and equity returns that fail to exceed the 8.5% average annual return of the S&P 500 since 1980.  I believe it would be a great year if we did meet that 36-year average, but I am not optimistic thinking we will fall somewhat short—something that has happened about four times every ten years since 1980.

Let me say upfront that I do not have a crystal ball or some magical powers to predict the future.  In fact, I have felt for years making predictions was a fool’s errand.  However, I do believe that it is very necessary to have some expectation about the near future to properly position portfolios.  Let me offer my rationale for why I think next year will look much like this year.

1)      All the actors on the global stage are the same.  The political and economic leaders are unchanged and are not expected to change in 2016 (clearly 2017 may be a different story).  We know what President Obama thinks about US economic policy, what Ms. Yellen thinks about monetary policy, what Ms. Merkel thinks about the European Union (EU), and so on.

2)      Going into the November presidential elections there will be no improvement in fiscal policies coming from Congress.  I do believe there remains more downside risk in Washington as President Obama tries to maximize the regulatory legacy of his administration in his last year.

3)      Corporate earnings and revenue growth have been slowing.  Corporate earnings is the food that feeds the market and without earnings growth, markets will struggle, in my view.

4)      Oil prices will continue to struggle to find equilibrium.  Even if oil prices do stabilize, I believe they will be lower than they have been over the past decade for the near future.

Here are some of the key themes and issues I anticipate will be important in 2016:

China remains a problem for the world.  The Chinese have a big challenge on their hands.  They are trying to turn a manufacturing economy into a more consumer-oriented economy.  Additionally, the communist lords who rule China have tried to have a capitalistic economy under their authoritarian rule.  By controlling the media, communications, corporations, and markets, they have managed to succeed as long as China remained at the center of the manufacturing universe.  Today, however, other countries like Vietnam, Malaysia, and Indonesia are all competing for low-cost manufacturing jobs.  This has placed growing pressure on Chinese manufacturers who are paying more for labor and struggle to get the financing necessary to upgrade their manufacturing capabilities.  Furthermore, the Chinese government’s push to have the Yuan as part of the International Monetary Fund’s basket of reserve currencies which till now has included the US Dollar, British Pound, the Euro, and the Japanese Yen; places pressure on the Yuan to be more freely traded and has led to a sharp devaluation in the past six months or so.  Until China proves that it can be a trusted and transparent member of the economic community, I believe there will be continued uncertainty in the global markets, but do not look for the global economy to collapse over this single issue.

I believe that oil prices will stabilize.  I do not know where that point of stabilization will occur, but I do believe it will.  This is how commodity markets have always worked.   I do believe the price will stabilize closer to $32/barrel than $95/barrel of our recent past.  I continue to believe that low oil prices are a great benefit for most of the economy, but clearly, the energy sector is under a great deal of stress.  The United States has the potential to become the world’s greatest oil producer but has a long way to go even as oil exports have been permitted for the first time in over 40 years.  Energy prices will continue to be a key issue in 2016.

The Federal Reserve will remain in the forefront of investors’ minds.  After getting the first rate hike accomplished last year, the discussion will now turn to the frequency and magnitude of future rate hikes. The Fed must walk a very tight balance between normalizing rates while not harming a sputtering economy or reacting too late to prevent an inflation surge.  Markets are currently predicting two additional 0.25% rate hikes this year and next.  Where would the financial media be these days if they did not have the Federal Reserve to worry about?

Interest rates should continue their upward trajectory; however, there are many factors that influence interest rates including the Fed, inflation, and economic growth.  Interest rates have historically been the most difficult to predict and the past few years have been no different.  Rising interest rates need economic growth and some degree of inflation to move upwards.  I believe real economic growth will continue to run below 2.5%, so for rates to rise considerably higher than where they are today, I think inflation will need to tick up.  Inflation, in my view, will remain subdued; however, if oil prices stabilize, there may be an uptick in inflationary pressure. I discussed this issue in some detail in my December 20, 2015 Update.  If inflation speeds up, the Fed may have to pick up the frequency and possibly the magnitude of their rate increases which may in turn put additional pressure on bonds.

The Bond asset category will continue to struggle in my view.  Rising interest rates, uncertainty in the lower quality bond sectors, and the Fed’s monetary policy all point to a similar weak performance like we saw in 2015.  Higher yields will continue to come from higher-risk assets that may be prone to periodic selloffs. 

The US Dollar will continue to strengthen in 2016—just not as fast.  The currency market is the largest capital market in the world with average trading volume in excess of $5 trillion each and every day.  The free flow of cash around the world is instrumental in orderly global trade, but it is also an indicator of the strength or weakness of a country or region.  Currencies trade like commodities and are subject to the same supply/demand issues that affect the price.  The US Dollar has been in demand because traders have believed interest rates on US Treasuries will continue to increase compared to other nation’s bonds, and because the security of US Treasuries is second to none.  Traders who fear the geopolitical turbulence frequently turn to US Treasuries thus increasing demand for the US Dollar.

European growth will continue to lag the US.  I have little confidence that developed European countries will be able to grow at levels close to or better than the US.  Europe is the US on steroids in terms of over-taxation, government regulation, and wealth transfer payments.  All of this gives me little reason to be optimistic about growth in developed Europe even as the European Central Bank (ECB) continues with its quantitative easing program.  Eastern Europe, if allowed to act independently of either the European Union or Russia could offer excellent investment opportunities.  However, this is a big if.  I believe Emerging markets will continue to struggle under the challenges of a stronger US Dollar and weakening demand from China.  As I have said recently, I am not ignoring international investing; I am just suggesting there are some serious headwinds to investment there now.

I believe volatility will increase due to the Fed’s desire to return to more normal monetary policies.  We have benefited since the 2008 recession by Fed policies that indirectly helped dampen volatility, and that has been a great thing for investors.  I do not know a single investor that enjoys volatility, but most accept this as the price to be paid to be a long-term investor.

Finally, I fear that acts of terror will continue in 2016.  As the world adapts to this new reality, I do not believe markets will over-react to such events provided they are isolated and have minimal impact on economic activity. 


Although I do not believe 2016 will be a great year, I do believe the US economy is not going to fall off a cliff.  We appear to be in a transitional year.  After years of near zero interest rates from the Fed, we may well be for a period of rate increases, albiet small ones.  Leadership in the White House will certainly change in early 2017, but to who we have no idea.  From an investment perspective, I hope that the next President and Congress can do more to help growth than has been the case for so many years.

The S&P 500 is currently 71% oversold.  Traditionally, when markets become more than 100% oversold it becomes an attractive point of entry.  Another important signal I watch, the New York Stock Exchange Bullish Percent (NYSEBP) is an indicator of what I consider the overall riskiness in the market.  The current reading is 28 and I consider anything below 30 to be generally less risky going forward.  For perspective, the NYSEBP reached down to 26 last August during the first China related selloff, and to 18 during the last major correction in the fall of 2011.

Most of you are now familiar with the Dorsey Wright & Associates Daily Asset Level Indicator (DALI) chart below.

As of January 11, 2016.  Source: DorseyWright & Associates.

This chart outlines the most basic relative strength relationship between the six major asset categories.  Since my last Update, there has been no change in the order of the six major asset categories, but there has been some changes to the underlying tally scores of each.  Domestic Equities has shown some weakness falling from 341 to 323 since my December 20th Update.  The numbers indicate that weakness in the small capitalization sectors is responsible for much of the decline.  Fixed Income (bonds) remains number two and has improved as has Cash (Money Market sector).  Currencies and Commodities have also improved although the Commodity asset category remains firmly in last place.  International Equities weakened by the continuing struggles of the emerging market sectors.

The high yield bond sector’s struggles will conintue in 2016 primarily because of the energy sector, and the year will yet another mediocre year for bonds in general.  The best bond sectors at the start of the year are high credit quality and municipals.  I think the floating-rate (bank loan) sector is oversold enough to find the values compelling along with their good yields. 

I believe commercial real estate could provide positive returns as supply continues to lag demand and is a sector I am evaluating.

I cannot stress enough that the weak start in 2016 is just that, a weak start.  Volatility is the price you pay to be an investor.  There are 51 more trading weeks remaining in the year and while I believe this will be a below trend year for equity returns, I do think markets will be positive for 2016.

I hope all of you had a very Happy New Year and cheers to your happiness, health, and prosperity!

Paul L. Merritt, MBA, C(k)P®, AIF®, CRPC®
NTrust Wealth Management

P.S.  If you think this type of analysis would be of benefit to anyone you know, please share this communication with them.

Past performance is not indicative of future results and there is no assurance that any forecasts mentioned in this report will be obtained.  Technical analysis is just one form of analysis.  You may also want to consider quantitative and fundamental analysis before making any investment decisions.

All indices are unmanaged and are not available for direct investment by the public.  Past performance is not indicative of future results.  The S&P 500 is based on the average performance of the 500 industrial stocks monitored by Standard & Poors and is a capitalization-weighted index meaning the larger companies have a larger weighting of the index.  The S&P 500 Equal Weighted Index is determined by giving each company in the index an equal weighting to each of the 500 companies that comprise the index.  The Dow Jones Industrial Average is based on the average performance of 30 large U.S. companies monitored by Dow Jones & Company.  The Russell 2000 Index Is comprised of the 2000 smallest companies of the Russell 3000 Index, which is comprised of the 3000 biggest companies in the US.   The NASDAQ Composite Index (NASDAQ) is an index representing the securities traded on the NASDAQ stock market and is comprised of over 3000 issues.  It has a heavy bias towards technology and growth stocks.  The STOXX® Europe 600 is derived from the STOXX Europe Total Market Index (TMI) and is a subset of the STOXX Global 1800 Index.  With a fixed number of 600 components, the STOXX Europe 600 represents large, mid, and small capitalization countries of the European region.  The Dow Jones Global ex-US index represents 77 countries and covers more than 98% of the world's market capitalization. A full complement of sub indices, measuring both sectors and stock-size segments, are calculated for each country and region.

Information in this update has been obtained from and is based upon sources that NTrust Wealth Management (NTWM) believes to be reliable; however, NTWM does not guarantee its accuracy. All opinions and estimates constitute NTWM's judgment as of the date the update was created and are subject to change without notice. This update is for informational purposes only and is not intended as an offer or solicitation for the purchase or sale of a security. Any decision to purchase securities must take into account existing public information on such security or any registered prospectus.
Emerging market investments involve higher risks than investments from developed countries and involve increased risks due to differences in accounting methods, foreign taxation, political instability, and currency fluctuation. The main risks of international investing are currency fluctuations, differences in accounting methods, foreign taxation, economic, political, or financial instability, and lack of timely or reliable information or unfavorable political or legal developments.

The commodities industries can be significantly affected by commodity prices, world events, import controls, worldwide competition, government regulations, and economic conditions. Past performance is no guarantee of future results. These investments may not be suitable for all investors, and there is no guarantee that any investment will be able to sell for a profit in the future.  The Dow Jones UBS Commodities Index is composed of futures contracts on physical commodities.  This index aims to provide a broadly diversified representation of commodity markets as an asset class.  The index represents 19 commodities, which are weighted to account for economic significance and market liquidity.  This index cannot be traded directly.  The CBOE Volatility Index - more commonly referred to as "VIX" - is an up-to-the-minute market estimate of expected volatility that is calculated by using real-time S&P 500® Index (SPX) option bid/ask quotes. VIX uses nearby and second nearby options with at least 8 days left to expiration and then weights them to yield a constant, 30-day measure of the expected volatility of the S&P 500 Index.
TIPS are U.S. government securities designed to protect investors and the future value of their fixed-income investments from the adverse effects of inflation. Using the Consumer Price Index (CPI) as a guide, the value of the bond's principal is adjusted upward to keep pace with inflation. Increase in real interest rates can cause the price of inflation-protected debt securities to decrease.  Interest payments on inflation-protected debt securities can be unpredictable.
The NYCE US Dollar Index is a measure that calculates the value of the US dollar through a basket of six currencies, the Euro, the Japanese Yen, the British Pound, the Canadian Dollar, the Swedish Krona, and the Swiss franc.  The Euro is the predominant currency making up about 57% of the basket.

Currencies and futures generally are volatile and are not suitable for all investors.  Investment in foreign exchange related products is subject to many factors that contribute to or increase volatility, such as national debt levels and trade deficits, changes in domestic and foreign interest rates, and investors’ expectations concerning interest rates, currency exchange rates and global or regional political, economic or financial events and situations.

Corporate bonds contain elements of both interest rate risk and credit risk. Treasury bills are guaranteed by the U.S. government as to the timely payment of principal and interest, and if held to maturity, offer a fixed rate of return and fixed principal value. U.S. Treasury bills do not eliminate market risk. The purchase of bonds is subject to availability and market conditions. There is an inverse relationship between the price of bonds and the yield: when price goes up, yield goes down, and vice versa. Market risk is a consideration if sold or redeemed prior to maturity. Some bonds have call features that may affect income. 

 The bullish percent indicator (BPI) is a market breath indicator.  The indicator is calculated by taking the total number of issues in an index or industry that are generating point and figure buy signals and dividing it by the total number of stocks in that group.  The basic rule for using the bullish percent index is that when the BPI is above 70%, the market is overbought, and conversely when the indicator is below 30%, the market is oversold.  The most popular BPI is the NYSE Bullish Percent Index, which is the tool of choice for famed point and figure analyst, Thomas Dorsey.