It is hard to believe that Christmas is just TWO Friday’s away as the year seems to have slipped by in blur. This brings two primary issues into focus. The first is that I have not done any shopping as of yet. The second is that despite the hopes of a stronger economy and earnings environment at the beginning of this year, those hopes failed to come to fruition. However, even as earnings and corporate profits have deteriorated, along with many of the underlying economic data points, the market has managed to eek out a 1% gain for the year. The good news is that there has been no inflation to chip away at that modest gain.
In early November, I discussed the need for many hedge and mutual funds, which were lagging their respective benchmarks, to play catch up. The chart below shows the S&P 500 as compared to the Morning Star Hedge Fund index. You can see the underperformance of funds this summer and the resulting performance chase to date.
In that missive, I laid out the expectation (dashed blue line) of a market decline back to support which would facilitate the year-end advance.
“With the markets currently oversold on a very short-term basis, the current probability is a rally into the ‘Thanksgiving’ holiday next week and potentially into the first week of December. As opposed to my rudimentary projections, the push higher will likely be a ‘choppy’ advance rather than a straight line.
In early December, I would expect the markets to once again pull back from an overbought condition as mutual funds distribute capital gains, dividends, and interest for the year. Such a pullback would once again reset the market for the traditional ‘Santa Claus’ rally as fund managers ‘window dress’ portfolios for their end-of-year reporting.”
Here is the updated version of that chart which shows the markets playing out very closely to that previous projection.
However, while the seasonal tendencies suggest that the markets will push higher through the end of the year, there is no guarantee that such will be the case. With economic remaining weak and the Federal Reserve on the verge of tightening monetary policy further, while the global economy struggles with a deflationary backdrop, there is a rising possibility that “Santa fails to visit Broad and Wall.”
5 Charts Suggest Markets On The Naughty List
While I do suspect that the markets will likely end positively by year-end, it is 2016-2017 that is becomes more worrisome.
From a statistical standpoint, the odds of both a recessionary environment and negative market returns rise substantially over the next two years as shown in the charts below.
2016 has the lowest average positive return of all years, with 2017 posting the most negative average rate of return. However, both 2016 and 2017 have posted negative return years more than 40% of the time. Considering that most negative return years coincide with a recessionary environment, 2017 is tied for the second most recessions of the ten-year cycle.
Okay, you can breathe easy, right? Statistics say no recession likely until 2017. As I stated previously in “The Coming Market Meltup and 2016 Recession:”
“There are plenty of reasons that that the market could lapse into a far bigger correction sooner than the historical evidence would otherwise suggest. Such an event would not be the first time that an “anomaly” in the data has occurred.
The inherent problem with most analysis is that it assumes everything remains status quo. The reality is that some unexpected exogenous shock is likely to come along that causes a more severe reversion as current extensions become more extreme. “
The following 5 charts suggest a rather substantial possibility that something could “break” within the markets sooner, rather than later.
1. World GDP Is Contracting. According to the IMF’s most recent report, world gross domestic product contracted by 4.9% in 2015. The only other time that world GDP has contracted to such a degree was in 1980, starting year of the IMF database, when it fell by 5.9%. The U.S. experienced a recession at that time as well as in 2001 and 2009 which also coincided with global economic declines. Despite many beliefs to the contrary, the U.S. is not an island that can withstand the drag of a global recession.
2. Junk Bond Warning Rises. Jeffrey Snider at Alhambra Partners made a very important point recently stating:
“In other words, as junk bonds have been the leading edge to the domestic end of the “dollar” run, this demands close and ongoing scrutiny in light of a potential escalation. After all, this is just another indication of how advanced the deterioration has become, when the “usual” carnage and selloff is no longer noteworthy, giving way to only the (possibly) spectacular.”
3. Institutions Are Selling. According to BofA, institutions continue to offload equities to retail clients. This is typical of a late stage market cycle as “smart money” harvests their gains while telling their “retail clients” to “just buy and hold for the long term.” (Just a question to ponder – “if they don’t buy and hold, why is it good for you?”)
4. International And Emerging Market Divergence. As I stated above, there is currently a belief that the U.S. can remain isolated from the rest of the world. Given the global interconnectedness of the world today, there is little ability for the U.S. to permanently diverge from the rest of the world. As shown below, historically when international and emerging markets have declined, the U.S. has been soon to follow.
5. Combined Monthly Sell Signals. Lost in the day-to-day volatility of market action, is the longer term look at the underlying TREND of price action. Much like driving a car at full speed, assuming you don’t crash along the way, the car will continue to “coast” for some distance even after the tank runs dry. The same is true for the market. When investors are “exuberant” about the markets, they can keep prices elevated longer than underlying fundamentals and logic would dictate. However, like a “car running out of gas,” the momentum of the market begins to substantially slow until its inevitable conclusion of the advance. If we look at various measures of price action on a MONTHLY basis, we can clearly see warnings that have only previously existed at major market peaks. While this does not mean the markets will immediately crash, historically it has suggested that investors were much better served by becoming more risk adverse.
Whether or not a recession begins in 2016 or 2017 is largely irrelevant. The reason is that by the time the BEA backward adjusts their data, and the National Bureau of Economic Research declares the start of the recession, it will be far too late react.
What is clear, is that the “risk” of being overly exposed to the market currently far outweighs the potential reward. This is why understanding the difference between “possibilities” and “probabilities” is critically important going forward.
Is it “possible” the markets could advance further over the next 12-24 months. Absolutely. However, the “probabilities” are mounting that such will not be the case and the resulting negative outcome to investors portfolios will be more than most expect. However, this is the inherent risk/reward dynamic that all investors face, the difference is whether or not you do something with the information at hand.
In the meantime, Wall Street has some great stocks for you to buy.
Images: Flickr (licence attribution)
About The Author
Lance Roberts – Host of StreetTalk Live
After having been in the investing world for more than 25 years from private banking and investment management to private and venture capital; Lance has pretty much “been there and done that” at one point or another. His common sense approach has appealed to audiences for over a decade and continues to grow each and every week.
Lance is also the Chief Editor of the X-Report, a weekly subscriber based-newsletter that is distributed nationwide. The newsletter covers economic, political and market topics as they relate to the management portfolios. A daily financial blog, audio and video’s also keep members informed of the day’s events and how it impacts your money.
Lance’s investment strategies and knowledge have been featured on Fox 26, CNBC, Fox Business News and Fox News. He has been quoted by a litany of publications from the Wall Street Journal, Reuters, The Washington Post all the way to TheStreet.com as well as on several of the nation’s biggest financial blogs such as the Pragmatic Capitalist, Zero Hedge and Seeking Alpha.