Signs of weakness means sell off will continue
A seemingly coordinated drop in equity prices that started at the outset of this year is still with us as we enter the second month of 2016. The troubling signs began last year. A December rally, which could have pushed the major averages into the black, never materialized. US indices actually fell between 1.5- 2% for the month, guaranteeing they would finish the year in the negative. Even more worrisome, was the fact that the market had taken small-caps stocks down 5% and Transports down more than 7% just before year-end. This seemed a continuation of the turmoil from over the summer, and the feeling was the malaise would carry into 2016. It was only a matter of time before the large-caps came into the crosshairs.
The preference for the largest-cap stocks was in its own way a flight to safety and masked underlying weakness in markets overall. Large-cap stocks outperformed their MidCap and SmallCap bretheren in 2015 (Table 1). Even more telling was the underperformance of the S&P500 Equal Weighted vs Cap Weighted indices. Large stocks such as Amazon (AMZN), Home Depot (HD), General Electric (GE), Boeing (BA), Alphabet (GOOG), and Facebook (FB) skewed sector performance higher (Table 2). When you mute the effects of company size through equal weighting, price performance for 2015 is worse. Now even these big winners are facing selling pressure.
Lastly, some major indicators of economic strength have been telling a “slowdown” story for a while now. ISM manufacturing peaked in late 2014, and besides a brief bump over the summer, has been heading down ever since. The indicator has been running at or below the important level of 50 for five months now, indicating a manufacturing stagnation/contraction. Industrial Production and Capacity Utilization show that same declining pattern since 2014. Manufacturing is only about 12% of the US economy, but many were counting on growth from this area. Finally, the CITI Economic Surprise index has been very negative lately indicating the US economy is underperforming expectations considerably (Chart 1).
In hindsight, there were plenty of reasons to worry about US equities last year and certainly time to have acted. To be fair, there were a number of recommendations to cut back on stock exposure coming into 2016. But now we find ourselves in the midst of a stock market that looks like it wants to trade lower. According to the Delta Market Sentiment Indicator, a large majority of stocks are trading below their intermediate-term moving average, indicating elevated risk levels, and recommending a large cash position (Chart 2). We may not technically be in a BEAR market territory, but with a majority of stocks down more than 20% from 52-week high, we don’t have much to argue about. The question now is will this selling persist and if so how much worse can it get.
The downturn so far is understandable given the fundamental and economic picture in the US. We have an equities market that has been at varying stages of overvaluation since at least 2014. We now have more global risk factors and a Federal Reserve starting to hike, indicating contracting multiples for 2016. Growth has been hard to come by in the past few years, as oil prices and the strong $US dollar have taken a toll on earnings. S&P500 EPS for last year came in at $104 which was lower than both 2013 and 2014. Given a 2-2.5% forecast for GDP and the fact that margins are at peak levels, it is hard to see earnings having a breakout in 2016. EPS estimates for this year started at $125, but have already been lowered to $120. Estimates tend to start high and get reduced by 5-10% over the course of the year. Given that valuations will likely come down this year, we need a P/E around 15 based on 2016 EPS before this market can look to bottom and possibly rally again.
Using the current EPS estimate of $120, a 15 multiple would give us about 1800 level for the S&P500, down another 4% from the current level of 1880. However, the $120 assumes a 15% jump in EPS over last year, which is too optimistic. An EPS estimate of $113 would give you 8% EPS growth this year, and still be in line with lowered estimates revisions in past years (Table 3). In this scenario the S&P500 would be at 1700 given a 15 multiple, or down another 10% from here.
Realistically, we are looking at an S&P500 in the mid-1700 range indicating another 7% of downside risk. If we experience these lower levels along with signs of capitulation, this could present a buying opportunity.