2016, In Like a Lion

There are three psychological aspects of any bear or bull market: denial, acceptance, and fear or ebullience. In the bull, all good news is embraced and bad news is dismissed. Vice versa for the bear. It seems like the appetite for bad news is increasing. The key is to focus on the facts and ignore the din. Don’t get caught up in crowd think – concentrate on research, discipline and data. Emotions are easy, comfortable, and perilous.

The lead story in The Wall Street Journal yesterday morning discussed the nightmarish open to the new year on Wall Street Monday. It has been quite striking to see how quickly sentiment can change. It seems like just yesterday when economic data were improving enough for the Fed to begin the unwinding of the monetary stimulus that has been so instrumental to the economic recovery. In fact, following a late summer swoon, the S&P 500 rose 9% from the August lows to end the year just slightly unchanged compared to the end of 2014. Now it seems the sky is falling again. Many fear that Monday’s sell-off could be just the beginning.

“What concerns U.S. investors isn’t just China. It is the spreading signs that weak global growth and a rising U.S. dollar are harming U.S. corporate earnings and economic output, and could continue to do so this year. On Monday, investors learned that U.S. manufacturing activity declined in December for the second consecutive month and that construction spending fell in November.” The WSJ article goes on to quote Krishna Memani, chief investment officer at OppenheimerFunds, Inc.: “The near-term outlook for stocks is not so good. There are lots of drivers: the Federal Reserve tightening monetary policy, China down, global instability, oil prices remaining weak and the stronger dollar.”

For our part, we’d agree that there are a lot of factors weighing on the stock market. In fact, we’d add a few more headwinds, including turmoil in the junk bond market, capital flight from emerging markets, high corporate profit margins, high stock valuations, election uncertainty, rising economic inequality, rising consumer savings rates, and the looming problem of entitlement spending. But historically, it hasn’t been unusual for stocks to “climb a wall of worry”, which means that stock prices sometimes tend to perform well in the face of a multitude of challenges. Why does this happen? Because the stock market is a discounting mechanism. This means that stock prices already reflect all the news that’s been made public, so incremental changes in stock prices should only reflect changes to those narratives. If investors fear that oil prices will go to $20 and they instead stabilize at $35, there could be a positive reaction in energy stocks. If China’s economic growth stabilizes at 6% rather than a much lower level feared by the market, U.S. multinational stocks might also react in a positive fashion. If corporate earnings hit 2016 estimates rather than falling short as many expect, the major market indices could actually rise, not fall. You get the drift.

Trying to time the markets is a fool’s errand. While we’d agree that the preponderance of evidence suggests that investors should keep their expectations low for 2016, we also believe that there are solutions to many of the challenges we face. We think investors need to remain mindful of the opportunities as well as the challenges. In a recent speech I listed some potential positive developments which could positively impact the economy, and therefore corporate profits and stock prices, over time. They included the following: address entitlement spending; enact corporate tax reform; repatriate corporate cash trapped outside the US; invest in infrastructure and education; promote immigration; and reduce trade barriers. Now granted, many of these initiatives will require improved political cooperation, but there again, the market may already be assuming the worst.

When collective investor sentiment becomes too negative (which I am NOT suggesting is the case right now), opportunities are created. If there’s one thing we learned from 2015 it’s that sentiment can turn on a dime. Just as we have been cautioning against excessive optimism, we also caution against excessive pessimism. Keep your wits about you, do your homework, and benefit from the undisputed wealth creator that is the U.S. economy.

Peace and Happy New Year,

Michael