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While we have had a negative view on stocks for more than a year now, we have always been wary of not missing the point when the negative outlook gets so well reflected in stock prices that the most likely outcome is for stocks to start reversing direction. We may be at that point now. If not, we have probably at least put in a temporary bottom. Most sentiment indicators have reached the extreme levels usually seen at market bottoms. Also, the price of both oil and copper have started to recover versus the price of gold, the U.S. dollar looks to be stalling out at these higher levels and the breadth of the market has failed to confirm a new downturn. All of these indicators are positive for stocks, at least in the short term. Global stock markets have had a very rough ride over the past year. This has been a full-blown bear market for everything but the Dow Jones Industrials and the S&P500. At the lows in February, the average European stock market was down over 25% from last year’s highs and the average Asia Pacific market was down almost 30%. A small number of very large U.S. growth stocks have held up the overall U.S. averages but, as almost all investors realize, there has been trouble brewing ‘below the surface.’ More than 40% of stocks on the NYSE made new lows when the market bottomed on Aug. 25 and on Jan. 20. But the percentage of stocks making new lows was far less when the market bottomed in February. That loss of momentum set in place the conditions for a tradable rally here. Stocks outside of the U.S. are looking better on a valuation basis as well. Emerging markets have low comparative valuations. While the U.S. market is still trading around 17 times current earnings, the developed world, ex-U.S. is trading only at 14.5, and emerging markets are even lower at 9.5. Europe also has depressed valuations and is probably experiencing one of the better economic recoveries with the tailwinds of excessively easy money conditions and a low currency value. But also, from a valuation perspective, we would no longer argue that the U.S. market is broadly overvalued. We have been adding to stock positions since the lows we saw on January 20th. While the technical condition of the U.S. stock market still looks susceptible to further downside, many other global markets (including Canada) may have already seen their worst levels for this cycle.
Part of our thesis for a somewhat more positive view on stocks is the fact that we were never expecting the U.S. economy to fall into recession. Our caution resulted from the view that excessively easy money conditions, aggressive corporate stock buybacks and bullish market sentiment had engendered a level of optimism on stocks that needed to be corrected. While this economic recovery has been below that of past cycles, this was due primarily to the fact that consumers are still unwinding their debts from the prior cycle and therefore not spending at typical recovery levels. Corporations were taking this period of low growth to invest in buying their own stocks rather than expanding. The net result has been a period of sub-par growth, but not outright recession. The chart below shows the two most followed consumer sentiment indicators in the U.S. (Conference Board and University of Michigan) over the past 50 years. Both indicators have fallen sharply before every recession (shaded areas on chart). However they currently are at elevated levels after rallying for the last five years and are not indicative of any further slowdown in growth, at least for now.
While we don’t expect the global economy to fall into recession, growth has clearly slowed down significantly in the U.S. The main problem for the U.S. economy has been the strength of the U.S. dollar. While this has been a tailwind for Canadian and European manufacturing as it helps their exports to the U.S. increase, it has been a headwind for the U.S. economy as it has impacted the profits and sales for multinational corporations in the consumer and industrial sectors. This is shown clearly in the chart below of the annual growth of U.S. industrial production during the current recovery. This growth actually went negative in the last two months of 2015. Earnings reports from major U.S. industrial companies such as GE, Honeywell, Caterpillar and Dupont, to name a few, support this view as all pointed out the negative impact of the dollar to their outlook of slower overseas sales. However, the service sector of the economy has held up relatively well, offsetting some of this weakness in industrial production.
Another potential benefit for stocks, though, is that the U.S. dollar looks to be in the process of peaking. The recent rally in the price of gold, the recovery of the Euro and the strength of the Yen are all indicators that the very ‘crowded’ long U.S. dollar trade may be starting to unwind. This comes despite the fact that the U.S. Federal Reserve (the ‘Fed’) is the only global central bank that has begun to remove the excessively easy monetary conditions with their increase in interest rates last December. However, the gap between the growth in the U.S. economy and the rest of the developed world is starting to narrow, suggesting that the Fed may not end up being as aggressive on interest rates in 2016 as they have advocated. Their own projections are showing four interest rate increases this year while market expectations show them moving only once! If the U.S. dollar starts to roll over, then commodity prices should be able to rebound further. Most importantly though, the strength of the U.S. dollar has been great for growth stocks in the U.S. market, as the likes of Netflix, Amazon, Google, Home Depot, Disney, Facebook and the major biotech stocks have been the market leaders since 2012, pushing their valuations to record levels even as most of the rest of the market was falling. If that trend is starting to reverse, then we could start to see a shift to the industrial and cyclical sectors of the market, including the resource stocks. That would also suggest we could start to see the Canadian stock market do somewhat better than the U.S. after lagging since 2011. We are already starting to see this occur in 2016. Most of our recent purchases have been in the more ‘cyclical’ parts of the market including sectors such as Energy, Basic Materials, Industrials and Technology.