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Stocks started 2016 on pace for the worst beginning to a year ever, but then made one of the sharpest reversals on record on February 11th which ended up bringing the market all the way back to positive returns for the year. More intriguing was the fact that the worst quality stocks lead the recovery, with the beaten-up energy, materials and industrial stocks leading the advance. Emerging markets were also some of the biggest winners with the downtrodden Brazilian stock market leading the pack with a gain of over 20%. Pundits referred to the rally as ‘the dash for trash!’ Clearly investors had just gotten too bearish on the outlook for stocks and commodity prices. Once oil broke down below US$30, the consensus had it going to $20 in a hurry and even more investors piled into that short trade. The same situation occurred with stocks as bearish sentiment climbed higher at the same time as there was too much cash on the ‘sidelines’, waiting to buy on weakness. As we wrote in the title to our Market Comment last month, the ‘path of least resistance for stocks looks to be higher!’ But now stocks have rallied sharply, oil is back above US$40 per barrel, valuations are back to the top end of their recent range and investors are expecting the U.S. Federal Reserve to stay even more ‘dovish’ about interest rates than expected when they started raising rates in December. Moreover, the volatility of the stock market has dropped sharply, indicating lower levels of concern about the outlook.
The S&P500 has tracked its way back over 2050, which has been the top end of the trading range over the past two years. Will it once again be turned back from this upper bound or will stocks break through to new highs? Our view is that the upcoming first quarter earnings reports will be at the top of the list for market-moving factors in April as well as the ultimate determinant of the short term direction for stocks. Some early reports have shown continued strength in overall consumer spending (Fedex ‘beat and raise’) but more headwinds for the capital spending group (Caterpillar misses and guides down for year). In terms of the outlook for overall profit reporting this quarter, the BAML Earnings Revision Index (shown below) has started heading lower again from somewhat depressed levels, suggesting that the outlook is still too optimistic and that earnings will be a struggle in 2016. Consensus numbers are predicting that earnings will decline be 8% year-over-year, which would be the fifth straight quarter of negative results. In terms of sector results, energy earnings are expected to be down 98% year-over-year, according to estimates from Thomson-Reuters, while earnings from the basic materials group are forecast to drop over 20%. Oddly enough, those were the two best-performing sectors during the first quarter as commodity prices rebounded.
Another key determinant of the direction of stocks will be the direction of the U.S. dollar. The trade-weighted value of the U.S. dollar hit an interim peak in early February and its subsequent decline provided the spark for the rallies in oil, most commodity-related stocks as well as the currencies of resource producers such as Canada and Australia. If the U.S. Federal Reserve holds back on interest rate increases in the first half of 2016, then the U.S. dollar may fall further and commodities could continue to fuel stock market gains. However we expect that the strong employment numbers and higher inflation in the U.S. will keep the Fed on the path to ‘normalize’ their interest rates, which would push the U.S. dollar higher again. Canadian investors obviously have a vested interest in the outcome here. After falling to a multi-year low of US 68¢ in January, the ‘Loonie’ surged back in the past two months to over US 77¢, the top performing currency among the major industrialized countries. This coincided with the TSX stock index in Canada leading all of the industrialized stock markets. What is the next move for the ‘Canuck Buck?’ The chart below shows how closely the move in the Canadian dollar continues to be aligned with the overall move in commodity prices. No matter how we evolve our economy into a service and technology-oriented base, we are still viewed globally as ‘hewers of wood and drawers of water,’ meaning that the economic outlook (and therefore the currency outlook) is tied directly to the move in basic commodity prices, particularly oil. Seeing the recent downturn in the western Canadian economy, it’s hard to effectively argue against that view. Unless your view is that oil and metal prices are going to continue their recent rally, the logical view is that the Canadian dollar will continue to deteriorate in value against our southern neighbour.
