Special Market Update:

January 27th, 2016

Stock markets in the U.S. and around the world have started off the year with significant weakness, and volatility has increased to levels not seen in quite some time.  Here are a few key points that I see as we evaluate what is going on economically and in the financial markets.

There are a number of reasons for concern.

  • Oil prices continue to drop (a negative for energy sector earnings, and increased geopolitical risk).
  • Corporate earnings have been declining for multiple quarters (less reason for investors to pay premium valuations and push stock prices higher).
  • U.S. Manufacturing output is weakening (recession risk).
  • Potential bond downgrades at the highest level since 2009 according to S&P (recession risk).
  • Stock market valuations remain very elevated on a historical basis (do current economic fundamentals justify the current premium values for stocks?).
  • The Federal Reserve is no longer pursuing Quantitative Easing programs, and is instead beginning to raise interest rates (perceived “safety net” is no longer in place).
  • Renewed financial market weakness in China (loss of upward momentum in financial markets).

Putting market action into context.

  • Although U.S. manufacturing is weak, the U.S. service sector remains robust and is a much larger portion of the economy (lowers the risk of very large market decline).
  • Periodic bear markets are a normal part of the investment cycle (provides the best opportunity to pick up good bargains that benefit us over the longer-term).
  • Bear market declines when we are not experiencing a recession are typically much less severe than when we do have a recession (we do not currently appear to be in a domestic recession).
  • Although interest rates have been rising moderately, they are still quite low by historical standards (an increase of ¼ percent in short-term interest rates is not likely to entice many people back into money market accounts).

There are an increasing number of developing opportunities.

  • High yield bonds are at the most attractive valuation levels relative to treasuries since late 2009.
  • Foreign stocks are at the lowest valuation levels relative to the U.S. in nearly 20 years.
  • Energy stocks have already experienced a severe bear market, much like real estate and financial stocks did during 2007-2008 and this has historically provided a good buying point.
  • Markets are beginning to move away from being so heavily influenced by Central Bank interventions and back to more traditional market drivers such as economic activity, earnings, and valuation. This helps make analysis and asset allocation more reliable due to the fact that there is much more of this type of data to work with.

While the volatility is unnerving and is likely to continue a while longer, our tactical investment strategies have been adjusting as expected.  They are positioned quite defensively if the market decline does continue.  Because markets are still trading at high valuation levels, it would not be unusual to have this volatility continue for a few more weeks or months.  We may spend the first half of the year with asset allocation primarily owning cash, bonds, and other defensive investments, and making opportunistic purchases into oversold asset classes or shorter-term purchases into the general market if the risk/reward profile is compelling.

For more information on specific strategies or any other information, please contact Ryan Connolly at rconnolly@weatherstonecm.com or at 720-407-4311.


Michael Ball