The beginning of 2016 started in an emotional frenzy, as world markets dropped sharply out of the gates on fears of a sputtering world economy, plummeting commodity prices, a stubbornly hawkish Federal Reserve, and a decelerating earnings backdrop. The violence of the move in January was stunning, and by early February the number of world markets that had fallen more than 20% from their highs clearly argued that a bear market across the globe was taking place. But with share prices falling so fast, gloom quickly took hold and set the market up for a rally off the lows. What has unfolded since mid-February is a rally to the upside that has been just as violent and abrupt as the drop in markets that preceded it. The genesis of the rally was likely too much short term pessimism and oversold conditions, but it was also aided by more European central bank intervention and a Federal Reserve that was forced to pull back some of its hawkish rhetoric.
In the early part of 2016, the markets have been on an emotional roller coaster ride that has amounted to a vicious tug of war between fear and greed. This ride has tested investors’ nerves, patience, and has generally served to confuse those that are looking for signs for what is next.
With so many cross currents swirling in just the first three months of the year, we continually reassess our strategy to favor protecting our clients’ portfolios. We continue to believe that the latest move is likely a classic bear market rally, though we also acknowledge that there is some chance that our base case call may have run its course. While some analysts might challenge the notion that we have experienced anything more than a correction during the last few quarters, our belief is that the number of markets and individual stocks that fell into bear market territory (> 20% top to bottom losses) during this cycle makes for a compelling case that a bear market had gripped markets worldwide over the last few quarters.
But whether or not a bear market has taken place is debatable and distracts from the main question we ponder today: Will the volatile bear market environment continue, or is there a chance it could be over and evolving into a new bull market cycle already? Unfortunately no one rings a bell for investors at the top or bottom of markets, and so our team is forced to scour the evidence and reassess what the future might hold for the markets. We currently believe there are three possible scenarios developing in regards to which direction the markets might head from here. We are prepared to act in each.
Scenario 1: Bear Market Growls Again
The first scenario postulates that global markets are currently in the middle of primary downtrends, and that the rally that has unfolded since February has been nothing more than a simple reflex that occurs when a market gets oversold enough for a rubber band-like snap back. Given the ferocity of the move off the bottom, it is natural that some investors are questioning whether or not a bear market rally could be so robust. We understand this reaction to a strong market move, as even the somewhat defensively oriented S&P 500 has climbed 13% off of its February lows. But despite the scorching nature of the current market rally, it is not uncommon for bear market rallies to experience runs of this magnitude. Lowry’s is a well-respected technical research service that tracks such statistics in an effort to stay on the correct side of the primary trend in markets. In a recent study, they listed five historical periods where bear market rallies exceeded 13%, with the average reaching nearly 18%. We understand that these numbers by themselves don’t prove that the current rally off the bottom is a bear market rally, but we do think that they provide important context in regards to whether the recent bounce could have taken place within the confines of a primary trend that is currently down.
Our assessment is that the rally we are experiencing is well within the range of a typical bear market countertrend rally, and more importantly that the market is approaching significant levels that should be difficult to penetrate meaningfully to the upside if our thesis is correct. In addition, stocks are also severely overbought in the short-term, which makes them susceptible to profit taking soon when the right catalyst arrives.
Beyond the technical environment, the broad market still carries high valuations in the U.S. at a time when there continues to be much uncertainty regarding the ultimate direction of U.S. monetary policy. Meanwhile the U.S. economic trajectory has been down, and our anticipation is that we’ll see another sub-par first quarter for growth to start 2016. Across the globe, Japan and Europe appear to be suffering from a recent surge in currency appreciation, and in the emerging markets there is continuing evidence accumulating of structural challenges with many economies seemingly in the midst of a long lasting slump. Poor world growth has weighed on global pricing power, and earnings continue to sag. While central banks are trying to keep a floor under inflation and growth rates, markets seem to be starting to question the effectiveness of current central bank policies, particularly newly enacted negative interest rates that are weighing on global banking shares. To compound things, the global political environment is contentious and markets must digest the ongoing presidential election in the U.S. and the potential for a British exit from the European Union.
In short, we still think the highest probability is that the market is close to the end of its bear market rally phase, and may soon resume declining. Currently we’d assign about a 50% probability that our bear market thesis is still correct, which currently makes it our highest conviction scenario. Under this view we believe there is little reason to alter our defensive positioning. Should we begin to see renewed signs of pressure, we may elect to trim our volatility targets even further. But with an already defensive profile we feel little pressure to further de-risk the portfolio, particularly given that we may be close to an important inflection point, and that the probabilities of scenarios that are not our base case have risen since last quarter.
Scenario 2: Bull Market Pain Trade
While we continue to think the odds favor a renewed downturn, there is a chance that a different path could be developing. The late Barton Biggs had a term for markets where participants get trapped the wrong way and the market grinds against them: the pain trade. An alternative possibility is that the global bear market was somewhat short and shallow, and is actually already over. In this view of the world, the markets are grinding up as many investors are still in disbelief that the market cycle has turned for the better. The last time we had a true bull market pain trade occurred in 2011, when the possibility of European banks and the Euro currency collapsing had many investors fearful that system risk was too high to invest. In hindsight we now know that the bull market began climbing a new wall of worry in October of 2011, though we also know that it took several quarters to convince many investors that a new and lasting bull market was in motion.
2011 was not that long ago, and we’d like to think that cycle taught us some lessons. Maybe one of the most important lessons is to listen to the markets and not dig in too deeply on any one view. At minimum, we know not to rule out this type of scenario from occurring again. Despite our current view, we acknowledge that some evidence has improved in line with the recent rise in market prices.
One positive has come in the form of a stabilization in commodities prices, which if it persists could drastically lower the risk of defaults in the energy patch and commodity producing regions of the world, and might put a floor under struggling energy earnings. Another possible bullish catalyst is that central bankers throughout the globe may have been forced to get back in synch with one another in an effort to defeat deflation, poor growth rates, and strains running through the global banking system. The European Central Bank pulled out all the stops at their recent meeting, and the Federal Reserve surprised the markets by pulling expectations of future rate hikes down from four to two during their March Federal Open Market Committee Meeting. At the same time, the People’s Bank of China has recently been floating potential policy options to backstop an enormous amount of non-performing loans that threaten to cripple credit markets abroad. Another positive from a currency perspective is that the U.S. dollar has begun to pull back and the Chinese renminbi has stabilized. The former should help earnings and trade in the U.S., and the latter might quell fears of a destabilizing drop that could unleash a potential currency war.
Lastly, in a sea of tepid to poor economic data, we have taken note that the latest series of Federal Reserve regional manufacturing surveys surged back from contractionary to expansionary levels. At present we don’t find this evidence compelling enough yet to change our view, but it does imply that there is some chance that markets could be starting to react to a possible inflection point in growth in coming quarters. If this is the case, then an increasing number of world economic data points should start to fall in line and reflect this thesis, and the rally in markets should gradually broaden to include more sectors and industries. While some positives have grown and there is a chance the bull is reasserting itself, we currently mark this scenario as a somewhat low probability development. For now we give the resumption of the bull market a 20% probability. At 20%, it is enough to keep us holding some of our cyclically sensitive investments and refraining from selling even further into the market rally in case we are incorrect. But it’s also not enough to begin building risk back in the portfolios yet.
Scenario 3: Range Bound Roller Coaster Markets
There is one more scenario that may be gaining some traction, and that is the idea the market might be locked in a wide trading range rather than a trending bull or bear market. This thesis acknowledges that U.S. valuation is high, that growth across the globe isn’t great, and that politics and earnings may continue to weigh on markets, particularly in the U.S. where share prices are generally more expensive than other parts of the globe. But those looking for a trading range also don’t feel like there is a reason for the bottom to fall out either. Supports for oversold markets can be found in central banks that may be back in liquidity overdrive, world growth rates that are very slow yet stable, and with little to no excesses showing that might typically lead to an all-out bust. Believers in the range trade acknowledge that investors may have to be more selective by market and a little quicker to the trigger in markets that may be more prone to be zigging and zagging rather than trending up and down. In a range bound market, value will mostly likely be found by scouring the world for markets and sectors that offer good relative value at a time broad markets may effectively deliver next to nothing for those who buy and hold. While it’s not our base case, this thesis is more plausible than it was a quarter or so ago. Should we come around to this view of the world, we may have to shift tactics and be a bit more nimble to short term opportunities, until we think a trending market has again taken over. At present, we’d give this thesis a 30% probability, which is an upgrade from prior quarters, but is still substantially below the base case of a bear market resumption. Even if this view turns out to be correct, our hunch would be that we are much closer to the top of the range than the bottom, which means there is little reason to add any risk to portfolios right now. But a drop towards the lower end of the range may become an interesting time to add back some holdings if we believe the range story is gaining some traction.
Staying Patient but Remaining Flexible
There is much in flux within the markets and our team feels a technical inflection point may be close. Given the recent market run and our ranking of the probabilities of each scenario, we think it’s prudent to stay patient with our defensive positioning and monitor what develops at important resistance levels in a variety of markets. How the market resolves itself in coming months might set the stage for more defensive positioning, or could tip us in a more positive direction. At times like this, the most important thing we can do is be patient, remain flexible, and be prepared to move in the direction that the evidence most supports.
For now, we remain in risk management mode as a precaution that we may be passing through the eye of the storm and approaching another wave of volatility. If we are correct, then it is most important to keep defensive. If we are incorrect, then we should soon start to see evidence accumulate that the world is in repair, and if it is, we stand ready to reengage and make money while the tide of a new cycle is going in.
Whippy volatile markets tend to fray nerves and wear down the patience of investors, but at times like this, we lean on our investment process. That process is built on objectively weighing evidence, having flexibility, and applying judgment. It is the process that has produced healthy risk adjusted returns over the long term, and we believe it will continue to pay dividends for investors who can stay patient through this temporary whipsaw and ride out a full market cycle.