Weekly Update

January 22, 2016 Update

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Is a recession coming? Part 1

As pundits and market analysts look for clues behind this year’s shockingly bad start to the stock market they have raised the volume on calls that a recession must be coming soon to U.S. shores, presumably having washed across the Pacific from China in the form of continually plunging oil prices and a central bank out of the good drugs the market needs to survive. Below is the first in a two-week exploration of the topic of potential recession in the U.S. We are starting with summary of a recent call with a Chief Strategist at a major brokerage firm. He outlines the reasons why the U.S. will NOT be experiencing a recession anytime soon. Next week we will provide some of the opposing arguments in favor of a looming economic recession. First a reminder that the technical definition of a recession is two quarters of negative economic activity usually viewed as a negative Gross Domestic Product (GDP). The U.S. GDP has been growing at a fairly steady 2-3% in recent years.

“There is nothing to suggest a coming U.S. recession, not even close.” – large brokerage market strategist on January 14th, 2016.

First, a couple of comments about the twin-headed market monster that is China and falling oil prices: The mainland Chinese stock market is dominated by retail investors who have very much a trading mentality. They go in and back out. A ban on selling larger stakes in companies expired January 8th leading to a surge in selling as investors chose to get out while they could, assuming further market weakness was ahead. The point is that looking at the Chinese stock market as a leading indicator for a U.S. economic recession is silliness in the extreme as the mood of retail Chinese investors has no economic link to the U.S. The Chinese economy has been slowing for years now and steadily so, which has led to weakness throughout emerging market economies. This is nothing new and U.S. markets have by and large been doing just fine despite a slowing Chinese economy. As for oil prices, their decline is more about an excess of supply rather than a sharp falloff in demand. Low oil prices help consumers worldwide. This will be a significant positive for the global economy ultimately. Lost in the rhetoric is that China is a huge importer of oil. Plunging oil prices are a big positive for the Chinese economy. A very small portion of the exports of the U.S. and European economies goes to China. The direct impacts to the U.S. and Europe of a slowdown in China are modest at worst and more likely quite small.

Recessions come from one of four causes:

  1. financial crisis recession – To occur, this requires a big collapse in the banking industry such as we saw in 2008. We know there are some energy-related loan losses now and in the future. But the total amount of these losses is very small (as low as 2% of all loans) while banks are holding substantially more capital than in the past. Not to mention that central banks are much better equipped to intervene and offload troubled assets than in the past.
  2. overbuilt sector recession – The energy sector is clearly overbuilt, just as the housing sector was overbuilt prior to the 2008 recession and technology prior to 2000. But homebuilding accounted for 6% of the U.S. economy at the time of its collapse whereas the energy sector accounts for less than 1% of economic investment. Housing construction employed about 6M workers. The energy industry employs about 250k in mining and extraction of oil and gas. The energy industry is just not large enough to send the U.S. economy into recession by itself.
  3. inventory recession – short-term buildups of inventory used to cause recessions in our grandparent’s time. It’s less of an issue these days as technology has led to much tighter balancing of inventory with demand. Of course those tools haven’t stopped the energy industry from filling their storage tanks to the brim! But a widespread misreading of demand and excess in production has not been a cause of recession for a long time.
  4. tightening monetary policy – Turning off the monetary spigot can cause a recession as investment slows to a trickle and the economy dries up. While this could happen at some point if the Fed really raises interest rates substantially, we are at the very beginning of any tightening process with still plenty of credit available to companies. In fact 2015 was one of the largest years ever in issuance of corporate debt. There is no shortage of capital available.

Economic positives: wages and employment are increasing, housing continues to pick up, government spending is growing after a long period of stagnation due to the federal government sequester and weak state tax revenues. All of this should keep consumer spending at a strong level, and the consumer drives 70% of the U.S. economy. Which sector of the economy is going to fall by enough to push the overall economy into two consecutive negative GDP readings? While earnings were down -6% last year, that was entirely due to a rising U.S. dollar and falling energy earnings. Both of those factors will be flatter in 2016 and far less of a drag on earnings, especially in the second half of the year. Valuations have now dropped to under 15x earnings, which has historically been somewhat cheap, especially given the low level of inflation and interest rates currently seen. Remember the powerhouse market gains of 2013? At the end of that year stocks were valued at a P/E ratio on projected earnings (aka forward P/E) of 18.5. Stocks are now being valued the same as they were prior to that monster year in 2013 – a P/E of 14.8. The 20-year average forward P/E ratio is 17.2 for comparison.

Neither China, nor oil, nor the Fed will unduly harm the U.S. economy in the near-term. Another supporting view that focuses on the housing market as the best leading indicator for a recession is found here: Update: Predicting the Next Recession

Where is all the economy doom and gloom coming from? We will take a look at that next week.

Be careful what you’re buying

Structured investment products often darken the windows so investors don’t know or understand what’s behind them, then charge a lot for the privilege of investing in them. We found this article of warning from Bloomberg of potential interest to some of you who might encounter proprietary indexes and/or structured investment products:

How Wall Street Finds New Ways to Sell Old, Opaque Products to Retail Investors

Market Update

Investors returned to work Tuesday having needed every minute of the three-day weekend to clear their heads of the shellacking stocks have taken in the first two weeks of the year. Tuesday began well enough with Chinese markets moving markedly higher on a GDP report that inspired hope of future monetary and economic stimulus from the Chinese leadership. The early gains were quickly sold off, however, with renewed weakness in energy and materials stocks driving indexes downward to a flat finish. Cold water was thrown on the idea of fresh Chinese stimulus ahead of Wednesday’s session while Goldman Sachs (GS) failed to offer any earnings news to placate the bearish tone.
Stocks opened low and tumbled ever-lower through the first half of the day with the S&P 500 falling below its August 2015 lows and even its October 2014 nadir. That plunge finally brought out bargain hunters who swept in to buy stocks en masse. A nearly -4% drubbing in the Nasdaq Composite sharply reversed upward in the afternoon to leave the index almost unchanged, a massive psychological victory for investors looking for this market to stop falling. U.S. 10-year Treasury yields slid below 2.0% in the flight to safety. Thursday offered no real follow-through, however, with stocks eking out a +0.5% rise amid plenty of remaining caution. Oil prices did push higher to nudge back closer to $30/barrel, a trend that accelerated over Thursday night trading when crude oil prices surged higher to move well above the $30 mark. Good earnings from oil service giant Schlumberger (SLB) bolstered the oil sector while investors also looked favorably upon results from oil-heavy railroad play Kansas City Southern (KSU). Investment banker Piper Jaffray told clients to buy Apple (AAPL) ahead of their earnings report while putting forth a target price on the stock of $179, almost double the stock’s price from earlier this week. It was a typical oversold rally with many stocks recovering sharply from their recent selloffs. Indexes closed the day having held and modestly built on the strong market open en route to a +2.0% gain.

Warm wishes and until next week.