2015: This Is The Year That Was

Political Poker

Well it’s that time of year again folks; a time to pause and reflect on the events that have transpired over the last 12 months, and an opportunity to consider those with the potential to shape our collective future. Compiling this year’s review of what happened and what we can look forward to has been rather a bleak affair in part, but to bury our heads in the sand is to invite risk into our financial future – you just can’t seasonally adjust the real world.

Global Tensions Have Continued To Rise

It is a close call, but I think we can all agree that our political leaders just about managed to edge out the central bankers in the dying minutes of a closely contested battle for “who can create the most headline risk and thereby sow the most seeds of doubt among the investing community” championship of 2015 – certainly they have done little to foster a sense of stability and optimism in a world that has grown increasingly fractious in the last 24 months. 

Coming into the year tensions were already heightened due to the civil war in Syria, the nefarious acts of ISIL, and the Russian annexation of Crimea in 2014. This year, despite attempts by the leaders of Germany and France to broker peace and a ceasefire agreement being put in place in February, the fighting in Ukraine paused for less than a day then resumed with more ferocity than ever. February also saw airstrikes undertaken against ISIL in Libya by the Egyptian military in retaliation for the execution of a number of their citizens, and they were joined by Russia in September who also saw fit to bomb ISIL, this time in Syria. 

There have been many atrocities committed this year by a number of different groups all over the globe, but the act that has the most potential to ignite ‘a flame of indignation’ that may well result in sustained conflict is the Paris attacks in November. The rhetoric coming from French President Francois Hollande in labelling the terrorism an ‘act of war’is certainly very worrying:

"Faced with war, the country must take appropriate action… France will not show any pity against the barbaric acts by ISIL. All measures to protect our compatriots and our territory are being taken within the framework of the state of emergency.”

I think the best summary of our current situation with respect to ISIL and the potential for a collective war effort I have read thus far was written by Jon Lee Anderson of the New Yorker (HERE) who makes the point that:

“Until now, most of the violence in the West have been small-scale, but the Paris attacks demonstrate that ISIS has the desire and the potential to increase its operations abroad. Indeed, the day before Paris was hit, ISIS bombers struck in Beirut, killing at least forty-three civilians. Two weeks earlier, a Russian passenger plane at Sharm el-Sheikh exploded in midair, killing more than two hundred passengers. San Bernardino added its own disquieting cast to the extremist trend. This is everyone’s war now.”

In 2016 we are likely to see further fomentation of a war in the Middle East take place involving the nations of America, Britain, France, Russia, Turkey, Egypt, and Iran to name but a few. Certainly headline risk is going to be huge in the year ahead, and that typically causes a contraction in liquidity as people assess their personal circumstances and prioritise preservation of what they have rather than go all out for capital growth. We may well be heading into a Risk Off environment. 

The CB Carrot Loses Appeal

I said they came a close second in the running for top headline creators, and there is no way anyone could review the year just past without including a few words about the contribution to economic uncertainty by Central Banks around the world. I can’t remember a year in which they received so much press attention.

Central Bank Stimulus 

The tone was set early on with the shock decision by the Swiss National Bank to de-peg the Franc from the Euro in January. The second before they took action the Euro was worth 1.2 Francs, and a few minutes after it had dropped to as low as 0.85 Francs. The shockwave rippled out across the investment world, with many large banks and brokers impacted in the form of large currency trading losses - Deutsche Bank and Citigroup lost $300 Million between them alone. 

The effects of this action are still being felt by many in Eastern Europe who took out mortgages in Swiss Francs to take advantage of lower interest rates than those available domestically, and now find themselves struggling to pay down a debt that increased by roughly 30% in an instant. Not a great move by an institution with a mandate to promote economic stability, but had they announced their intentions there is no doubt that the world would have front run the Euro/Swissie currency trade and their own losses would have been much larger.  

Next we had the announcement from the ECB that they would begin a massive asset purchase program in March, pledging to buy 1.1 Trillion Euros in bonds over the next year and a half. European markets had been rallying prior to the announcement since the ECB move was well telegraphed in advance, and they initially soared with the German DAX index putting on 17% from the middle of February into mid April. The gains then all but disappeared over the next few months when markets fell into August as investors came to the realisation that there was little the ECB could do to fully solve the fiscal problems in Europe, especially when Greece failed to make a scheduled interest payment to the IMF on July 1st. 

Eurozone Inflation

ECB QE was designed to spur inflation in the Eurozone, but the reality is that it has failed to have much of an impact. It briefly managed to bump the inflation rate to positive, but the effects quickly dissipated and in September inflation dropped back below the zero line leading to calls for yet more easing measures. Mario Draghi agreed to increase the size and scope of the bond buying program in December. This time the announcement of extra stimulus failed to result in a stock rally – the carrot is losing its appeal.  

Not to be outdone, the US Federal Reserve grabbed its fair share of the headlines this year, as Janet Yellen and her board of governors played their version of peak-a-boowith the investment world. ‘Where’s the rate hike? Where’s the rate hike? There it is!!’ To be fair I think they would have acted in the summer without Christine Lagarde’s very public calculated plea to the Fed not to raise interest rates, but having promised normalisation repeatedly throughout the year and having had the majority of its economic criteria met, it could not very well fail to deliver or face further recrimination from an increasingly befuddled and bemused investing public. I think Jim Bianco of Bianco Research captured the mood best when quoted on CNBC in September:

“If the Fed’s policy was to intentionally confuse the market, how would it differ from what they are doing now?”

 

As it is, the Federal Reserve have not only scaled back their easing measures (they are still rolling the maturities of their existing $4.5 Trillion bond book) but they have now increased the base rate for the first time since 2006. Stock market reaction was initially positive but it soon rolled over, dropping 4%+ over the next week before the seasonal Santa Rally began to take hold. The question is now how the market will cope in a high debt low inflation rising rate environment and my view is that we may struggle. 

We can already tell that ‘debt troubles’ is going to be a buzz phrase in 2016. The rise in interest rates by the Fed, although small, will have a significant impact globally as it will pressure those emerging markets who chose to issue dollar denominated bonds when rates were low, and it will pressure the European bond markets – after all why would a conservative investor lend money to a teetering Italy or Spain only to receive less of a return than if they had parked their money in the safe bet US 10 Year Treasury? Eurozone yields should begin to rise this year regardless of further accommodative policy by the ECB, and that will in turn begin to bite into European government budgets. Greece may simply be the canary in the coalmine. 

The current best article summarizing the potential debt woes we have to look forward to this year comes from Carmen Reinhart of Harvard University’s Kennedy School of Government, who says:

“As 2016 begins, there are clear signs of serious debt/default squalls on the horizon. We can already see the first white-capped waves.. the US Federal Reserve’s move to increase interest rates, together with slowing growth (and, in turn, investment) in China and collapsing oil and commodity prices, has brought the capital inflow bonanza to a halt.. From a historical perspective, the emerging economies seem to be headed toward a major crisis. Of course, they may prove more resilient than their predecessors. But we shouldn’t count on it.”

Suddenly Breadth Matters

For months of this past year I watched the breadth statistics deteriorate only to find the index remained within a percent or two of the all time high, knowing that at some point there would be a drop and getting frustrated as none came, until August gave us a short sharp savage decline. It took just 4 days to drop 10%+ which is something that has happened only 9 times in stock market history, and panic was everywhere. The outflows from bull funds were epic in their size and scale, and although much of this money has returned to the equity market we now find significant damage done to the average as a whole. 

As we come into the New Year the average 14 day RSI reading for S&P500 stocks is under 50 and falling; the number of stocks above their respective 200 day moving average is 42.71% (and more worrying is that in many cases that moving average is declining, telling us the intermediate trend is now down); and 64.8% of stocks in the SP1500 finished at least 10% below their 2015 highs. The average stock has not been participating in the rallies, and but for a handful of large cap-weighted companies distorting the average as a whole, we would be well on our way to re-testing that August low by now. 

Profit margins have fallen 60+ basis points on average this year, and the only time since the early 1970s that this has not been the precursor to a recession was 1985 – in fact it marked a major high the US Dollar and a major low in the US stock market. This time around I am not so sure we have the same set of circumstances that would see the dollar make a high and equities make a low, at least not without a decent pullback first.

I won’t go into it in great detail here as I am writing a piece on equities to be published this week, but the end of 2015 gave us two statistical omens we should be wary of – the first is that this is the first year ending in a 5 to give us a negative return in the S&P500 (the average return up until now had been 25.32% over 8 instances); the second is that the 5 month moving average has now closed below the 20 month moving average for the first time since 2008. The time before that was 2001 and if those years sound familiar it is because they were all bear market years. 

 

More worryingly still we find that operating earnings peaked in the 3rd quarter of 2014, and have declined steadily ever since – something that has foreshadowed stock market declines with a high degree of accuracy in the past. The average company has simply not fared as well in 2015 as in recent years and this further emphasises the point that we now have an ‘aging’ rather than a ‘raging’ bull.

As we start the New Year I believe we should be adopting a more cautious approach than in years past, and my subscribers and I are already short the market in terms of our trading positions. Although we will likely see the January Effect play out again this year, I feel it could be limited to a small number of beaten down stocks in areas such as Energy and Mining, and may not lead to gains in the index as a whole. 2016 could well be a year to remember, but perhaps not for positive reasons.