INSIGHTS

On November 30, 2015

AAM Viewpoints - The Pivot Point for 2016

All investment specialists are asked to put a timeframe on economic growth, stock market runs and the Federal Reserve’s actions on interest rates. Rather than falling into the trap of picking a date, we often refer to other measurements that leave a little more leeway since the track record of market timing is extremely poor, at best. This opens the doors for some to seek the fleeting fame that comes with a correct call to the date…though backing it up with correct continuous calls thereafter never materialize. As such, we often put such questions into the answers referring to America’s pastime, baseball. Quite plainly, in which inning is the current state of the economy?

Last year we targeted the cycle in the 7^th inning. We also qualified it as saying the later stages of a baseball game often last the longest with continual switching of pitching match ups and more elongated at bats. With that being said, most would like to assume that we are in the 8^th inning currently…that would be too simple. Considering the events of this year, it might be most apropos to say we were in a rain delay and the game is very likely to go into extra innings.

With earnings behind us, many are begging to call for recessions out citing key indicators of year-over-year sales and earnings growth of corporate America as well as consumption slowing down. Often to the contrarian market timing calls, the cryptic puzzle is obvious but the majority is oblivious. Recall that in 2012, the ECRI (Economic Cycle Research Institute) made a recessionary call based off of multiple indicators, one key being lack of wage pressure. Their research was logical and not biased; however, with the benefit of hindsight, it was clear the levels indicating past recessions and the trends of the indicators left quite a bit of error variance. In an era when we have more timely access to a plethora of data sets and computing power to seek out patterns, we are still left with the frustrating conclusion that human irrationality is not only the main driver of economic growth and declines, but is also ripe with conflicting and revised data points.

There has been an increasing call for recessions recently due to some of these metrics. Often, you have to take every measurement with some aspect of subjective context, often which we shift to our own bias and belief. One of the more pronounced warning sign is the year-over-year sales and earnings growth for corporate earnings. This has obviously been influenced by the U.S. dollar’s rise which has risen 10.7% year to date and up 26% from its lows set in May 2014. The increase in the dollar, in light of the Fed’s delayed rate hike moves, looks very similar to the timeframe of 1992-1995. Starting in June 1992 and then using June 2014, one can see a fairly similar pattern. In the chart below, the arrow marks the point in February 1994 when the Fed began raising rates and didn’t stop until February 1995 when it was 300 basis points higher.

The Fed raised rates far more aggressively than even the staunchest hawk currently. At best, it appears the Fed will move rates “quarter by quarter,” a rate that is a third of the pace in 1994-1995. Even then, the dollar gave back almost its entire gain it garnered leading up to the rate hikes.

Currency speculators and investors have the investment timeframe of a fruit fly and it doesn’t appear they are going to want to wait around three years to fully realize the rate hikes needed to justify the dollar’s gain.

Consider the narrative in the market place that associates rate hikes with negative returns for financials. Here again, history doesn’t necessarily match up. Though the chart below may look a bit busy, a pattern of immediate outperformance in financials when the Fed raises rates is fairly consistent. When one takes into account that banks holding $2.8 trillion in cash, with $1.92 trillion being held in excess reserves, combined with the regulatory restrictions toward the use of risk capital, one can understand that the potential outperformance may be bigger as banks are forced to make money from traditional banking functions rather than trading.

For the other recessionary calls based on consumer spending, consider that the consumer discretionary sector has had a total return of 23.8% since June 2014 when oil began to fall from its highs. Many were claiming that the discretionary sector didn’t have a benefit from the lower cost of energy; however, the price-to-earnings ratio only rose 1.9% to 20.42, the price-to-cash flow dropped 5% to 12.63 times and price-to-sales had a similar move as that of the price-to-earnings ratio. Financials will be a good focal point for investors for 2016, in our opinion.

The pivot point for 2016 appears to be the U.S. dollar. There appears to be a logical narrative that has been quite a bit ahead of itself in pricing in a substantial amount of rate hikes that may never occur; or at best will require more time than the average dollar bull will wish to hold. We expect it to churn shortly after the Fed begins raising rates, and ultimately following the pattern of 1994-1995. This would mean that small and mid-cap look to outperform in the first half of the year, but we expect to begin to see favorable year-over-year comparisons in the second half of 2016.

CRN: 2015-1102-5021R

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the Disclosures webpage for additional risk information at https://www.aamlive.com/legal/commentary-disclosures. For additional commentary or financial resources, please visit www.aamlive.com.