The first month and a half of 2016 were brutal for the U.S. equity market,
as the major averages plunged over 10%. The culmination of the decline came on
Feb 11th when the Dow Jones Industrial Average dropped 1.6%, and the S&P
500 decreased 1.2%. Since then, the market has managed to hobble back to its
2015 closing level, leaving major averages relatively flat for the year.
But to understand where the market is heading from here we need to
recognize what caused the selloff in early 2016 and what led to the recent
rebound.
December 2015 ushered in the first rate hike by the Federal Reserve in
nearly a decade. The Fed's liftoff from ZIRP was highly anticipated by a
massive rally in the U.S. dollar that began in July of 2014.
On January 25, 2016, the dollar index (DXY), which measures the greenback
against a basket of six major currencies, hit a short term high of 99.52.
Since then, it dropped to a low of 93.62, which was a drop of 6%. The
decrease in the dollar was the primary contributor for the rebound in the
major averages. Investors sold dollars because Fed Chair Janet Yellen backed
away from her previously threatened four rate hikes during 2016.
The fall in the dollar provided crucial support to global markets by
boosting distressed commodity related debt held by financial institutions,
improved the projected earnings of U.S. multinational corporations and also
bolstering banks' holdings of dollar-denominated foreign debt. In other
words, the FOMC temporarily bailed out the global banking system on the back
of the greenback.
But now the DXY is once again bouncing around that crucial 94 support
level from where it has bottomed five times in the past year. And to keep the
global equity bubble inflated, the FOMC must determine if it wants to
engender a dollar bear market or allow equities to crash.
Wall Street puts its hope on a sinking dollar
The sad truth is there isn't any solid fundamental factor to drive stocks
higher. Therefore, investors have misplaced their hopes on betting the
inflation produced from a falling dollar will be able to bail out the entire
market.
A coordinated central bank attempt to depreciation the dollar is the
Last desperate hope to keep the bubble inflated because the overvalued stock
market isn't being supported by earnings or GDP growth.
The U.S. is not the only country suffering from secular stagnation. The
slowdown in global growth has been fully acknowledged by the International
Monetary Fund (IMF). Firstly, the IMF just took down its outlook for U.S.
growth to 2.4 %, from 2.6 %. And despite aggressive monetary policies
implemented by the Bank of Japan, it has halved their forecast for Japanese
growth this year to just 0.5 %. In 2017, when a consumption tax hike takes
effect, the IMF expects the Japanese economy to shrink actually shrink once
again -- as it has the habit of doing -- this time by 0.1 %.
The nineteen countries that share the euro currency are projected to
collectively expand 1.5% this year, down from the 1.7 % projection. And Latin
America, still suffering from China's slowdown, is expected to shrink 0.5 %
this year, down from a January forecast of plus 0.3%. This contraction is led
by Brazil whose economy is projected to shrink 3.8 % this year.
All this bad news has led the IMF to cut its global growth forecast for
the fourth time in the past year, this time from 3.4%, to 3.2%. Last year the
global economy grew 3.1 %, its slowest pace since the recessionary year of 2009.
U.S. Q1 GDP, according to the Atlanta Fed Model, is set to grow by a
meager 0.3%. The Atlanta Fed's model doesn't include an estimate for nominal
growth, but using last quarter's GDP deflator we can glean that Q1 nominal
growth (inflation + real growth) will be about 1.2%. Nominal GDP growth of
just 1.2% is beyond pitiful. And since S&P 500 earnings tend to grow with
nominal GDP, we can make the same sorry assessment about the health of U.S.
corporations.
Hence, according to Zack's Financial Research, total earnings for Q1 are
expected to be down 11.1% on negative 2.3% revenues. Earnings growth is
expected to be negative for 11 of the 16 sectors that Zack's covers. The
negative earnings growth in Q1 will be the fourth quarter in a row of
earnings declines for the S&P 500 index.
The weak dollar may provide some temporary relief to the stock market.
However, the major averages are still extremely overvalued and overleveraged:
Margin debt as a percent of the economy is higher today than both 2000 and
2007.
The median price-to-earnings ratio that sits at 22.6, is at a higher level
than the market peak in 2007. And at 22.6, the S&P 500 index is currently
25.3% above its median fair value.
The Prices-to-Sales Ratio is now not only higher than in 2007; but also at
any other time in history with the exception of the top of the internet
bubble in 2000. And finally, the total market cap of corporations in relation
to the economy is also higher than any other time in history outside of the
NASDAQ craze.
All things being equal the combination of falling corporate earnings and
revenue, along with peak market valuations and leverage should cause the
equity market to collapse. This is why the Fed has decided to hold in
abeyance future rate hikes, in hopes the falling dollar will continue to bail
out the global financial system.
But a falling dollar isn't a long-term or viable strategy to generate
economic prosperity. All you have to do is look at Japan to realize that
growth doesn't come from a crumbling currency. The yen has dropped 35% in the
past few years and Japan's economy and has been mired in a perpetual
recession. At best, the USD breaking 94 on the DXY will provide only
temporary relief for the major averages. But inflation and currency
destruction is the bane of viable growth and will lead to yet a further
dislocation between asset prices and underlying economic growth...and that
means the eventual day of reckoning will be much more pernicious.
