The I.O.U. market: Stocks could fall 10-20% more

Written February 10, 2016 by
Jack Bouroudjian
Chief Economist

The market tone began to shift in December — and the warning signals started to flash red.

We started to witness a contraction in earnings for a couple of quarters in a row, which resulted in the price-to-earnings ratio of the S&P 500getting rich. We watched crude oil have a parabolic move to the downside as producers couldn’t pump fast enough. And we started to see the Federal Reserve move rates at a time when all the other central banks were doing the exact opposite which created risk aversion.

As it turns out, this became an I.O.U. market: interest rates, oil and uncertainty.

Interest rates have been acting in a counterintuitive manner ever since the Fed moved. With the central bank making their first move at the end of 2015, one would expect the long end of the yield curve to reflect that action and see rates go up. We have seen the opposite: The yield curve has flattened and the long end of the curve is the beneficiary of asset allocations which are driving capital out of equities and into fixed income.

It seems that the Fed missed the window of opportunity back in September and now finds the market price action, as told by Fed speakers last week, troublesome. Now the governors are faced with an unemployment rate of 4.9 percent and the dilemma of full employment in an underperforming economy. The next moves by the Fed will be debated for years; It’s almost as if they can’t win. Unfortunately, for the next few months the Fed finds itself in a “lose-lose” scenario. They’ll be damned if they do and damned if they don’t.

Crude oil is a world in itself. Being in commodities for the last 30 years of my life, I can honestly say that I have never seen this type of price action in such a short period of time. What were life-of-contract moves, are now happening on a weekly basis. When we’re taught the basics of supply and demand in determining value, we learn that fundamentals are more important than technical analysis. Had someone traded technicals the last 7 months, they would have found plenty of areas to buy the market which would have been a loser most every time.

Crude is purely a victim of oversupply, which, in itself, has serious ancillary effects for the short term. With the velocity of the move down, many oil-producing nations did not have time to prepare a financial cushion for a prolonged depression of prices. One serious consequence has been liquidation of assets by sovereign wealth funds, especially in European financials. This has triggered the “relative value” trade in equities and the spillover has been felt here in the U.S. With technology allowing for cheaper production, the Saudis and Russians pumping full throttle and a U.S. dollar that stays strong, crude could be oversupplied and in trouble for a while.

Uncertainly is poison for investors. Lately there have been plenty of things to make investors uncertain. China, the growth engine of the last decade, is slowing down; the U.S. elections, as entertaining as they might be, have an avowed socialist running; the business cycle has matured and it looks as if it has come to an end. Couple all these with the Fed, the effects of lower crude and the lack of growth from the economy and we have the foundation for a continued move lower in equity prices for the near term.

The IOU market condition doesn’t mean that the bull market is over. A 30-percent pullback in what could be a 20-year long bull market should not be considered a “bear” market but rather a serious correction in prices and value. It means that this leg of the bull is over for now. The repricing that we are witnessing is absolutely needed if we are to continue higher.

Every market must be repriced from time to time in order to maintain the “animal spirits.” But let’s keep in mind what is on the other side of the repricing of assets. As we start to find clarity in the race for the Oval Office (Unless Sanders is nominated) and we see crude stabilize later this year, corporate America will find itself in a strong position. Balance sheets as a whole are strong; and with a steady dollar, earnings could be a surprise later this year. The lower input costs and a resurgence of growth, both here and abroad, will trigger the next leg higher in stocks.

In many ways, it really is an I.O.U.: The market will owe us the next leg up after the clouds of uncertainty part. We could see another 10 to 20 percent lower in prices before we’re all done, but the bottom will come and it will be the buy of the decade.