A Round Trip Market
Market Backdrop
Stocks fluctuated widely in the first quarter but ended essentially where they began. In the first two weeks of the quarter the S&P 500 lost about 9% and by its low point on February 11 it was down 10.5%, which left it more than 14% off its record high on July 20, 2015. As been customary in this bull market buyers began to step in at the lows and continued buying through the quarter’s end, not only recouping losses but adding modest gains. The S&P 500 finished the quarter with a gain of 1.4%. However, under the surface there was a sharp rotation out of the faster growth areas of the market such as Biotech, Technology, and Consumer Discretionary to more defensive area such as Utilities, Telecom and Consumer Staples. Portfolio managers who are unable, by mandate, to stay out of the market tend to hide out in these defensive areas during downturns.
The selloff in the stock market was mainly on concerns about falling energy and commodity prices, slowing economic growth, credit concerns, and whether the Federal Reserve would aggressively raise rates throughout 2016 in the face of economic uncertainty. Remember, the Fed raised short term rates for the first time in December 2015, just prior to the stock market decline. However, during the first quarter, the yield on the 10-year U.S. Treasury bond actually declined from its 2015 close of 2.26% to end at 1.79%.
Falling commodity prices brought back memories of 2008, as credit concerns mounted about the stability of bank balance sheets and their ability to withstand potential bankruptcies by energy firms, should the weakness in crude persist. As such, banking stocks fluctuated widely during the quarter.
Another concern about low oil prices was the effect on oil producing nations’ finances. Reports surfaced stating many of those oil producing countries were indeed raising funds by selling stocks and bonds from their investment portfolios, which are called Sovereign Wealth Funds. Word also spread that Saudi Arabia was considering selling some interest in their state owned oil firm, ARAMCO, and also issuing debt in order to plug holes in their fiscal budget. This created further downward pressure on stocks and the riskier areas of the bond market, mainly high yield credit.
The market eventually reached its low point on February, 11 and then staged an impressive rally through the quarter. The primary catalyst for the rally was stabilizing energy prices as well as Federal Reserve Chair Janet Yellen’s mid-February testimony to Congress, where she tempered expectations for further rate increases. Yellen followed up her dovish stance at an end of quarter speech at the Economic Club of New York, where she used such phrases as “proceed with caution”, “gradual increases in the federal funds rate” and “pace of global growth a concern, influenced by developments in China”. Those comments furthered a rally that was already underway in stocks and commodities.
Outlook
Under the surface there may be pent up demand brewing for stocks. A recent Bloomberg article pointed out that short interest, which are bearish bets on stocks, has risen to an eight-year high and above $1 trillion. Very high levels of short interest are typically a contrarian signal because historically people are most fearful at market bottoms.
I believe the recent decline had more to do about memories of the past rather than any significant fundamental weakness in the U.S. economy. Although the U.S. economic growth has been subpar when compared to previous expansions, it has been enough to improve employment.
Common sense dictates that lower energy cost are beneficial to an economy of energy consumers more so than perceived weakness in bank balance sheets. It is not 2008 again and I believe those fears will subside as commodity prices stabilize.
The strong dollar and decline in energy prices has contributed to the recent decline in corporate earnings. As 2016 moves forward, I expect corporate earnings, which are the lifeblood of an economy, to rebound as commodities and the dollar stabilize, leading to meaningful earnings contribution from commodity and industrial companies.
As usual, the market backdrop includes a fairly typical menu of concerns, with the Federal Reserve and corporate profits front and center. For our clients we will continue with our focus to search out fundamentally strong companies that have the ability to grow their business and profits.
Thank you for your confidence.
Sincerely,
Nadim Joseph Nahas
Co-Founder/Portfolio Manager