In his fourth quarter earnings preview: The Lost Year? Reid Davis, Pinnacle Trust’s Investment Officer focused on U.S. equity analysis, details a 2015 where we saw the S&P 500 post three consecutive quarters of year-over-year earnings declines for the first time since 2009. The declines are primarily due to a decimated energy sector and a stronger dollar, which hurt multi-national corporations’ overseas profits. 2015 also shows that at current equity values, a 2% domestic economy will struggle to produce enough topline revenue growth to propel the major equity indices significantly higher.
Looking forward to 2016, it will be prudent to expect the unexpected. Pinnacle Trust expected volatility to pick up in 2015 and that view has not changed. Remember, volatility is not always a bad thing. It keeps markets honest and leads to opportunities. Consensus views from major investment firms expect 2016 to be a lot like 2015, up and down, but overall sideways.
Is it possible that 2016 will simply be 2015 version 2.0? Let’s call 2015 a “flat year” and for historical purposes let’s define flat year as a total return for the S&P 500 of inside plus or minus 5% (-5% to 5%). Since 1928 the S&P 500 has had a “flat” year 11 times. But it has never had back-to-back years that returned between -5% and 5%. Looking at the historical data, we see that the average down year for stocks is -13.69% and the average positive year is 22.96%. The medians are -9.50% and 19.8%.
With history as a backdrop, it seems likely that we will have a double digit market move in 2016. Of the prior 10 years where the S&P 500 returned between -5% and 5%, the following year has had a double digit move 10 times, with 9 of them being positive. 1940 is the exception, when the S&P 500 lost 10.67%. Of the five time that the market returned between 0% and 5%, the following year had a double digit positive return five times.
What could go right in 2016?
The positive case for 2016 begins with stabilization in the U.S. energy sector. According to FactSet, 2015 earnings growth for the energy sector is expected to be -58.8%. From that level it will not take much of a rebound to have a positive impact on the broad indices.
The next positive factor could be a reversal in dollar strength. If the move in the dollar has reached its peak and begins to reverse, multi-national corporations will have currency exposure as a tailwind to profits.
2015 was propped up by tech stocks. Companies such as Facebook, Amazon, Netflix and Google, now commonly referred to as “FANG”, led the NASDAQ to a positive year and helped offset the beleaguered energy sector in the S&P 500. 2016 could be the year of financials. Financials have the second largest weighting in the S&P 500, at 16.5%, and are also among the most attractively valued from a free cash flow to enterprise value, dividend yield, cash flow yield and book value yield perspective.
The primary argument against stocks remains valuations. Stocks are trading well above their historical norms and with 2015 as a benchmark and the Federal Reserve raising interest rates, it does not appear valuations are going to expand. However, if valuations just hold, a combination of stock buy backs, dividends, modest top-line growth flowing through to earnings growth, and a recovery in the energy sector can quickly add up to a 10% return for the S&P 500.
What could go wrong in 2016?
A continued drop in the price of oil and other commodity prices could create concerns over the global economy and send equity markets south. The International Monetary Fund (IMF) expects 3.6% global GDP growth in 2016, a .5% increase from 2015. Expectations for more declines in the growth rate of the global economy, instead of a pick-up, could force a risk-off environment. Issues in China could be the catalyst do bring down overall global growth.
The U.S. remains the largest economy in the world and has held as an anchor for the globe over the past 5 years while we have dealt with the European debt crisis, potential Grexit, recession in Brazil and general slowdown in emerging market economies. However, despite its relative strength the domestic economy has not been able to meet American expectations. Any disappointing economic news out of the U.S. could trigger a sell-off. In the past 5 years bad news has been good news because it meant zero interest rates and more quantitative easing (QE) from the Fed. With QE a thing of the past and the Fed raising rates, bad news will now be bad news.
Political and geopolitical headlines could be damaging in 2016. Markets do not like uncertainty and the U.S. Presidential election is anything but certain. On the geopolitical front, ISIS enters 2016 atop of the list of concerns. Thus far, markets and the economy have taken the recent terror attacks in stride, however, a larger scale attack could be damaging. Recent tensions between Iran and Saudi Arabia have the potential to further destabilize an already unstable region of the world.
Going into 2016, expect some weakness early in the year. The market has not been able to regain its highs and we likely need to test the lows set last summer. After that things will become “data dependent.” If the U.S. and global economy hold up, a double digit return for stocks would be normal based on history. However, 2016 will look more like the average for all years (11.41%) versus the average for positive years (22.96%). If 2016 brings economic weakness we could break through the summer market lows and enter into bear market territory. Today, the indicators point to status quo for the economy which will likely lead to a correction followed by some yearend strength that could push the S&P 500 into double digit returns for the year.
From everyone at Pinnacle Trust, we wish you a very happy and prosperous 2016.
Jeremy Nelson serves as President & Chief Investment Officer at Pinnacle Trust. You can reach Jeremy by emailing him at email@example.com or by calling him at 601-291-5911.