As I did in October 2014 and August 2015 when fear last gripped the equity markets, I am writing to give you another out-of-consensus – that is, positive – market outlook. The last two scares offered good equity buying opportunities, as does this one if the bull market remains intact, which we believe it will. While recent stock price action certainly feels “bearish,” thus far the markets are testing the levels they hit in the last two corrections.
AN OUT-OF-CONSENSUS CONCLUSION: U.S. Earnings Growth Will Re-accelerate In 2016
We believe that inventories in most industries, while notoriously difficult to measure in the short term, are beginning to deplete rapidly. Inventory liquidation is happening for two reasons: business confidence has eroded and purchasing managers are trying to avoid inventory losses as prices fall. At the same time, consumer confidence in the US, after quadrupling from its lows in 2009, remains at high levels thanks to increases in both employment and purchasing power. Consumption is proceeding apace, suggesting that the big surprise at some point in 2016 could be inventory shortages, which would trigger a significant acceleration in economic activity and upside surprises in earnings. Already, in the auto sector Delphi and Autoliv have stated that they were forced to rehire employees in China after being surprised by the rebound in auto sales in Europe and China during the fourth quarter of 2015. In the equity markets, truth will win out, as it always does, when positive earnings surprises proliferate.
THE BAD, THE GOOD, AND THE MISUNDERSTOOD
In this piece, I will address what most investors fear (the “Bad”), what they ignore (the “Good”), and what may be other sources of confusion (the “Misunderstood”). Investors are interpreting almost all news as bad news, and need a catalyst to change their mindsets.
FED TIGHTENING: BAD?
Equities have been selling off on any sign that the Fed might raise interest rates for the second time in this cycle. In early February, when the Department of Labor released the January employment report, equities swooned because by many measures it was the strongest report in years, raising the odds of another Fed “tightening” in March. While the headline nonfarm payroll number was weaker than expected, every other number in the report— household employment, average hourly earnings, and the average workweek— was much better than expected, pointing to out-sized increases in production and income at the beginning of 2016.
Clearly, the fears associated with the Fed’s first tightening move in December were misplaced. In January alone, manufacturing employment jumped by 29,000, compared to the 32,000 created in all of 2015. Also in January, the Purchasing Managers’ new orders index jumped from 48.8 (50 or lower signaling a decline) in December to 51.5 in January, as manufacturers seemingly scrambled to satisfy surprisingly strong demand, relative to low expectations. Indeed, inventories as measured in the Purchasing Managers’ Index had been falling since last June and still are falling.
The employment report also pointed to personal income growth in the 0.8-1% range during January, annualizing at or near a double digit rate, and giving the Fed added support to continue normalizing rates with a 25 basis point increase to 0.5%. The Fed is letting the markets work again….and that is GOOD.
OIL PRICE DECLINE: BAD?
Equities have been selling off in response to the collapse in oil prices from nearly $115 per barrel in 2011 to $30 today. In 2015 alone, they were cut in half. The threat of widespread defaults has sent high yield bond spreads in the energy sector to levels even higher than in 2008, raising fears of another round of systemic risks in the banking sector.
Because of increased regulation resulting from the Great Financial Crisis, US banks are much less exposed to such risk than in the past. In Europe, banks do have more exposure to the energy loan debacle and their stocks are suffering disproportionately, but European sovereign debt spreads remain at fairly low levels, suggesting that the hit to bank shareholders and bond holders will not cause a seizing up of the entire banking system. Given any indication to the contrary, ECB President Draghi has left no doubt that the central bank would be lender of last resort. All that said, the irony is that the drop in energy prices is a massive tax cut and a net positive for 85-90% of consumers and businesses around the world…and that is GOOD.
Equities have been roiled by fears of a massive Chinese devaluation, which would destroy the purchasing power of its consumers and pull another leg out from its stool. The first leg was the bursting of an industrial super-cycle gone too far. As a result, commodity prices, as measured by the Commodity Research Bureau (CRB), have collapsed to 160, a third of their peak in 2008 and less than half of their more recent peak at 370 in 2011.
China’s industrial weakness has been telegraphed for more than four years, and financial markets have adjusted accordingly. Indeed, inventory liquidation based on China’s outlook may have gone too far if consumers continue to surprise on the high side of expectations, stimulated in part by the oil price declines and China’s government policies. On a year over year basis, in China unit auto sales were up 7% on average in 2015 and 17% in December 2015, while in Europe they were up 5% and 18%, respectively, and in the US, 5% and 2.5%, all of which were upside surprises.
The fear of a massive devaluation in China flies in the face of China’s stated objective to re-balance its economy from industrial investment toward consumption. Since August, the yuan’s 3-4% decline relative to the dollar seems to be related to its new position in the IMF’s Special Drawing Rights basket, which also includes the euro, the yen, and the pound. China’s industrial excesses have been and are BAD, but they are well understood and may be distracting investors from the news coming out of its consumer sector…which is GOOD.
While earnings in the US have eroded at a low single digit rate in the last quarter, the juxtaposition of falling inventories against rising final demand is a set-up for a significant rebound in profitability. Also important, the dollar has been flat to down against most of our major trading partners since March 2015, and will turn from a serious headwind into perhaps a profits tailwind by the second quarter. The dollar’s 25% appreciation from June 2014 to March 2015 also forced corporate America into serious cost controls, which could leverage the gain in profitability even more than would otherwise have been the case. Just as important, the quality of profits has been rising dramatically, as underlying profitability has been camouflaged by inventory losses and over-depreciation, the latter because of the accelerated decline associated with technology cost curves. The outlook for profits is much better than expected…which is really GOOD.
Probably most MISUNDERSTOOD
Certain deflationary forces – those associated with technologically-enabled innovation – are exceedingly good for growth and profits. Not since the late 19th century has the world enjoyed as many general purpose technologies as are evolving today: the next generation internet, robotics, energy storage, life sciences sequencing, and blockchain technology. Combined, they could lead to a deflationary boom and wealth generation dwarfing that of the computing age. You can learn more about the promise of these platforms, as always, on ARK’s research platform.
2016: THE FLIP SIDE OF 2000
During the tech and telecom bubble, investors caught a whiff of how profoundly general purpose technology platforms, like the internet, were going to transform the world, and they bid stocks up on the number of eyeballs that would turn into revenues at some point in the future. Good news was good news, and somehow bad news was good news. All news was good news and the general market outlook was distorted. Clearly, they were 10 to 15 years too early in making that call and paid a horrible price during the bust. On March 10, 2000, the market was hit by more sellers than buyers for some reason, and that was it.
Today, we have not only the next generation internet but four other general purpose technology platforms that are evolving more rapidly than the eighteen months to two years that Moore’s Law accommodated. Unfortunately, the memories of 2000-2002 and 2008-2009 have investors interpreting bad news as bad news and good news as bad news…selling now and asking questions later. One of these days, as the cyclical backdrop brightens and some investors reassess their positions, more buyers than sellers will surface, and good news will be good news once again.
Catherine D. Wood
ARK's statements are not an endorsement of any company or a recommendation to buy, sell or hold any security. For a list of all purchases and sales made by ARK for client accounts during the past year that could be considered by the SEC as recommendations, click here. It should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities in this list. For full disclosures, click here.