By Doug Kass at Real Clear Markets
“Darling I don’t know why
I got to extremes,
Too high or too low,
There ain’t no in-betweens.
And if I stand or I fall,
It’s all or nothing at all.
Darling I don’t know
Why I got to extremes.”
— Billy Joel, I Go To Extremes
The recent relief rally has energized bulls, while pundits who worship at the altar of price momentum are now optimistic even though fundamentals have arguably changed little since these “talking heads” expressed fear when the S&P 500 hit 1,812.
But based on the market’s two dips and subsequent rallies during January and February, it appears accurate to say that buyers live higher and sellers live lower (as I’ve frequently written).
Of course, when singular events threatened the global economy and markets in the past, forceful, responsible policy responses quickly silenced the growth scares. These provided a series of “buy-on-dip” opportunities over the past six or seven years that routinely took markets to or through their previous highs.
But as global growth weakens and monetary-policy limitations become more and more apparent these days, our fragile and interrelated global economy is becoming more vulnerable to tail-risk interruptions and “black swans.”
The chances of policy mistakes grow ever more likely as monetary authorities try unconventional strategies like negative interest rates, while any sustained drop in stock prices will likely inflict a “negative wealth effect” on the U.S. economy.
Jim “El Capitan” Cramer yesterday produced a great 14-point checklist of things to look for when deciding whether stocks have stabilized, writing:
“We had 14 boxes that needed to be checked before we want to hold on to stocks when they rally and buy them more aggressively when they come in. I make it so there are three boxes that are definitely vacant of checks. The others are full or half checks, eight and three, respectively.
You are never going to have all the planets align at once. But are there enough checks and half checks for me to say the dips must be bought and the rips? I wouldn’t be so quick to sell them. They might be the real deal.”
Of course, a key feature of Real Money Pro is that we provide opposing viewpoints. So respectfully, I’d like to state that my analysis concludes that Jim’s optimism might be premature. To paraphrase Jimmy, it’s my view that “it might feel better, but it isn’t better.”
Below are my top 10 reasons to expect more volatility during 2016 — and possibly even more market risk than at any time since the 2007-2009 Great Recession:
1. The Market Is Statistically Overvalued. The S&P 500 has rallied about 9% since its February lows and is now just some 7% away from its all-time high. But I calculate the index’s fair-market value at approximately 1,860 based on the probabilities for five different economic scenarios. That’s roughly 6% below Wednesday’s close.
2. The Market’s Mechanism Is Broken (Part One). In the absence of an effective U.S. Securities and Exchange Commission, the disruptive influences of quant strategies and leveraged ETFs could linger for years.
3. The Market’s Mechanism Is Broken (Part Two). The Volcker Rule and the Dodd-Frank securities law have limited brokerages’ the ability to assume risk and carry inventory of equities and fixed-income products. This has restricted the market-making function that has historically absorbed volatility and provided liquidity. Moreover, today’s low commission structure creates little incentive to assume capital risk. Finally, we’ve seen the elimination of the old specialist system, which provided a human element to buffer declines and market distortions.
4. The European Banking Industry Is Doomed. European banks play a greater role in the supporting the European Union’s economies than our banks do in helping the U.S. economy. However, Europe’s financial firms are currently overleveraged, undercapitalized, under-reserved and victimized by negative interest rates.
5. The EU Sits at the Epicenter of Global Risk. The risk of a Greek and/or British exit from the European Union has risen in recent months as far-left and far-right parties in both countries grow more popular. (This is actually happening in much of the rest of the world, too.) At the same time, the euro’s future is function of the EU’s ability to ward off increased credit stress and a broader European economic downturn.
6. Monetary Policy Is Cutting Off Global Banking’s Profitability (and Lending Role). More-stringent and restrictive lending could lie ahead. In a world in where credit spreads are already wide, that would pose multiple risks.
7. Corporate-Profit Expectations Are Trending Lower. As noted I in yesterday’ sopening missive, forecasts for first-quarter S&P 500 earnings have dropped by 9.6% over the past three months. That’s double the rate of earnings reductions since 2011, as well as the largest drop since the 2007-2009 Great Recession.
8. The Geopolitical Backdrop Is Uncertain. The world is flat, networked and interconnected, and America can no longer see itself as an “oasis of prosperity.” Moreover, our politics are increasingly embracing left- and right-wing extremes as the electorate abandons the middle course in the face of diminished expectations. To top it all off, the world’s neighborhood is unsafe. Wars are raging not only in the Middle East, but also in Ukraine despite repeated EU peace-deal attempts. Russia is also becoming more aggressive along the East/West divide from the Baltics to the Balkans.
9. China’s Outlook Has Soured. Capital is fleeing and domestic economic growth is flailing in this engine of global growth.
10. Emerging Markets Are In An Almost Untenable Position. A trio of problems — the end of commodities’ bull market, a lack of structural reforms and ongoing currency debasements that translate into huge debt-repayment woes — will weigh on these markets for years.
The Bottom Line
“Out of the darkness, into the light,
Leaving the scene of the crime.
Either I’m wrong or I’m perfectly right every time.
Sometimes I lie awake, night after night
Coming apart at the seams.
Eager to please, ready to fight
Why do I go to extremes?”
— Billy Joel, I Go To Extremes
I grew more bullish in January and February and bought stocks into the lows then, but now I’m selling into the market’s early March highs. By contrast, investors who base their views on price momentum were bearish weeks ago and are now confidently bullish.
However, I believe stocks’ current relief rally could be short-lived. The fundamental flaws that exist today are more numerous than in the past, and they represent sizable risks following the quick advance that we’ve seen from the S&P 500’s February lows.
Unfortunately, there are fewer policy levers to pull to prevent future economic turmoil and eruptions amid today’s generally fragile trajectory for global growth. As such, I continue to believe that the balance of 2016 holds the prospect of heightened volatility and lower stock prices