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Profit, Multiple & Margin Trouble Are In Store For Global Equities In 2016

The U.S. dollar has recently been negatively correlated both with the MSCI All-Country World Index (ACWI) and deep cyclical sectors. Given that the U.S. comprises over 50% of the MSCI ACWI, a firming in the U.S. dollar eats into U.S. corporate sector profitability via negative translation effects and the importing of global deflation. In fact, global EPS have been contracting for three consecutive quarters and according to our model will remain under pressure in 2016. Now P/E multiples are under pressure. Since the late 1970’s the forward P/E multiple for the S&P 500 has compressed at the onset of fresh Fed tightening cycles. Consequently, global equity markets are unlikely to make any significant headway in 2016, especially as margin pressures intensify. Instead, the risks are heavily titled to the downside, making a capital preservation portfolio mindset a necessity.

For additional information on Global Alpha Sector Strategy’s Quarterly Review & Outlook please visit the website at gss.bcaresearch.com.

chart 1

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  • Hopes fading for global profits, once seen as equity catalyst
  • Forecasts are still too high for 2016, market watchers say

Stocks are losing their last line of defense.

Amid a selloff that erased more than two years of gains -- about $14 trillion -- from global stocks now on the brink of a bear market, at least earnings stood as a potential bright spot. Those hopes are fading: analyst profit downgrades outnumbered upgrades by the most since 2009 last week, according to monthly data from a Citigroup Inc. index that tracks such changes.

Declines in oil and and other commodities, the withdrawal of Federal Reserve support, Europe’s fragile recovery and China slowdown fears are combining to jeopardize one of the few remaining stock catalysts after a global rally of as much as 156 percent since 2009. And profit growth estimates are still too high for this year and 2017, says Bankhaus Lampe’s Ralf Zimmermann.

“The momentum in the global economy is slowing down to such an extent that people are seriously talking about recession,” said Zimmermann, a strategist at Bankhaus Lampe in Dusseldorf. “This is not just China, it’s far more widespread. There are few places to hide. Even defensives will feel the pain.”

Investors are running for the door -- they pulled about $12 billion from global stock funds last week, and the MSCI All-Country World Index is near its lowest level since August 2013.

Economists’ projections for worldwide expansion in 2016 have dropped steadily in the past months to just 3.3 percent, with estimates for China and the U.S. falling since the summer. The biggest bears are getting more bearish -- DoubleLine Capital’s Jeffrey Gundlach sees global growth slowing to just 1.9 percent in 2016, making it the worst year since the aftermath of the financial crisis in 2009.

This earnings season may not provide much reassurance, say strategists at JPMorgan Chase & Co. Analysts project a 6.7 percent contraction in fourth-quarter profits for Standard & Poor’s 500 Index members. For peers in Europe, estimates call for growth of just 2.7 percent for all of 2015, about half the pace predicted four months ago.

There are some pockets of optimism: lower energy prices may encourage consumers to spend more, Europe’s recovery has been exceeding expectations and the Fed has given itself the flexibility to delay further rate hikes. The earnings bar is so low that the scope for positive surprises is great, says ETF Securities’ James Butterfill.

“Fundamentals in the U.S. and Europe still look pretty good,” said Butterfill, head of research and investment in London. “Markets seem to be overly focused on the poor state of global manufacturing, and losing their view of the consumer. Confidence is rising, people have more money in their pockets, and company earnings should reflect that. Now is a good opportunity to buy because everyone is so bearish.”

For others, the outlook is gloomy. Europe’s resilient recovery is threatened by companies heavily reliant on American and Asian demand.

“Even without a recession, profit forecasts for the full year are too optimistic,” said Stewart Richardson, chief investment officer at RMG Wealth Management in London. “It’s not just a China problem, U.S. growth is slowing on its own right. It looks like Europe is not slowing, but give it six or 12 months and maybe it will be.”

TIPPING POINTS, STUDIES, THESIS, THEMES & SII

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MOST CRITICAL TIPPING POINT ARTICLES THIS WEEK - Jan 10th, 2016 - Jan 16th, 2016      
TIPPING POINTS - This Week - Normally a Tuesday Focus
BOND BUBBLE     1
RISK REVERSAL - WOULD BE MARKED BY: Slowing Momentum, Weakening Earnings, Falling Estimates     2
RISK REVERSAL - WOULD BE MARKED BY: Slowing Momentum, Weakening Earnings, Falling Estimates 01-19-16   2

 

As volatility in the stock market grows, a handful of experts are raising an alarm about the rise of index ETFs and mutual funds, which has never accounted for this much of the market before.

They warn that the unprecedented amount of index ETFs trading in the market — index ETFs accounted for nearly 30 percent of the trading in the U.S. equities market last summer — could magnify, or even cause, flash crashes.

In turn, that may put individual investors, who are increasingly invested in index funds, more at risk. And many may not realize how exposed they are to the risks of a relatively small group of stocks held in the major indexes, said experts.

financial bubble NYSE
Siegfried Layda | Getty Images

Tim McCarthy, a former president of San Francisco-based Charles Schwab and Japan's Nikko Asset Management, has been a longtime proponent of index investing. But he now advises that investors diversify their investment styles as well as their asset classes.

He suggested investors move 25 percent to 50 percent of their equity portfolios into actively managed absolute return funds, preferably those with a 10-year track record and a relatively small amount of assets of between $1 billion to $2 billion. (Research has shown over the years that active managers stand their best chance of success before their assets under management grows too high.)

As always, he said, investors should look for low fees.

A stock bubble in index funds

He said he has grown increasingly uneasy about the risks based on the hypergrowth of index funds, and the price difference between stocks outside and inside index funds.

From 2007 through 2014, index domestic equity mutual funds and ETFs received $1 trillion in net new cash and reinvested dividends, according to the Washington, D.C.-based Investment Company Institute. In contrast, actively managed domestic equity mutual funds experienced a net outflow of $659 billion, including reinvested dividends, from 2007 to 2014.

Meanwhile, the price of the underlying equities in index funds is rising, though no one is sure exactly why. Research by S&P Capital IQ, as of Dec. 31, found stocks that were in the Russell 2000 were trading at a 50 percent premium to stocks that were not, up from 12 percent in 2006. The statistics are based on median price-to-book ratio.

That kind of price difference is seen by some as a kind of canary in the coal mine, indicating that there is a bubble in the stocks of companies held in index funds — and that their prices could come down further and faster than other stocks in a downturn. In turn, that could put pressure on the share prices of the index mutual funds and ETFs themselves.

"It's complicated, but it could be a very big problem," said David Pope, managing director of quantamental research at S&P Capital IQ. He and colleague Frank Zhao studied the liquidity in the market for the S&P 500 last summer and identified the 10 stocks that had the biggest difference in liquidity at that time, compared with the index. They included ExxonMobilBerkshire HathawayJohnson & Johnson,MicrosoftGeneral ElectricWells FargoProcter & GambleJPMorgan ChasePfizer and PepsiCo.


"A structural problem may arise when the liquidity demanded by the ETF exceeds the liquidity availability of some of the underlying holdings," they wrote.

Basically, if an investor wants to sell an index fund as the market declines, the managers of the fund might have trouble selling some of the stocks in the fund. An active manager could choose to sell any stock in her fund and thus potentially navigate a downturn better. But an index fund manager has to sell exactly the shares held in the index in the same proportion as demanded by the index. If the fund manager doesn't find a buyer for, say, shares of ExxonMobil, the price of ExxonMobil will fall until a buyer is found.

Assessing the risks

While market theorists have always recognized this as a potential problem for index investing, no one has been sure exactly how it would play out or when problems might arise. As long as there are enough buyers and sellers actively setting prices and trading, index funds and stocks should pose no extra risk. It's just that no one is sure exactly how many is enough.

Indeed, not everyone thinks McCarthy is right, and others point to different risks as bigger causes for concern, including the unknown impact of the way that high-frequency traders place orders.

"So we have two new factors when it comes to a potential market situation," said John Rekenthaler, vice president of research for Chicago-based Morningstar. "There are always new factors. Most of the time, new factors don't play out according to expectations."

He pointed out that two decades ago, people worried about what the impact of 401(k)s would be in the market and whether non-professional investors would be apt to sell more quickly in a downturn. The opposite turned out to be the case.

Even if the risk posed by index investing is rising, the growth in index funds doesn't necessarily pose a huge system risk, pointed out Sean Collins, senior director of industry and financial analysis for the Washington, D.C.-based Investment Company Institute. "The share of assets going into index funds is rising. Does that necessarily cause markets to be dysfunctional? The answer is no," he said.

He pointed out how much more diversity there is now in index investing. Much of the money flowing into index funds has been going into markets in which there hasn't been much indexing before, including emerging markets equities and bond markets.

McCarthy said investors would be wise to look at their portfolios with the emerging risk of index funds in mind. There's not much an individual investor can do to guard against the risks posed by high-frequency trading, short of bowing out of the market entirely.

What investors should do

But there are some steps investors could take to manage the risks posed by an index fund-dominated market.

In addition to investing some of their stock portfolios in actively managed funds, McCarthy suggests investors take a hard look at how diversified they are.

First, he said, an investor could make sure he or she isn't double-exposed to the same stocks. He cited the case of a friend of his, a doctor, who had invested in blue-chip stocks, some mutual funds and in an S&P 500 fund that turned out to hold — guess what — many of the same blue chips and tech stocks. In the downturn in 2000–2001, he lost 50 percent of his portfolio.

Every market is different, McCarthy said. But in part because of the flow of money into index funds, the U.S. equities market has become more dominated by a handful of big technology stocks. That's something that index fund investors, like his doctor friend, may not easily recognize now.

As someone who has managed the back end of trading systems, McCarthy said he is increasingly uneasy about the level of index investing and has begun to give speeches about the potential dangers of a market in which a growing number of managers are hamstrung by the requirement that they match their indexes.

But he knows that he's at the leading edge of people talking about it — and that many think he is warning too hard and too fast. "This is unfamiliar territory for me," he acknowledged. "But index investing has so much power, and it's derivative-priced.

"Sometimes it's better to be vaguely right than exactly wrong," he said.

— By Elizabeth MacBride, special to CNBC.com

 

GEO-POLITICAL EVENT     3
CHINA BUBBLE     4
JAPAN - DEBT DEFLATION     5

EU BANKING CRISIS

   

6

TO TOP
MACRO News Items of Importance - This Week

GLOBAL MACRO REPORTS & ANALYSIS

     

US ECONOMIC REPORTS & ANALYSIS

     
CENTRAL BANKING MONETARY POLICIES, ACTIONS & ACTIVITIES      
     
Market Analytics - WEDNESDAY STUDIES
STUDIES - MACRO pdf      

TECHNICALS & MARKET ANALYTICS

 

   
 
COMMODITY CORNER - AGRI-COMPLEX      
     
THESIS - Mondays Posts on Financial Repression & Posts on Thursday as Key Updates Occur

2016 - CRISIS OF TRUST

  • LOSS OF CONFIDENCE & TRUST - People No Longer Believe in the System
  • DEMONIZATION OF OPINION & EXPRESSION - Era of "Controlling the Narrative"
  • ERA OF UNCERTIANTY - A World of Increasing Uncertainty & Risk
  • CASUALTIES OF UNCERTAINTY - Individualism, Risk Taking, Capitalism & Economic Growth
2016 THESIS 2016
2015 - FIDUCIARY FAILURE 2015 THESIS 2015
2014 - GLOBALIZATION TRAP 2014

2013 - STATISM

2013-1H

2013-2H

2012 - FINANCIAL REPRESSION

2012

2013

2014

THESIS 2012 - FINANCIAL REPRESSION

2012

2013

2014

 

2016 Outlook – James Turk, Alasdair Macleod, John Butler;

Financial Repression Is Intensifying

Discussion on the year ahead .. negative interest rates potential for the U.S.$ – unintended consequences .. the risks of capital controls .. malinvestments from ZIRP & massive money printing .. the importance of investment in real assets as stores of value .. how financial repression is intensifying  .. 48 minutes

 

 

2011 - BEGGAR-THY-NEIGHBOR -- CURRENCY WARS

2011

2012

2013

2014

2010 - EXTEND & PRETEND

   
THEMES - Normally a Thursday "Themes" Post & a Friday "Flows" Post
I - POLITICAL
     

CENTRAL PLANNING - SHIFTING ECONOMIC POWER - STATISM

MACRO MAP - EVOLVING ERA OF CENTRAL PLANNING

 

G THEME  
- - CRISIS OF TRUST - Era of Uncertainty G THEME  

CORRUPTION & MALFEASANCE - MORAL DECAY - DESPERATION - RESENTMENT.

US THEME PAGE
- - SECURITY-SURVEILLANCE COMPLEX - STATISM G THEME  
- - CATALYSTS - FEAR (POLITICALLY) & GREED (FINANCIALLY) G THEME  
II-ECONOMIC
     
GLOBAL RISK      
- GLOBAL FINANCIAL IMBALANCE - FRAGILITY, COMPLEXITY & INSTABILITY G THEME  
- - SOCIAL UNREST - INEQUALITY & A BROKEN SOCIAL CONTRACT US THEME  
- - ECHO BOOM - PERIPHERAL PROBLEM M THEME  
- -GLOBAL GROWTH & JOBS CRISIS      
- - - PRODUCTIVITY PARADOX - NATURE OF WORK   THEME

MA w/ CHS

  01-08-16 THEME

MA w/ CHS

- - - STANDARD OF LIVING - EMPLOYMENT CRISIS, SUB-PRIME ECONOMY US THEME
MA w/ CHS
III-FINANCIAL
     

FLOWS -FRIDAY FLOWS

FLOWS - Liqudity, Credit & Debt

LIQUIDITY: Central Bank Liquidity Increases has slowed or Stopped

>> CREDIT: Cycle has turned

DEBT: Defaults/ Bankruptcies Will Emerge

 

MATA

RISK ON-OFF

THEME

w/ R Duncan

 
CRACKUP BOOM - ASSET BUBBLE 12-31-15 THEME  
SHADOW BANKING - LIQUIDITY / CREDIT ENGINE M THEME  
GENERAL INTEREST

 

   
STRATEGIC INVESTMENT INSIGHTS - Weekend Coverage
     

 

RETAIL - CRE

 

 

  SII

 

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YEN WEAKNESS

 

 

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OIL WEAKNESS

 

 

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