3 Reasons to Worry

12/21/2015


While there's no shortage of reasons for U.S. equity investors to worry heading into 2016, we'd put three at the top of the list:

1) The Federal Reserve, interest rates, and inflation. With its Dec. 16 decision to raise the interest rate on overnight borrowings by a quarter percentage point, to a range of 0.25% to 0.50%, the Fed did what most investors expected. And its commentary regarding future increases, that it "expects economic conditions will evolve in a manner that will warrant only gradual increases in the fed funds rate," was in line with what the Fed has been saying for months.

The Fed, like most investors, is counting on inflation remaining tame, which would allow it to raise rates gradually. If inflation begins to surprise on the upside, yields on longer-term bonds will rise and the Fed could be forced to raise short-term rates more quickly than it anticipates.

Economists have been warning for years that inflation is set to accelerate — and have been consistently wrong. But those warnings did not come with the U.S. unemployment rate down to 5% and wage growth picking up. Once the effects of lower oil prices and a stronger dollar begin to fade, headline inflation is likely to rise.

What to watch: The Fed's preferred inflation measure increased 1.3% excluding food and energy in the year ended October. With yields on 10-year Treasury bonds below 2.3%, even a move to the Fed's 2% inflation target is likely to unnerve some in the bond market. Any sustained move above 2% could trigger an inflation scare, which could push 10-year Treasury yields above the 14-month high near 2.5% reached in June.

2) Oil and commodities deflation. The U.S. is still a net importer of oil — and a net beneficiary of the crash in oil prices. Still, the boom in the oil patch was one of the few significant growth opportunities for U.S. industrial suppliers, and defaults related to that bust are causing problems in the bond market.

The oil bust is also slowing growth and raising credit-quality concerns for Russia and several nations in Latin America and the Middle East, as is the price collapse in such commodities as iron, copper, and soybeans.

What to watch: The fact that the Dow Transports have slumped amid a sharp drop in fuel prices is discouraging, as it suggests investors think reduced demand will offset any cost savings. We'd like to see the Dow Transports avoid a close below the August closing low of 7,466.97, and we'd like to see oil and other commodity prices start moving sideways.

3) Profit growth and valuations. A company's expected rate of profit growth is crucial in evaluating whether its stock represents a good value. That idea is central to our growth-at-a-good-price approach, but finding attractively valued growers has become more difficult.

Among members of the S&P 500 Index, the median sales change in the most recent quarter was 2.5% — well below the 20-year norm of 6%. The median change in per-share earnings was 4.2%, versus a 20-year norm of 9.4%. While lower oil prices and a stronger dollar explain much of the slowdown, companies also face a sluggish global environment.

At 19 times trailing earnings, the median S&P 500 stock trades at a slight premium to the 20-year norm. If inflation and interest rates stabilize not far from present levels, historical comparisons will still point to stocks as a much better value than bonds — provided earnings growth rebounds.

What to watch: Investors are having a hard time figuring out how much of the slowdown in profit growth is temporary. December-quarter reports — and the year-ahead guidance that comes with them — will be especially telling this year. Keep an eye on how the broad market reacts to the first couple weeks of earnings season, which begins in the middle of January.

What to do now, in four parts

Hold 84% to 85.2% of your equity portfolio in stocks, with the rest in a short-term bond fund.

Watch the averages, as a move in both the Industrials and Transports below this year's lows would be bearish.

Keep looking for opportunities one stock at a time, emphasizing attractively valued growers.

Have a happy 2016.


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