2015 has not started well for investors.
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The first day of trading was mostly flat, but the S&P 500 (SPY) saw a 1.6% drop the next day, and then almost another 1% loss the day after that. On Wednesday things began to recover and, at the time of writing, the market remained green on Thursday.
To consider how this year is going to play out, we need to consider three major themes which are dominating the minds of traders, and have caused much of the early-year volatility we have seen. Each of these themes is dominating market movements, and a better understanding of their significance can help investors decide on portfolio allocations for the coming year.
1. QE and Capital Flows
Quantitative easing expanded the money supply and, at least in theory, encouraged banks to lend and invest int he economy. The idea of the practice was to get more liquidity in the system, and that would in turn stimulate spending, investment, and growth. In 2013, QE caused a massive run-up for stocks; SPY soared 30% in a year, and just about anyone could make money in the market. The rush of cash to assets meant many high-risk growth stocks (TSLA, NFLX, P, KNDI, PLUG) saw massive growth, only to splutter and in some cases fail in 2014.
In the U.S., QE ended in October and with it the market’s momentum. SPY is up 2.7% since the beginning of October, which is decent but not spectacular. At the same time, the period saw volatility, as measured by the VIX, spike three times—a trend that was unthinkable in 2013. Now investors want to know if this frequent volatility will continue, and if small gains and quick reversals will become more frequent. That will impact not only portfolio allocations but trading frequency, so it’s an important theme for active money managers.
2. Valuations
With capital flows, valuations became less important; the money was coming in, and it was impacting companies operating at a loss (P, PLUG) as much as companies with lofty valuations (FB, LNKD, TSLA). The P/E ratio was all but ignored in 2013, because it just stopped mattering when a trillion new dollars were coming into the market. With QE over, valuations are extremely important.
And on that note, there is significant reason for caution. The S&P 500 TTM P/E ratio has hovered around 20, briefly falling above and below that number. Anything above 16 is historically high, but anything above 20 is considered pricey by almost all fundamentalists’ standards.
This doesn’t mean stocks are too expensive. There is the chance that companies will raise profitability and boost EPS in the future, causing the P/E ratio to fall even if prices remain constant or increase. A broad 5% reduction in EPS would yield a 5% boost to a stock portfolio with a constant P/E, excluding dividends, which is far beyond what bond markets are offering. The real question here is whether companies can raise their EPS, and how, and by how much. And that brings us to the next major theme:
3. U.S. GDP Growth
Is the U.S. economy still seeing healthy growth? Is there room for growth to continue, after the last estimate saw an annualized 5% growth rate? According to some analysts, there’s a chance that U.S. growth will overtake China growth in the next two years; such a concept was unthinkable just two years ago. But now it’s taken seriously.
GDP growth would inevitably be good for U.S. stocks, but is it realistic? Is that growth already priced in? If so, what benefit will there be in holding U.S. stocks now? Is there perhaps an upside to GDP growth—and if so, where would it come from? Many argue that the upside will come from cheap oil, but that assumes cheap oil will remain. It also assumes that the U.S. will be a net beneficiary of cheap oil, when its energy production has increased massively over the last decade (this is largely why we’re getting cheap oil in the first place). A smart analyst will work out the macroeconomic implications of cheap oil on GDP growth, and that’s what many are busy trying to do right now.
4. Global Risks
If we take the most optimistic perspective and assert that cheap oil is broadly good for U.S. stocks and there’s good reason to bet on the U.S. economy, there is still the global risk to consider. Venezuela is in economic collapse, prompting Cuba to shift to America. Russia’s recession is a given, and the implications for this on eastern Europe are unclear and unnerving. The European Union’s political malaise, internal infighting, and failure to stimulate growth are very big concerns for many reasons. China is slowing and a credit bubble is still a risk there, as has been the case for years.
There’s a lot of reason to worry about the global system, which some optimists say is all the more reason to buy U.S. stocks. But how much of total U.S. company revenues come from abroad, directly or indirectly? What portion of growth do U.S. companies get from abroad? Which companies are more reliant on global demand?
There are many questions that need to be answered before the global picture gives a clear buy or sell signal.