First Quarter 2016 Comments

The first quarter of 2016 suffered the worst start to a year in U.S. stock market history, with the S&P 500 down over 10% by the second week of February and down almost 15% from its peak in May of 2015. However, that index recovered to finish in positive territory, returning 1.4% by quarter’s end.  Other US stock indices were mixed, with the Dow Jones Industrial Average and the Russell Mid Cap Index both up 2.2% and the Russell 2000 (US small cap stock index) down 1.5%. The MSCI index for foreign developed stocks lost 3.0% while its emerging market index gained 5.8%. The US Aggregate Bond Index delivered a strong quarterly return of 3%.


At the start of the first quarter, fear infused the market.  Yale’s Robert Shiller in his book “Animal Spirits” observes that market movements can be herd-like and produced by a mix of factors unknown.  What produced this record market drop in the first quarter?  Clearly, as earnings estimates were dropping, pessimism about earnings contributed… but earnings estimates had been dropping all along.

More likely, additional factors contributed, including on the one hand a growing consensus that the economy was weak, afflicted with overcapacity, excess inventory, a recession in manufacturing, and still meager wage growth, but on the other hand a fear that the Fed was on a path to raising interest rates.

While beneficial and perhaps even critical for the health of banks, in order to make money off of money, and for the ability of insurers to meet annuity and pension obligations, higher interest rates would be problematic for the rest of the economy.  First, they could slow the purchases of those things that are financed by debt, like houses and automobiles.  Second, and as worrisome, in a world in which half of foreign government bonds have dropped into negative interest rate territory, higher interest rates in the U.S. would attract foreign cash; boost the U.S. dollar further; make U.S. goods more expensive to foreign buyers; exacerbate America’s export challenges under conditions of an already slow global economy; make foreign goods less expensive by comparison; encourage their import and competition with domestic manufactures; create downward pressure on prices; and force U.S. companies into cost cutting modes in order to maintain margin, all of which could be both deflationary and recessionary.   In fear, the stock market adjusted to the threat.

But as might always be expected in a market economy, self-corrective mechanisms also intervened.  First, try as it might, it isn’t the Federal Reserve that sets most interest rates in the economy, but the market.  Consequently, anticipating a growing potential for deflation and recession, the market took control of interest rates…. and lowered them.  The 10-year Treasury rate fell of its own accord to levels not seen in a year, and well below the dividends paid on the S&P 500, establishing a floor for the stock market.  Who would want to own cash, paying nothing, or bonds paying 1.7% with little upside potential, when they could own a basket of U.S. blue chip stocks paying 2.3% in dividend and priced close to their long term average when compared with earnings?   If nothing else, corporations sitting on mountains of cash would increase their buy-back of shares and support prices, if retail investors would not.

Second, as a consensus developed that the Fed would not be able to act as soon or as vigorously as it had indicated, the U.S. dollar weakened, making U.S. goods more attractive.  Meanwhile, the labor market continued to strengthen, layoffs fell to their lowest levels in decades, oil prices stabilized and began to move upward, and soon the fears of the quarter diminished and stocks rebounded, dividend paying stocks especially so.   Emerging markets and foreign stocks too enjoyed a rebound.

Unfortunately, active bond managers generally failed to keep up with the whipsaw of market interest rates.  Positioned to protect against declines in bond prices (which move inversely to interest rates), many bond managers lagged in performance or even lost a little bit when bond prices rose instead.


In spite of the stock market’s recovery, there are reasons to worry.  Though from a long term perspective the stock market still looks more attractive than bonds, after its rebound it is not nearly as attractive as it was at its lows in the first quarter.

Fundamentally, the economy may now present the stock market with a challenge.  After an era during which profits were at record highs in part because wages (an important part of the cost structure) were at record lows as a percentage of GDP, cash generally has accumulated more in the pockets of capital owners, whether kept in companies or paid out as dividend, and less in the pockets of the work force, who have seen median incomes decline in inflation-adjusted terms.

Worrisomely, capital owners are ever fewer.  Households have liquidated stocks out of fear or necessity as a result of the market’s turbulence and recessions since 2000.  According to Gallup, the percentage of Americans invested in the stock market directly or indirectly has fallen from 67% in 2002 to 52% in 2016.  It may also be the case that as a result of the reduction in the estate tax, capital owners are no longer as incentivized as they once were to share the rewards of capital ownership, whether through employee stock ownership plans or transfer of capital to charitable endowments (such as the Rockefeller or Ford Foundations, or the Lilly Endowment).  Today, 10% of the population owns over 80% of U.S. stocks, and 1% owns nearly 40%.  Meanwhile, the Wilshire 5000, once the benchmark of the total U.S. stock market, encompassing almost all its publicly-traded stocks, is now down to 3500 companies, and merger and acquisition activity seems likely further to reduce that number.

Objectively, the economy’s profits are becoming more concentrated in fewer companies in fewer hands.  The consequence of this concentration is that corporate profits are not recirculating as they did before back into the broader population to fuel increasing consumer buying power, but instead are accumulating in households whose needs for goods and services have long since been met.   Profits, then, are overwhelmingly saved rather than spent, and so the Wall Street Journal has reported a global savings glut.  The so-called velocity of money, a measure of the turnover of a dollar as it changes from hand to hand through the economy in the purchase of goods and services, has dropped by a third since its high in 1997, and is in a 5-year trend of ever lower record lows.

Meanwhile, the cost of education once born by the tax payer or by the charitable donor has shifted onto the student, who upon graduation is struggling to make debt payments, has no extra money to spend, and can’t get loans for other purposes.   On the other end of life, as a result of recession early in the last decade, financial losses in the wake of the housing bubble, job losses in the financial crisis, and a spend down of savings to preserve lifestyles, typical working households approaching retirement have very little to spend, for they must work longer and save that which they can manage to earn.

The picture we have drawn of compounding, concentrating profits going unspent at the top level of the economy on the one hand and a struggling population suppressing demand on the other is problematic.  For example, Walmart is projecting flat sales and is closing stores, their competitors now out of business, the profits in the local economy having been swept away, rather than returned in the form of higher wages, no more to be earned, and none to recirculate to fuel other opportunity.  In Indianapolis, Simon Property Group reports that in spite of bankruptcies of tenants, it’s doing fine, but a flat-lining economy is responsible for a 10% decline in 1st quarter profits compared to the previous year.   The fear is that with profits under pressure, cost cutting must resume, placing pressure in turn on demand, producing a downward deflationary spiral which, as we’ve seen in Japan, could be difficult to arrest.

Under the circumstances, with the Fed unable to do much more, with consumer demand under pressure, with little need for business investment in an environment of global over-capacity, and with relatively strong housing already in play, but potentially insufficient to sustain economic growth, that leaves government as the remaining sector able to contribute measurably through fiscal means.   To that end, a chorus of important voices is rising in harmony.   Paul McCulley, formerly of PIMCO and now of Cornell, his former colleague Mohamed El Erian now of Allianz, 5-star rated Bond Manager Scott Minerd of Guggenheim, famed investor Carl Icahn, Blackrock’s Larry Fink, and J.P. Morgan’s Jamie Dimon all are calling for fiscal action, by which is meant an increase in government spending financed either with debt at today’s low interest rates, taxes, or a combination of the two. It is noteworthy that even Donald Trump, who is emerging to claim the Republican nomination, is calling for increased spending on the military and on infrastructure and has declined to sign a pledge not to raise taxes.


Elections do have consequences.  Though Congress harbors resistance, all three remaining main party candidates for the Presidency, Republican Trump and Democrats Clinton and Sanders, are now embracing both increasing wages and government spending.  The success and mix of their proposals would determine the course of the economy and of corporate profits, as would their failure.

While cash offers only future buying opportunity and no return in the meantime, the U.S. stock market now seems fully valued, with upside in prospect should the election produce greater odds of fiscal stimulus, but poised for eventual disappointment should gridlock continue.  The bond market, on the other hand, offers gains under conditions of gridlock, but potential losses under conditions of economic growth.  Because of the considerable uncertainties of this election year, diversification offers both the best potential and protection.


The thoughts expressed on this web page provide insight into the investment and/or financial planning considerations of members of C.H. Douglas & Gray, LLC, a firm providing fee-only financial advice in asset management to households and institutions in states in which it is registered. Specific investment advice is available only to clients of the firm. Contact C.H. Douglas & Gray for more information.