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2016 Stock Market Outlook

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2015 came to a close with a whimper and 2016 opened with a bang! The stock market is down 5.9% after eight days of trading in the New Year. China’s stock market took a nose dive before trading was halted on two separate days. World markets followed, worried about slowing global growth and the dramatic fall in oil prices. Panic selling is hard to watch!

Fear that China’s economy is slowing added to the drop in oil prices as they have been a huge importer of oil and other commodities. There have only been three other instances in history when crude oil prices declined 50% in six months; 1986, 1991 and 2008. Today’s decline resembles 1986. It is rare for oil prices to drop this much without a recession. Like 1986, our economy is relatively strong while worries persist that global growth is declining. In 1986 small, undercapitalized energy companies folded and assets were acquired by stronger, more established companies. This should happen now with the price of crude below $34 a barrel. Companies like Chevron and Exxon are strong and could become stronger. In the meantime, with their stock prices down and their dividend yields over 4% it pays to hold or add to positions.

Investor sentiment has swung from bullish on the market to extreme fear of loss. Analysts expect earnings in the fourth quarter to drop 6.7% compared to the third quarter. Larry Kudlow on CNBC said “profits are the mother’s milk of stocks”. Oil prices alone won’t drive stock prices through 2016 – earnings and profits will. The S&P 500 price/earnings ratio has dropped from 18X to the current 16.6X. Energy stocks are 9% of the S&P 500 and a major contributor to estimates for lower earnings. Many other companies and industries are doing well. The question is; have earnings expectations fallen so low that meeting them, let alone exceeding them, will provide a sense of relief? If this is the case, investors will scramble to cover short positions and buy out of favor, low expectation stocks.

2015 was an interesting year to say the least. It is hard to imagine that the S&P 500 was essentially flat after the dramatic drop in August and the 7% recovery in the fourth quarter.
Volatility was high as investors reacted to a dramatic drop in energy prices, waited for a Fed rate hike, worried about geopolitics and reacted to pundits predicting the end of the bull market. Investors swung from bullish to bearish and back again in a matter of weeks.

It is not uncommon for stocks to start the year down and then end the year higher and this year may not be an exception. Cash balances are high and the market was not at extreme levels before this early January decline. It could be costly to sell stocks into this decline and miss a rapid recovery in prices as we witnessed in 2015. Our economy is not in recession and corporate profits, while down in the energy sector, should be reasonably healthy otherwise. The US dollar has been strong which hurts corporate earnings. If this reverses in 2016 earnings could actually be stronger than expected.

Only a handful of stocks kept the S&P 500 from a negative return in 2015. While most stocks had a lackluster year a small number of growth stocks had stellar performance. Growth was the only strategy that produced positive returns, fueled by a few large technology and consumer discretionary stocks.

A narrow market is a sign that the rally is long in the tooth and winners in one year are often losers in the next! These 2015 winners were companies like Netflix, Amazon, Facebook, Google and Priceline. These large companies are now very expensive and could reverse course in 2016 if they do not meet lofty expectations or as investors appreciate the value in many of the sectors and stocks that are not as richly priced.

This year financial services stocks should benefit from higher interest rates, credit card companies will do well if consumer spending stays strong and energy stocks should recover with oil prices as production cuts kick in and supply drops to meet demand. It is possible that expensive growth stocks will disappoint investors who bought at the top.

2016 may be a low return year if earnings remain weak throughout the year but it is unlikely we will see the same magnitude of decline as 2008. Our economy is not in recession, stock prices are not inflated and investor expectations are low. Very little good news could send stocks higher. Panic is not an investment strategy!