Market View Update - June 2016

Originally posted at Briefing.com.

It has been a long, winding road mainly to nowhere this year. At its low in February, the S&P 500 was down 11.4% for the year. At its high earlier this month, the S&P 500 was up 3.8% for the year and less than 1.0% shy of a new all-time high.

That swing between the low and the high was extreme, yet, as we write today, the S&P 500 is just 1.0% higher from where it started the year.

The return on the price index thus far has been consistent with our expectation at the end of last year that investors would likely face low returns in 2016 since fundamental factors would be less accommodating and because of the uncertainty surrounding monetary policy would be rising.

So, with the first half of the year drawing to a close, the pressing question is: what will the second half bring?

Our answer is that we're inclined to think it will bring more of the same if the economy and earnings estimates don't ramp up, the Federal Reserve doesn't shape up, the dollar stays up for the wrong reasons, and the US presidential race remains so messed up.

Forgive us for getting all uppity on you, but a lot needs to happen still if this stock market has any fundamentally-based shot to trade up, up and away.

Can't Spell Yuck Without UK

At this point, the biggest constraint for the stock market is the so-called Brexit vote. It is going to be held on June 23, and it will determine if the UK is going to remain in the European Union or leave the European Union.

There's a lot at stake with that vote because the vote isn't just about the UK. It's really about the standing of the European Union.

Read Should Britain Leave the EU? Two Analysts Debate

A vote to leave could very well set off a chain reaction of similar referendums in other European Union countries. The potential contagion effect is what has the market handcuffed right now and investors working to cut risk.

That work has been pronounced in sovereign bond markets, where yields have plummeted in recent weeks.

There are plenty of nuances related to the Brexit vote, but for our purposes here, we see the angst surrounding that election as a recognition of a more deeper-seated issue.

Specifically, we see it as a recognition that the risk-reward tradeoff, irrespective of the Brexit vote, is not that favorable.

Then What?

Would there be a sizeable relief rally in the short term if the UK voted to remain in the European Union? Yes, there would be.

After that, though, what remains?

The S&P 500, which is richly valued at 17.9x trailing-twelve-month earnings in front of the Brexit vote, would still be richly valued (and probably even more so) after a remain vote.

Global economic activity, which has been constrained by the matter, will still be relatively weak.

Read also Global Liquidity Conditions Still Negative

Central bankers, who had acted confused about the outlook even when the Brexit vote wasn't front and center, will still be confused about what policy action they should, or should not, take.

And the presidential contenders will still be emphasizing what is wrong in the world as opposed to what is right (and probably pushing populist protectionist policies as a means for righting the wrongs... which is wrong).

Fed Feeds Uncertainty

A week ago, we spent time in this space pointing out a number of items going right for the market. It isn't all bad out there right now.

Heck, we're still talking about a stock market that is up year-to-date after being down as much as 11% less than two months into the year.

A huge rebound in oil prices was a major driver of the rally off the February lows, as was incoming economic data for the US that stamped out budding recession concerns, and a weakening dollar that helped bolster expectations for the economy and earnings prospects in the second half of the year.

Currently, the Atlanta Fed's GDPNow model forecasts real GDP growth for the second quarter at a seasonally adjusted annual rate of 2.8%, which is a marked improvement from the 0.8% growth rate seen in the first quarter.

The Federal Reserve, however, recently elected not to raise the target range for the federal funds rate, lowered its real GDP growth expectations for 2016 and 2017, and slashed its median projection for the federal funds rate for 2017 (from 1.9% to 1.6%), 2018 (from 3.0% to 2.4%), and the longer run (from 3.3% to 3.0%).

Check out Here's Why Neil Dutta Feels Good About the US Economy

That wasn't exactly the strongest vote of confidence in the economic outlook, but aside from that, the tempered views were like jabbing a stick in its eye. Only weeks before, many Fed officials, including Fed Chair Yellen, were prepping the market for a likely rate hike at either the June or the July FOMC meeting.

The aforementioned Brexit vote was cited as a factor forestalling a rate hike in June, yet the policy directive called attention to a slowing pace of improvement in the labor market and a decline in market-based measures of inflation compensation.

It was a remarkable summation of economic matters that didn't gel at all with the lip service the Fed officials had been paying to a possible rate hike in the near-term. To be sure, it was a blow to the Fed's credibility, so much so that Fed Chair Yellen practically got laughed at by the Fed funds futures market with her reminder that the July meeting is still a "live" meeting that could produce a rate hike.

We say as much knowing that the fed funds futures market currently assigns only a 10% probability of a rate hike in July and just a 50% probability of a rate hike in February 2017.

In brief, the Federal Reserve has been a true security blanket for the stock market for many years, yet its wishy-washy communication is quickly turning it into a wet blanket hanging over the market.

From our vantage point, the only thing seemingly being transmitted effectively right now with the Fed's monetary policy is uncertainty—and that uncertainty is leaving a lot of consumers, businesses, banks, and investors guessing, much to the detriment of the global economy.

Left-Right, Left-Right

A positive development that has not gone unnoticed is that earnings estimate revisions have stopped deteriorating. The inflection point came several weeks ago, as seen in the table below, yet there still hasn't been a ramp up in earnings estimates, which still only call for a sliver of EPS growth (+0.3%) for the calendar year 2016.

PeriodMay 23May 31June 9June 14
Q2 2016-4.9%-5.0%-4.6%-4.7%
Q3 20162.7%2.6%2.8%2.7%
Q4 20168.4%8.3%8.5%8.5%
CY20160.12%0.11%0.33%0.32%

Source: S&P Capital IQ

If oil prices keep fading, as they have been lately, and the dollar keeps strengthening, as it has been lately, and hiring activity keeps slowing, as it has recently, then it will come as little surprise to see the estimate trend reverse again.

Rising earnings estimates would help temper some of the current valuation concerns, and they would provide a useful gauge for investor sentiment.

There is hope in those prospects, yet the reality today is that the S&P 500 is trading at 17.4x forward twelve-month estimates, which is not only a premium to where it started the year but also a premium to the 15-year average of 16.0x, according to S&P Capital IQ.

On a trailing twelve month basis, the S&P 500 is trading at 17.9x earnings.

Ultra-low market rates are helping to hold the valuation line so to speak. Interest rate differentials and demographics are playing a part in pushing down market prices, but what is also wrapped up in those low market rates and a flattening yield curve are various concerns about the economic outlook that call into question the practicality of there being a strong earnings rebound.

The persistence of these small market rates has encouraged—if not forced—a search for yield in the stock market that has created concentration risk in high-yielding dividend stocks and has stretched the valuation for the high-yielding utility sector, which is trading at a 27% premium to its 15-year average forward P/E multiple.

No one ever enjoyed the idea of a forced march, yet that is what accommodative monetary policy is leading savers and income-oriented investors to do on the cadence that there is no alternative.

What It All Means

This stock market has shown a propensity to trade through fundamentals or to ignore them. It has capitalized at times on tactical trading behavior that has prompted a squeeze of short sellers and sidelined participants fearful of missing out on a meaningful up leg.

That fear factor has cemented since 2009 level with the stock market time and again escaping worst-case scenarios and being bought back on every dip thanks to the Fed's monetary policy actions.

The sudden and profitable turn of events in February this year provided the latest reminder of how tactical trading activity can make fundamental arguments look toothless.

We may soon run up against a similar scenario if the UK votes to remain in the European Union.

Things, then, will presumably look good again for the stock market and some tactical activity could generate some outsized, short-term gains. However, we think the risk-reward tradeoff for investment-minded individuals still involves more risk than reward this year.

That doesn't mean this stock market isn't capable of producing positive returns in 2016. What it means is that the upside potential of those gains isn't as great as the potential downside risk.

That's because the stock market already sports a rich valuation, the risk of monetary policy error is ripe these days, strong earnings growth is lacking, complacency in the thought that only good things will happen is still relatively high, and we're moving headlong into what is shaping up to be the nastiest and most undignified presidential race ever.

The stock market could go up, yet the fundamental basis for it to go up, up, and away continues to be lacking.

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Chief Market Analyst
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