2016: A Bad Year for Wall Street

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Welcome to the Prognostication Season — that time of year when everyone paid to comment on Wall Street is furiously shaking crystal balls, reading tea leaves and sacrificing goats and hamsters in an effort to divine where the market and the economy is headed in the new year.

I figured I might as well play along, even though it is a fool’s errand.

This coming year seems a little easier to predict than most, though most who are already predicting it are getting it wrong. They’re predicting U.S. stocks rise between 7% and 11%, depending on who’s doing the prognosticating.

If I’m right, we will see a second down year for stocks here in America — though one place (spoiler alert: Europe) will rise above the rest.

I said 2016 seems easier to predict than most because of what the Federal Reserve did earlier this month — it raised interest rates by 25 basis points for the first time in nearly a decade. In doing so, the Fed condemned American exporters to another year of declining profits.

That’s because raising interest rates here in America — and promising even more rate hikes — serves as a magnet for overseas money. If I’m a European or a Swiss or a Japanese investor earning nothing (or even experiencing negative bond yields in Germany, Austria, Switzerland, Denmark and elsewhere) I’m shoving as much cash as I can into U.S. dollars where I can earn a little something on my money. Heck, even though U.S. interest rates are now 0.5%, that’s still 1.25 percentage points higher than the -0.75% in Switzerland.

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Money flows to its highest use — and money will flow increasingly into America.

As that happens, the U.S. dollar strengthens ever more, which increasingly harms U.S. companies that sell their products overseas. And inside the S&P 500, that’s a lot of companies. Indeed, 46% of S&P 500 revenues come from overseas sales … which helps explain why corporate profits are under such pressure.

Profits in the third quarter fell 8.2% from a year earlier, the worst slide since the end of the global financial crisis. That, in turn, slowed the economy to a growth rate of 2%, well below the 3.9% growth in the second quarter.

We can expect more of the same in 2016 because of the actions the Fed’s move will have on the buck. Our greenback has rallied nearly 10% this year, and is up 25% since May of 2014. That’s what’s killing overseas sales — U.S. products aren’t competitively priced anymore. And if they are, it’s because of price markdowns that are, in turn, eating into those corporate profit margins.

Declining corporate profits here at home will lead to declining stock prices in New York. Making matters worse is the fact that U.S. stocks are already richly valued on a 10-year inflation-adjusted basis, so a reversion to the mean is in order anyway.

Weakening corporate profits will serve as a catalyst.

The Place to Be in 2016 Isn’t Wall Street 

Now, take all of that, reverse it and you have Europe.

Corporate profits in Germany, for instance, were up more than 4% year-over-year in the latest quarter. Profits are up as well in Belgium, Estonia, Poland, the U.K., Denmark, Spain and elsewhere on the Continent.

A euro (and other European currencies) that is weak relative to the dollar has made European exports all the more competitive globally — strength that will persist through 2016 because the Fed has (wittingly or unwittingly) made the dollar an even more attractive currency relative to the rest of the world, and in particular our key trading partners.

Just as weakening profits will erode U.S. stock prices, improving profits will, at the very least, buttress European stock prices and, more likely, push them higher. And unlike the U.S., stock markets in developed Europe are relatively cheap. On a 10-year, inflation-adjusted basis, they’re trading at a mid-teens P/E ratio — 40% cheaper than U.S stocks.

To me, then, predicting the future for 2016 is pretty obvious: Wall Street will likely head lower again, just as it did this year … and European stocks will head higher, just as they did this year.

Back in the February 2015 issue of the monthly Sovereign Investor newsletter, I predicted that the U.S., based on its historic overvaluation, would see average annual declines of as much as 3.1% in order to get back to a more normal valuation, while Europe would see average annual increases of 2% to 4% to get back to normal.

That’s almost exactly what we saw in 2016 — the U.S. fell (it’s down more than 2% as I write this) and Europe rose (it’s up more than 2%).

2016 will give much of the same, and that’s easy to predict because of the Federal Reserve’s Christmas present to the world and a lump of coal to Wall Street.

Until next time, stay Sovereign…
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Jeff D. Opdyke
Editor, Profit Seeker