The relative outperformance of U.S. stocks on Friday was interesting. You know the ol’ saying, the cleanest shirt on a dirty block (or something). This week you’ll see a parade of strategists, fund managers and pundits try to sell you on the U.S. (whether it be the U.S. Dollar, or stocks, or really any risk asset priced in dollars except oil and commodities) as a safe haven trade in a volatile investment world. You’ll be told about the ability for U.S. stocks to de-couple from the mess that’s enveloping global stocks. I suppose that’s possible. But it’s highly unlikely. The much more probable event is that U.S. risk assets follow those of Europe, maybe not to the same extent, but they’re not probably not going an entirely different direction.
When I peruse the damage done in U.S. stocks that I follow, and compare to the 3.6% decline for the S&P 500 (SPX) and the 4% decline for the Nasdaq Composite (CCMP) it tells me that Friday’s decline was orderly. But what comes next (even after a bounce) may not be as tidy.
The weakness in U.S. banks, cyclical stocks like industrials and tech, coupled with the bounce of the U.S. dollar (DXY trading at 3 month high as I write) suggest that we may be entering a period of C-suite caution (in the U.S.) as it relates to spending/hiring, and an increasingly dovish FOMC.
But as an investor, all you need to focus on right now are any signs of contagion spreading from Europe. Before Friday’s bloodbath, the general fears out of Europe were that we’d see more of the same, low growth, dysfunctional union but with a central bank willing to do whatever it takes to try to keep the ship afloat. Contagion risk from Europe was generally surrounding the fear of exporting deflationary pressures and negative interest rates. These were the signs you were looking for. But after Brexit, now the fear of contagion is all of the above but also whether Brexit will be the final deathblow to financial institutions that have yet to de-lever in the way U.S. banks did after our subprime crisis. If this uncertainty drags on, some of largest banks in the region could soon be state owned. Look at this and tell me it doesn’t have a sort of September 2008 feel to it:
I am not rooting for any of this, believe me. I worked on Merrill Lynch’s equity derivatives desk in 2007 to 2009, I was seated on a deck-chair for what should have been the third ocean liner to go down. We were on the precipice of a global financial collapse. Not just financial markets, but everything. It doesn’t feel like we are anywhere close to that at the moment now of course. And if the Germans, or the Swiss were to take some out-sized equity stakes in banks that bear their country’s name, then that could shore up their capital positions and avert a crisis, for now.
The likelihood of financial contagion spreading to the U.S. is not that high if some European banks have their equity wiped out. It won’t be pretty, but not really contagion. But emerging market banks are another story altogether. And that feedback loop would bring a second wave of volatility to the U.S.. In other words, de-coupling is nonsense.
So what comes next? If we continue to see the downward volatility in almost every major currency vs the dollar, then you will see central bank intervention. Probably coordinated. It’s hard to see the US dollar doing much else than remain bid in that scenario. And that would have commodities like crude oil giving back some of its recent gains. Shorter answer, global stocks might be in a similar sort of mess we were in back in January & February when global growth concerns gripped the world.
Maybe there is some tape-bomb that causes a short squeeze back to 2100 in the SPX. But as some focus turns to U.S. corporate earnings, U.S. multi-nationals aren’t going to get the same mulligan they got during Q2 results. Q3 guidance is going to be atrocious with all that’s happening, and the lofty $120 S&P 500 earnings estimate for 2016 will be nothing short of wishful thinking.
So when I get asked the question whether U.S. stocks are the place to be, my answer is only on a relative basis. Large cap stocks in the SPX (which is only down 5% from the 2015 all time highs) are masking a lot of bad performance in the broader market. The Russell 2000 is down 13% from its all time highs made last year, and the Nasdaq Comp is down about 10%. Aside from Brazil, that’s about as good as it gets globally. The Nikkei is already down about 27% from its 52 week highs, the EuroStoxx 50 (SX5E) down about 27% and the Shanghai Composite is down about 33%.
To state the obvious, the SPX has shown good relative strength in 2016, and until very recently you could thank the weak dollar. But a continuation of the recent surge in the DXY off of a 52 week low could change all of that quickly. Stocks don’t have to move the way currencies do, one up, one down, they can all go in the same direction. And they generally do in times of economic stress. Correlations approach 1.
I have been fairly steadfast on my view of the SPX for more than a year. And when the market has gotten close to proving me wrong I hear it from the peanut gallery. But I don’t see it as a direct call of exactly how all this is going to play out. What I do know is that the path of least resistance for the SPX is no longer higher. The two lower lows in the SPX since the May 15th high is significant, but more so was the February low, the first lower low in the SPX since the start of the bull market in March 2009 that has yielded 200% plus gains. There is a clear technical change in place from the years of QE induced gains for the SPX:
So who knows what will ultimately mark the top. Maybe it was Brexit, or maybe it will be signs of a recession in the U.S., or eventually China will once again dominate the headlines. But what all of these have in common for the SPX is something I’ve hit on numerous occasions since last Summer. It was well summarized by the WSJ’s John Hilsenrath on August 17th, 2015:
The Fed got trapped and Brexit threw away the key. With rates where they are the Fed’s only option is to go from unconventional monetary policy to outright clever. And how’s being clever working out for Europe and Japan??