Liz Ann Sonders: Dazed and Confused

Following is my contribution to Schwab’s 2016 Midyear Outlook.

Stocks Grapple With Brexit

Market expectations are that The Federal Reserve is unlikely to raise rates this year in light of weak growth and the deteriorating financial conditions associated with Britain’s vote to leave the European Union, known as Brexit.  We expect the U.S. economy and stock market to continue producing mixed results. One silver lining is that sluggish growth has kept interest rates low and inflation at bay.

Stock market valuations are slightly elevated, while earnings growth remains weak.  The aftermath of Brexit, along with the highly contentious presidential election, are likely to bring continued bouts of volatility and uncertainty.  But to us this uncertainty and pessimism of investors represents the most compelling support for stock prices longer term in terms of sentiment.

Volatility—recently and prospectively—has been partly a function of Fed policy uncertainty as it relates to the “loop” in which financial conditions have been over the past year or so (as shown in the graphic below).

Driven largely by the direction of the U.S. dollar, financial conditions have been waffling between easy and tight. This in turn has kept the Fed moving between a “hawkish” and “dovish” stance.  The Brexit-related hit to financial conditions supports a more dovish Fed and suggests a continuation of the frustrating range-bound and volatile stock market behavior.

The U.S. economy continues to move like a SLUG—with Slow, Lumbering, Unstable Growth.  Every time it seems to take two steps forward, it falters. This phenomenon is not new.  There has been a meaningful slowdown in growth every year since the economic expansion began in June 2009, including this year.

In a narrow range

In a couple of those years, recession risk appeared elevated.  Yet the U.S. stock market has had an incredible run, with a total return of about 250% in the S&P 500 Index from the March 2009 low through the close on the ugly market day after the Brexit decision. That said, during the past two years, U.S. stocks have traded in a remarkably narrow range.  In the near term, we expect more of the same, with volatility.

A sluggish pace of economic growth, accompanied by low interest rates and low inflation, is not an unfavorable backdrop for equities longer-term. This is why we don’t believe a major bear market is likely…remember, the tortoise beats the hare in Aesop’s fable.

However, slightly elevated valuations, the earnings contraction, and uncertainty/volatility associated with Federal Reserve policy—and more recently Brexit and the presidential election—represent the rationale for our continued “neutral” rating on U.S. stocks. By “neutral” we mean that investors should remain at their strategic equity allocations while taking advantage of bouts of volatility to consider tactical rebalancing of their portfolios.

Fed likely on hold this year

The Fed appeared itchy to raise rates until recently, following its initial move off the zero bound last December.  However, the cortisone of an weak May jobs number and Brexit in our view is likely sufficient to scratch that itch for the remainder of this year.

Clearly, given that the Fed has only raised rates once so far—and further hikes could be off the table this year—this cycle appears to be setting up to be an extremely slow one (or perhaps even a “one-and-done” cycle in the near-term).  As we highlighted in the beginning-of-year outlook, slower rate hike cycles were historically rewarded by stronger stock market returns relative to faster cycles.

There are risks associated with Fed policy: that the Fed gets behind the curve if economic growth and/or wage growth and inflation heat up, or it misreads a much slower economy and continues to signal rate hikes ahead.  Ideally, we have a “Goldilocks” scenario with economic growth not too hot and not too cold, but that could be elusive longer term.

Awaiting earnings growth

Another stumbling block for U.S. equities is at least slightly elevated valuations (depending on the metric) alongside still-negative corporate earnings growth.  Low interest rates and inflation continue to be supportive of higher-than-median valuation levels, but investor patience will likely wear thin if earnings growth doesn’t move into positive territory, which will be less likely if the dollar’s recent strength persists.

One other factor is the presidential election. Election years historically have generated solid average gains for U.S. stocks, but this is not a typical election year.  Voters are choosing between two of the least-popular candidates in history and it is also an “open election.”  President Obama is only the fifth president to make it to his eighth year since term limits went into effect in 1953.  As such, there are no incumbent candidates in the race.

Interestingly, year eight has been the worst of the election cycle, with a median decline for the S&P 500 of 6.6% since 1953 (the worst year of the eight).  “Presidents’ lack of incentive to stimulate the economy for re-election has dampened returns…stimulus has been much less in the back half of second terms,” notes Ned Davis Research, which compiles data on election cycles.

Hope on the horizon

All is not lost.  The dearth of investor confidence is one of the more positive indicators for the market looking into the second half of the year.  As shown in the chart below, the American Association of Individual Investors (AAII) survey recently showed the lowest level of bullish sentiment in more than 10 years, and the highest level of neutral sentiment in more than 13 years.

Following occurrences like this in the past, the stock market generally had exceptionally strong returns a year later, with a consistent track record.  The combination of very few bulls and very high neutrals is even rarer.  In the post-1987 history of the AAII data, there were only five similar occurrences historically—all of which were within the 18 months following the crash of 1987. Here, too, the market was up more than 20% within the following year.

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