February 29, 2016

2016 to be a difficult trading year

Like many kids of the late 1960's, The Grateful Dead was one of my lights to discovery when I searched for the meaning of life. St. Stephen was one of those songs that I played over and over again back then. Robert Hunter and Jerry Garcia wrote the song, which appeared in 1969 on the Dead's third album, Aoxomoxoa.

The Grateful Dead song is partly about St. Stephen and partly about "soul searching" in general (excuse the pun). The song asked many questions ("Did it matter. Does it now?"), but not even a great martyr like St. Stephen could answer them.

Later on when I began to formulate my career choices, I moved from The Grateful Dead to The Wharton School. During that early 1970's transition, I learned finance and began to formulate my investment methodology -- no longer by interpreting Grateful Dead songs, but by questioning whether the market was efficient or simply a "random walk."

I concluded that fundamental analysis suited me well, and I rejoined the working world (and society, my parents would say). After graduating from Wharton two years later, I became a Kidder, Peabody housing analyst.

Markets acted differently in the 1970's. The guiding beam was fundamentals, which seemed to determine stock prices' future trend. Things were more predictable for decades, from 1972 to 2012. But let's fast-forward to 2016, where we have a market that's without memory from day to day.

A Distorted Market

Quants have filled the vacuum created by quiescent retail- and institutional-investor communities, while levered ETFs (another Wall Street "invention") have grown like, well, mushrooms. Both have taken a much more dominant role in our markets.

Unfortunately, the U.S. Securities and Exchange Commission has become effete. Regulators twiddle their thumbs as the New York Stock Exchange and Nasdaq sell customer orders to high-frequency traders, and ETFs exaggerate price moves. The markets grow ever more volatile and break down further.

A Distorted Monetary Policy

Monetary policy has become America's dominant tool for engineering economic growth. U.S. politicians grow increasingly partisan and unable to compromise on legislation, leaving fiscal policy inert. The Federal Reserve keeps short-term rates near zero, while other central banks travel into negative territory.

But as I wrote in my diary yesterday:

*     Negative interest rates and wealth-tax talk aren't pro-growth to me. Instead, they're deflationary -- and if anything, talking about them only adds to the doom and gloom that's already floating around us.

*     We need true tax reform that simplifies the system and encourages growth while paying down public debt.
Of course, no one likes being told these difficult truths. We're like St. Stephen of the Grateful Dead's song: "Wherever he goes, the people all complain."

Just as St. Stephen got killed for speaking out, many investors and traders have gotten beaten up by the volatility that's associated with distorted markets and monetary policy.

Confidence Ebbs and a Crisis Begins to Develop

Today's market is fragile at best. It's influenced by strong deflationary forces that have conspired to reduce prospects for global economic growth and worsened the corporate-profit outlook.

And at worst, the market has been completely broken by the dominance of quants -- who worship at the altar of price and are agnostic to balance sheets, income statements and private-market values.

Either way, fiscal inertia, a dependence on monetary policy and the quants' dominance and influence have materially expanded the market's volatility and unpredictability. This eats away at confidence in a cumulative way that I can't overstate.

Navigating the market with a modicum of confidence (an essential ingredient to successful investing) has been abandoned. 

For Wall Street, there seems to be no answer or near-term solution to the structural issues that have poisoned our markets these days. Meanwhile, the odds of a global recession grow, as Citigroup (C) wrote in a research note yesterday:

"We are currently in a highly precarious environment for global growth and asset markets after two to three years of relative calm. ...
The most recent deterioration in the global outlook is due to a moderate worsening in the prospects for the advanced economies, a large increase in the uncertainty about the advanced economies' outlook (notably for the U.S.) and a tightening in financial conditions everywhere."

Fundamentals remain poor, while concerns about a Chinese structural and cyclical slowdown and Beijing's unsustainable currency regime are rising. Meanwhile excessive leverage and increasing regional risks (such as the risk that Britain might exit the European Union) are additional and growing concerns.

The Bottom Line

Global recession risk and the market's dependence on quants and easy monetary policy could be a toxic cocktail for stocks.

Our market without memory will remain a difficult place to navigate in 2016. And the structural problems above are likely to stay with us for some time, until a deeper bear market shocks authorities into action.

For now, as I expressed in yesterday's opening missive, I'm bearish on the S&P 500's prospects for both the short and intermediate term.

via www.realclearmarkets.com/articles/2016/02/26/a_broken_market_without_memory_will_make_2016_difficult_102031.html