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Had it not been for a small group of nifty companies, 2015 would have entered the history books as a terrible year for the US stock market. As it was, stocks were almost exactly flat, as were bonds and cash, meaning that US bonds and equities had their second-worst collective 12 months since 1995 – outstripped only by the disaster year of 2008.
“It’s the world of low numbers,” says Andrew Milligan, chief investment strategist at Standard Life in Edinburgh.
Yet there were some very high numbers for a group of four companies that have come to be known as the “Fangs” – Facebook, Amazon, Netflix and Google – and for a slightly wider group that added Microsoft, Salesforce, eBay, Starbucks and Priceline to create the “Nifty Nine”. Both groups gained more than 60 per cent for the year.
Away from the excitement generated by these hot companies, things were dire. The S&P 500 equal-weighted index, where each of the 500 companies receives 0.2 per cent of the index, was down, and underperformed the S&P weighted by market capitalisation.
Such a “narrowing” of the market is a classic symptom of a lengthy rally – this one has lasted almost uninterrupted since 2009 – that is coming to an end. Investors run out of ideas and instead pour money into a few companies with a positive story to tell. The underperformance of smaller companies is a sign that investors are growing more cautious.
The dominance of the Nifty Nine recalls the late 1960s and early 1970s, when a long bull market petered out into a period dominated by a “Nifty Fifty” of companies such as Xerox.
“Technically this feels very bearish,” says Jim Paulsen, chief strategist at Wells Capital Management. “The closest feel is the Nifty Fifty era when much of the market peaked in the late ’60s but the Nifties carried on until 1972.”
He said the performance of Amazon, which is revolutionising consumer industries, is particularly distorting, and that of the wider consumer discretionary sector – which was the best performing sector of 2015 – had a “night and day difference” without it.
Part of the reason is that profits are in decline, mainly due to the problems falling oil prices have created for energy companies. “We shouldn’t be surprised, because there’s a profits recession, and in profits recessions markets become very Darwinist,” says Richard Bernstein, an investment consultant. That Darwinism means that money flocks to the companies that can show strong revenue growth, such as Netflix – whose profits halved in the third quarter but continues to show subscriber growth – or Amazon. Both saw their share prices more than double, as funds flooded out of companies perceived to be losing out to them and registering disappointing profits, such as Viacom and other mainstream television media groups or Walmart and other retailers.
According to Peter Atwater of Financial Insyghts, who analyses market psychology, narrow participation is a symptom of extreme nerves, as last seen during the 1990s internet bubble. Writing before the US Federal Reserve decided to raise rates last month, he pointed out that for 2015, “the top 10 stocks in the S&P 500 are up 13.9 per cent while the other 490 are down 5.8 per cent – the largest spread since the late 1990s!”
It has also grown more important to pick winners, while there are plenty of losers to choose from. Thomas Lee of Fundstrat says that he had seen Fang-like concentrations in the past, but usually the top and bottom 10 cancel each other out. In 2015, the winners far outperformed the losers.
Mr Lee warned that “Fang likely ends with a Dang!” as top movers in one year have a strong tendency to underperform in the next.
Valuation trends suggest that the next move is more likely to be downwards. US stocks endured a correction during 2015, dropping more than 10 per cent in August as the Chinese currency revaluation sent tremors through the financial world. But, to quote Mr Paulsen, it was “not a pause that refreshes”.
“We did not reset valuations or refresh the profit cycle,” he says. Instead, the S&P 500 had almost regained its highs by the end of October, and US share prices, judged by a multiple of earnings, ended the year as expensive as they began it.
The two critical measures that should set the market’s direction are earnings and interest rates. In the third quarter, S&P 500 earnings dropped by 0.8 per cent year on year, and the consensus expectation is that they will be down 3.5 per cent in the fourth quarter, mostly thanks to energy. Meanwhile, Europe may have hit the bottom of its own profits recession, with earnings for the Stoxx 600 companies falling 5.1 per cent year on year in the third quarter.
The renewed fall in the oil price has raised concerns that energy companies will be forced to write down the value of the assets more sharply. Once this damage is done, hopes on Wall Street are high for a rebound from a low base; brokers’ analysts now forecast 7.9 per cent earnings growth for the S&P 500 as a whole in 2016. However, equity strategists and asset allocators, who take a more top-down view, expect these numbers to be marked down considerably as the year continues. Further, earnings tend to move in cycles, and in the US the cycle appears to have turned.
As for rates, the Fed has told markets to brace for four more rate rises this year, while the Fed funds futures market is implicitly only pricing in two. All else equal, lower rates would aid share prices. But all else is not equal. Lower rates would imply a sickly US economy, which would hit hopes for earnings.
So the great hope that a narrow US market will not tip over into a bear market this year is the US economy. There are few signs of a recession – and without a recession, equity bear markets are usually not severe. Indeed, outside of manufacturing, which is in a global downturn, the economy looks robust. The hope is that services will start to benefit as US consumers at last begin to spend the money they have saved on oil.
“Profit margins are not going any higher, and rates aren’t going any lower, and there’s a lot of things used up,” says Mr Paulsen, whose best guess is that another flat year is in the offing. “But it’s hard to see a recession.”
Excitement around a few big new-economy stocks was intense during 2014. Netflix and Amazon both more than doubled, while Facebook and the Google companies also enjoyed a great year. Put these stocks (known as the Fangs for their initials) together with Ebay, Priceline, Salesforce, Microsoft and Starbucks, to create a “Nifty Nine” and they beat the rest of the US market by more than 60 per cent.
That is worrying. Dominance by a few big companies – or a “narrowing” market – is a symptom of the end of a bull run, as it was in the early 1970s (dominated by the “Nifty Fifty”) or the late 1990s (dominated by the dot coms). The biggest 50 companies rose last year, but the Russell 2000 index of smaller companies fell, showing concerns about the economy, while an equal-weighted version of the S&P also fell. Most stocks were down, and interest is restricted to a few.
S&P 500 companies saw earnings decline slightly in 2015. This was in large part due to falling revenues at energy companies, driven by falling oil prices. But the strong dollar, which hit overseas earnings, was a factor. So was declining margins, as wages started a slight recovery. Both earnings and margins tend to by cyclical, implying both could have further to fall. Meanwhile, earnings in Europe fell by even more, raising hopes that European companies have reached the bottom of the profits cycle.
Valuing stocks is and will always remain an imprecise science. Many Wall Street analysts now make technical criticisms of Prof Robert Shiller’s cyclically adjusted price/earnings multiple, which compares to prices to average earnings over the previous decade. But a simple multiple of the previous twelve months’ earnings, which is much noisier and leapt to extremes during the earnings recession of 2009 when investors universally assumed that earnings would recover, gives a similar conclusion. Prices are not extreme, but clearly look expensive by historical standards.
The US stock market has vastly outperformed the rest of the world (including both developed and emerging markets) since the 2008 crisis. Lenient monetary policy helped this, as did the strength of the US economy, while the strong dollar amplified the outperformance. But the strong dollar should hit US companies’ overseas earnings, while strengthening the rest of the world, and other central banks are now aggressively easing monetary policy while the US Federal Reserve has just started to raise rates.
2015 was dominated by speculation over when the Fed would raise rates. There is every reason to expect this to continue. This chart shows the “dots” issued by the Fed, in which each dot represents the prediction of a different Fed governor for where target rates will be at the end of 2016. The median forecast is for four rises of 0.25 percentage points. The market expectation, derived from the Fed Funds futures market, is for two rises. This gap will have to be reconciled during 2016.
Copyright The Financial Times Limited 2016
(c) 2016 The Financial Times Limited
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