Rudi’s View: 2016 is The Year Of Conviction

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By Rudi Filapek-Vandyck, Editor FNArena

Global risk assets have started the new calendar year on the back foot, and that is some serious understatement. According to people who have access to many more years of data than I have at my disposal, never ever in modern history have global equity markets started a new calendar year with losses to the extent as witnessed in the first two weeks of January 2016.

Adding more bad news into the mix, the continuous sell-offs have forced asset prices through and below various multi-year trend lines and technical support levels. Even if one does not practice technical analysis, or one doesn't "believe" in it, I'd say that if history shows us one thing it is that when such events take place on a mass-scale -as has been the case these past few weeks- it is time for every type of investor to take note.

At the very least one would have to acknowledge the overall environment has changed rapidly. On my observation, selling orders have been hitting the local share market pretty much in indiscriminate form. The difference between stocks of various quality and vulnerabilities is no longer the difference between gains and losses, it's merely smaller losses versus larger losses, with only a small number of exceptions (CSL, ResMed, Medibank Private, etc).

Has there been panic? I believe not. But this can be explained either way. If we had experienced a cataclysmic sell-everything-at-all-cost event by now, maybe our confidence could be higher that we had at the very least seen an intermediary bottom?

Technical market signals have been flashing oversold signals for a while now, so a bounce is to be expected. This by no means implies all of the bad news has been accounted for. As a matter of fact, some of the more bearish chartists in the local market believe the upcoming bounce should be used to offload shares and to raise more cash. Targets to the downside vary between 4200-4500 for the ASX200 (though I have seen one mentioning of 4000). This implies potential for 7.5%-13.5% in further losses.

Not something any of us is looking forward to, I am sure.

Yet, the majority of market commentators and investment expert has remained relatively sanguine about it all. When asked about whether he would change his view for the year ahead, Commsec chief economist Craig James responded to an AFR journalist "It's just day 17. A lot can happen over the year".

It sure can.

Most projections are for the ASX200 to reach 5500 and higher by year-end, which would make for a juicy double-digit return, in particular now that we have lost more than 8% already from the late December reference point. Unfortunately, the track record for most of these forecasters is not very good. I might be a little harsh, but if my memory serves me correctly then index projections in Australia have mostly been well off the mark post 2010. While the share market managed to post positive returns in the past two years, despite many headwinds and a noticeable pick-up in volatility, it failed to even approach the kind of projections put forward at the start of each of these calendar years.

None of this means that predictions this market is heading for 4200 are thus of greater validity.

What Not To Like

A few things not to like about the current set-up:

– Valuations are not excessive, but they are not cheap either. The market PE in the US is still above long term average, in Australia it is merely around the long term average
– Market breadth in the US is very narrow (a la 2007)
– Unless we see a major rally in the next two weeks, January is starting the year on a negative footing. Statistically, in 72% of all such cases, this translates into a negative year ahead
– Equity markets are falling through December-lows. Statistically this usually means more weakness ahead (only two exceptions out of 31 such cases)
– Technical damage is rife and widespread, extending from commodities to Emerging Markets to equities in Developed Markets
– Global equities seem to take guidance from crude oil markets where the focus remains to the downside
– Anecdotal evidence suggests all is not well inside the Chinese economy

With regards to the latter point, consider the following statement published by CBA on Monday afternoon (after first explaining as to why China's GDP release is likely to confirm the government's 7% has been met in 2015):

"However, we expect the downturn in China's economy to resume in Q1 2016. A recent trip back to China suggests the economy remains in a rather bad shape. Public confidence and expectation are very low. Faced with rising non performing loans (NPLs), banks are cutting credit lines to private sectors despite the policymakers are calling for more supports in this area. New credits are mainly used to repay existing debts, rather than flowing into new investment projects. Such environment is expected to last a while, and get worse before get better.

We recommend our readers to maintain a cautious view on China’s economic outlook in 2016."

There will be relief rallies along the way, but it's probably worthwhile keeping in mind the trend in Chinese growth remains negative, opening up all kinds of unexpected and unforeseen risks for further negative shocks.

I don't want to spend too much time on the nitty gritty of all the things that can impact on the fundamental outlook for global equities, but in a world of too much debt, with slowing economies and a tightening Federal Reserve, after nine years of exceptionally low bond yields and exceptionally cheap and abundant money, I don't think any among us should be too confident other than that 2016 will offer a rough path, filled with potholes and traps, on top of much higher volatility, and a far from certain outcome.

Minus 20%

One of the confusing characteristics of financial commentary and predictions is that not everybody is working off the same terminology and interpretations. Last year Citi's Willem Buiter predicted a Global Recession in 2016. He wasn't talking about negative growth. His interpretation is (much) lower than potential growth, so low that it will open up all kinds of negative side-effects and problems. Thus far his prediction seems on the mark.

Dennis Gartman has already declared the world is in a bear market. Colin Twiggs is referring to "Primary Downtrends". RBS, as we are all aware by now, simply advised investors to "sell everything".

I am not a big fan for using the -20% rule in order to declare a financial asset is in a bear market, in particular in commodity markets this rule has been more violated than validated, I believe. But in equity markets, believe it or not, equity indices do not fall by -20% or more often.

I did a little research into the matter and the only times the Australian share market has fallen by at least -20% since 1994 was in 2008-March 2009 (we all know how devastating that was; in the end the market lost more than 50% from its November 2007 peak) and before that it happened in 1994. Back then the market peaked in January and troughed twelve months later losing 20.5% along the way. That proved an excellent starting point as the market subsequently started an uptrend and never looked back.

Despite all the carnage in 2011 when the eurozone was on the brink of collapse, the local share market "only" lost -17% during the process. Back in the post-Nasdaq meltdown bear market, shares lost -19% in 2002-2003.

For US equities -20% is equally a rare occurrence. The two most recent times it happened both marked a savage bear market; in 2008 and in 2000.

The good news is US equities are only down by -12% thus far from their 2016 peak, while the ASX200 has lost some -18% since its failed attempt to reach for 6000 last year. In both cases these numbers suggest investors who have been buying beaten down stocks will be rewarded for their bravery and their market savvy.

But who's to say this is the end of it?

Conviction Is Key

One of the smartest things I heard one fund manager say when interviewed last year was: "we cannot predict the future, but we can manage risk".

And that, I believe, is the smartest thing to do. I too do not know what exactly the remainder of 2016 is going to throw upon financial markets. It might be much better than what financial markets are anticipating/pricing in/reflecting right now. It might be worse. We do not know. It just seems to me that preparing for a good outcome and hoping it proves to be the right set-up doesn't seem to be smart. Hope never is a valid strategy.

Regardless of what exactly is going to be the outcome in twelve months' time, I think 2016 should be the year of Conviction. Time to take one hard, critical look at our portfolios and get rid of everything that hasn't worked out, that looks more vulnerable than strong, that is only in there because of our own mental weakness. Concentrate on "strength" and, above all, on Conviction.

Not everything that falls in price becomes a bargain, but once the (near) indiscriminate selling stops the strong, solid growth stories will prove their true value. 2015 has shown that tough times open up landmines and torpedoes. Think Primary Healthcare ((PRY)), Spotless ((SPO)), Santos ((STO)), Origin Energy ((ORG)) and many others. 2016 is likely to reveal an even tougher environment.

Do not underestimate the value of cash. Cash protects against instant losses. Cash offers freedom of choice and freedom to act on opportunities. Cash gives you comfort during times of turmoil.

Whatever you decide and do, do it with Conviction. This is not an environment to take weak punts and stay the course for all the wrong reasons.

Change. Investing in a low growth world

Feedback on the book I released in December last year has been overwhelmingly positive. The one and only review posted on Amazon.com gave it five stars. Subscriber Ivo messaged me last week, he enjoyed reading it so much, he's going to read it again!

While I did by no means predict the horrible start to the new calendar year, all the themes I touched upon in "Change. Investing in a low growth world" remain valid throughout the turmoil, and they will remain valid for a long time to come.

Paid subscribers (12 & 6 months) can get their free copy as a subscription bonus. Send an email to info@fnarena.com if you somehow missed out on your copy.

All others can purchase a copy via Amazon or any other of the main online distribution platforms (thus far the book is only available in eBook format).
 

(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions.)  

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