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 Major averages kicked off the year with their worst week in more
than four years as investors fled the market, and fear is on the
rise that a full-blown bear market may be lurking. While that may be
overstated, markets do face an unsightly assortment of obstacles.
Here are some of the biggest worries on investors' minds, and some
factors that may mitigate the downside risk:
CHINA: The volatility surrounding the world's second-largest
economy is a primary concern of investors. Attempts by officials
there to tamp the selling in equities and the steady devaluation of
the yuan have fed worries about capital flight. Moreover, a
weakening in the currency could hurt demand for imports,
particularly those sold in dollars like oil.
U.S. exposure to China in terms of gross domestic product is minimal
- only about 0.7 percent of overall GDP, according to Citigroup
strategists - but the knock-on effect for other emerging economies
cannot be ignored. Furthermore, Citigroup notes that companies with
more than 20 percent of revenues from China, including Apple,
DuPont, Texas Instruments and 30 others, have performed worse than
the overall market since the middle of 2015.
THE BULLISH CASE: China's weakened demand cuts the cost of
consumer goods and petroleum, and data on driving shows U.S.
consumers are spending their savings on gasoline by driving more and
spending on entertainment.
INVESTOR SENTIMENT: U.S. stock funds saw their worst week
since September as investors pulled more than $12 billion out of
equity funds, according to Lipper data. Every sector is down this
year.
After just five trading days, more than 40 S&P stocks have already
lost at least 10 percent on the year, and sectors normally
considered leaders including technology and consumer discretionary
are lagging the market.
Furthermore, areas that would be expected to benefit, for instance,
from the falling price of oil are struggling as well - the Dow Jones
Transportation Average is off by 7.5 percent in January, trailing
the S&P 500's 6 percent drop and even worse than energy's 6.8
percent fall.
"Sentiment is so bad in some corners of the market that
transportation stocks can't even rally while one of their main costs
deteriorates. It's rare to see new lows in transportation stocks and
oil at the same time," said Jason Goepfert, president of Sundial
Capital Research.
THE BULLISH CASE: Coincident lows in energy and transports
have, in the past, happened when the market is notably near a
bottoming out.
EARNINGS: Even though the U.S. economy is continuing to grow
as evidenced by recent figures on auto sales and jobs growth, albeit
at a slowing pace, public company earnings are in recession.
Estimates have fallen sharply in recent days, with fourth-quarter
results expected to fall by 4.2 percent from the year-earlier period
from a 3.7 percent drop anticipated at the beginning of the year.
The forward price-to-earnings ratio, as a result of the market's
rapid drop in the last week, has retreated to a more historically
average 15.3 level, but stocks often need to become cheaper to
entice investors while markets are in a swoon like this. Should
profit estimates continue to fall, that will put more pressure on
stock price to decline as well.
One side note that is of concern: Citigroup, which reports on
Friday, as a result of poor earnings a year ago, is by itself
lifting the expected S&P growth rate dramatically, according to
Thomson Reuters data. Without Citi, earnings are expected to fall
5.4 percent.
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THE BULLISH CASE: Excluding the huge drag exerted by the
energy sector, earnings are positive.
DIVERGENT MONETARY POLICY: Strategists interviewed late
Friday noted that the Fed's intentions to keep raising rates at a
steady clip, compared with the European Central Bank's plans to keep
monetary stimulus going, will continue to drive volatility as yields
in the U.S. rise and conditions tighten.
The CBOE Volatility Index, or VIX, closed at 27.01 on Friday, its
highest since late September, and VIX futures show an ongoing
inversion, meaning investors expect more near-term gyrations.
Richard Bernstein of Richard Bernstein Advisors LLC said Friday that
the Fed beginning rate hikes with the United States and world in a
profits recession had not happened since 1980-1981.
"We said many months ago it was a recipe for volatility - guess we
were right," he said.
THE BULLISH CASE: The Fed will continue to keep stimulus
largely in place with a slow pace of rate increases and massive
balance sheet designed to keep long-term interest rates from rising.
CREDIT SENTIMENT: The BofA/Merrill Lynch U.S. Corporate Bond
Index's spread has continued to widen, reaching 177 basis points
over comparable Treasuries on Friday, a few basis points away from
levels not seen since 2012. The equity market, for a time, had
ignored a similar rise in high yield spreads, but the decline in
high-rated credit is a potentially greater problem, because it
indicates reduced confidence in funding corporate spending.
Brian Reynolds, strategist at New Albion Partners in New York, says
the weakness in credit and in stocks are, in a sense, feeding on
each other right now.
"Credit traders continue to watch stocks like a hawk," he said. New
issuance has remained healthy and should continue. Eight big
high-grade bond deals hit the market on Friday. But further weakness
in credit could signal more bumps for equities.
THE BULLISH CASE: Reynolds believes demand from pension funds for
credit deals will keep these markets active, and even several months
of churning in the stock market will not derail credit activity.
(Reporting By David Gaffen; Editing by Dan Burns and Cynthia
Osterman)
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