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10 Market Predictions for the Rest of 2016

2016 has been absolutely crazy, and that's not even the half of it

By Charles Sizemore, Principal of Sizemore Capital

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Source: jacinta lluch valero Via Flickr

For the most part, 2016 has been … shall we say… interesting.

It started with one of the most volatile Januaries in the history of the stock market only to recoup its losses with a fantastic run in February and March.

It weathered the Brexit crisis and never-ending speculation about the direction of crude oil prices. And now we’re just months away from what is already the most contentious U.S. presidential election in memory. Oh, and let’s not forget the monthly Federal Reserve “will they, won’t they” rate hike anxieties!

This has been a year in which very little seemed to make sense. For the markets, bad news became good news; good news was bad news! except when bad news was really bad news or good news was really good news.

You follow that? Me neither.

At any rate, this market might not make a lot of a sense, but it’s the market we have to work with. So with further ado, here are 10 predictions for the remainder of 2016.

The Stock Market Finishes the Year Higher … Barely

As I’m writing this, the S&P 500 Index is up a little over 6% for the year. And that’s really not too shabby considering it was flirting with bear market territory after a rough end to last year and an even rougher start to this one.

But the question is: Where does it go from here?

Looking at stock market valuations, I’m naturally cautious. The cyclically adjusted price earnings ratio — currently sitting at 27 — suggests the market will return approximately zero over the next eight years or so.

Of course, in the short term, valuation really doesn’t matter. The only thing that moves the market is supply and demand, which is driven mostly by psychology. And the way I see it, less committed investors dumped most of their stocks in January … and they dumped most of what was left during the Brexit crisis. I suppose the presidential election could stir things up a bit. But at this point, I would expect the market to drift slightly higher if for no other reason than there simply isn’t anything obvious to stop them.

Energy Leads the Pack

I mentioned that the market is expensive — and it most certainly is. But there are a few pockets of value out there. One in particular is the energy sector. Energy stocks have been in the dog house for about two years now even while the broader stock market has moved higher.

Yes, the price of crude oil is less than half what it was two years ago. But energy stock prices more than reflect this. As a sector, energy stocks trade at a cyclically adjusted price/earnings ratio of just 14.6 compared to 27 for the S&P 500.

And there are signs that the industry is turning things around. The supermajors are about as lean as they’ve ever been after rounds of layoffs and cost cutting. And Halliburton Company’s (NYSE:HAL) CEO recently said publicly that the North American oil market had finally turned a corner and that the worst was behind it.

We’ll see what happens with the prices of oil stocks. But at least in this sector, you can get paid to wait. Yields for the supermajors range from 3% to 7%. In a world where a lot of bonds sport negative yields, that’s pretty attractive.

Trump Wins the Presidency

This is a close election, and depending on what poll you read you can reach a very different conclusion. But it appears that Donald Trump has started to pick up momentum … and that he will be our next commander in chief, for better or worse.

Republicans that were reluctant to support Trump are slowly (and mostly quietly) moving into his camp. Meanwhile, fallout from an email scandal that suggested the Democratic party was intentionally trying to sabotage the campaign of Bernie Sanders threatens to split that party. You also have the global issue of anti-establishment sentiment, which helped to fuel the Brexit vote. Trump is a major beneficiary of the general sense of unease with the status quo, whereas Clinton is really the embodiment of the status quo. With less than four months to go, momentum seems to be shifting to Trump.

Right now, the conventional wisdom is that Trump will be bad for the stock market because his protectionist policies will be bad for trade. Well, that makes sense on the surface. But I don’t expect that a President Trump would be able to do have the things he says he will. Changing treaties involves consent of the Senate, which will be hard to get. So while a Trump presidency might look radical on the surface, in practice I expect it to be pretty moderate … and benign for the stock market.

Brexit Does, In Fact, Happen

This might seem like an odd statement considering that the vote was over a month ago, with the Leave camp winning by a decent margin. But as of today, nothing has actually happened.

The British have not invoked Article 50, which officially starts the exit negotiations. David Cameron wasn’t willing to do it, and newly installed Prime Minister Theresa May probably won’t do it until she has an informal understanding with her European counterparts what, exactly, the post-Brexit relationship with Europe will look like.

There has been talk for weeks that the Brits may simply never invoke Article 50. The referendum was, after all, legally non-binding. There is nothing to stop the government from simply choosing to ignore it.

I don’t see that. While a second referendum might very well go the other way if done today, there is a general consensus that what is done is done.

A month after the vote, the world hasn’t ended. And once Article 50 makes it all official, I don’t see the world ending then either. So for the stock market, this means we’ll continue to keep calm and carry on.

The British Pound Rallies

While the world didn’t end with the Brexit vote, the British pound certainly took quite the beating. The day of vote, it dropped to 30-year lows versus the dollar … and it’s been sitting there ever since.

On the night of the Brexit vote, the pound dropped about 12%. Well, to put that in perspective, the day in 1992 that George Soros kicked the U.K. out of the European exchange rate mechanism, the pound dropped about 4%. This was the infamous day that Soros “bankrupted the Bank of England,” and the impact was roughly one third of what we saw the night of the Brexit. That doesn’t quite make sense.

No one has an interest in the pound “blowing up” here. While there is a lot of bad blood between the U.K. and the rest of Europe right now, no one wants to see the U.K. fall into a genuine debt or currency crisis. The U.K. and Europe will continue to be important trading partners, and a strong U.K., even out of the European Union, is good for Europe.

So if the pound sinks any further, I would expect major coordinated central bank action from Fed, the European Central Bank and the Bank of Japan to prop up the pound.

The Yen Plummets

If you think that weakness in the British pound seems a little overdone, the strength in the yen in on a whole different level. The yen has been on a tear for most of 2016. The exchange rate sat at around 120 yen to the dollar for most of 2015. But when the market starting getting wobbly in 2016, the yen started to get a lot stronger. That same dollar that bought 120 yen at the end of last year only bought about 100 yen today.

Part of this strength is due to short covering. Leveraged investors that had shorted the yen in order to buy higher yielding assets have spent 2016 covering those shorts, which means that they had to buy yen. And the Fed proved to be a lot more dovish than a lot of traders expected, so the dollar has come down relative to the yen (dollar weakness is yen strength).

But this can’t last much longer. Japan needs a weak yen in order to combat deflation. And while “helicopter” money wasn’t announced in the last policy meeting, it’s still very much on the table.

Japan is the most heavily indebted country in the world … more than even Greece or Italy. I do not see a plausible scenario that sees the yen go much higher for much longer. The yen will finish this year sharply lower.

Gold Takes a Nosedive

Gold is baffling to me. You really should never see a scenario where gold and bonds rally at the same time. Gold is first and foremost an inflation hedge, but inflation is anathema to bonds. Bonds do best during times of disinflation or deflation.

And let’s say that gold and bonds are rallying together as part of a “fear trade.” If that were the case, then stocks shouldn’t be rallying. Nothing about this makes sense.

Second-quarter GDP came out much weaker than expected at 1.2%, and first quarter GDP was revised lower to 0.8%. And bond yields around the world are pointing to a much larger risk of deflation rather than inflation.

Something has to give here. Either the bond market is wrong, or gold investors are wrong. Both cannot be right at the same time. And given the dearth of inflation … and of economic activity in general … I’m betting it’s the gold bugs that have it wrong.

The Fed Raises Rates

It seems almost silly now. But late last year, market pundits talked about a 2% Fed funds rate by the end of 2016.

Well, things didn’t quite work out like that. The Fed raised rates by 0.25% late last year and haven’t done a thing since. The Fed funds rate remains at a target of 0.5%.

Based on the Fed’s latest announcement, I think an additional rate hike before the end of the year is likely. The Fed desperately wants to hike so that it has a few rounds left in the clip for the next recession. With rates as low as they are, Fed monetary policy isn’t likely to be too effective come the next downturn. So I think they’ll probably raise rates by another 0.25% before year end.

But beyond that, it gets doubtful. No matter how much the Fed might want to raise rates, they have to be aware of market realities. Even at the pitifully low rates of today, U.S. rates look high compared to the negative rates in Japan and Europe. So the Fed will have to tread carefully, lest they cause the dollar to rise too quickly vs. the euro and yen.

The Dollar Rallies

This brings me to the next prediction for the remainder of 2016, that the U.S. dollar enjoys a nice rally. It’s hard to believe, but the U.S. is actually a high-yield market at this point. And the U.S. is the only major central bank seriously considering raising rates at the moment.

Well, money goes where it is treated best. And right now, that is the United States. Money is likely to continue seeping into the U.S. capital markets for lack of anywhere else to go right now. And all of that inflow of foreign capital is likely to push the dollar higher.

This also goes back to my earlier prediction about gold. A strong dollar is bad for gold, which is considered by its fans to be an “anti-dollar.” So, consider a strong dollar and weak gold to be two sides of the same coin.

Bond Yields Stay Low

And finally, I predict that bond yields stay near historic lows for the remainder of 2016. I don’t necessarily expect bond yields to go lower, mid you, and I think it’s possible they go ever so slightly higher from where they are today. But anyone expecting a major rout in the bond market, which would send yields higher, is likely to be disappointed.

To start, the number-one enemy of the bond market — inflation — is still in check. And with energy prices not showing a lot of life right now, inflation should continue to be in check for the foreseeable future. But the biggest issue is simply the globalization of capital. Bond yields are negative in most of the developed world right now, sometimes at maturities as far out as 10 to 30 years.

If you’re a pension fund manager in, say, Germany or Japan, are you going to buy bonds that guarantee a loss … or might you instead buy up U.S. debt, where you are at least guaranteed some kind of profit, however modest it might be. The answer is obvious.

Low yields abroad should act as an anchor to yields here. So while this is great for current bond prices, it also means that you’re not likely to get much in the way of yield on any new investments in bonds.

Charles Sizemore is the principal of Sizemore Capital, a wealth management firm in Dallas, Texas. As of this writing, he did not hold a position in any of the aforementioned securities.


Article printed from InvestorPlace Media, https://investorplace.com/2016/08/market-predictions-2016-fed-brexit/.

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