“Perfect Storm” Could Make 2016 the Year For That Third Big Drop

As I write this in January, the stock market is off to its worst start to a new year… ever! Things may or may not have rebounded by the time you’re reading this in February, but in the first two weeks of 2016, all three major stock indexes fell by more than 10 percent, officially entering market “correction” territory.*
Chances are you know all that, and if you’re a regular reader of this newsletter, you probably aren’t surprised by it. I’ve been saying since last summer that the “flash crash” the markets experienced in August in response to China’s economic troubles was the potential first sign that another prolonged major market drop was about to begin. This would be the third major drop of our current long-term secular bear market cycle. And although I’ve refrained from trying to pinpoint a precise date, I will say now that 2016 looks to be the year that a “perfect storm” is in place to make that third drop possible – even likely.
What’s contributing to this storm? Well, there are many forces at work, but I’ll explain the four that I believe are most significant.
First, last year showed that the lingering effects of quantitative easing have finally worn off. I’ve said before that I believe the only reason a third major drop didn’t begin three years ago, shortly after the market surpassed its previous peak, is that quantitative easing kept the markets artificially inflated. With easing out of the picture for the first time in seven years, 2015 was a flat year for the stock market. The S&P 500 actually fell slightly from 2,058 in January 2015 to 2,043 in December,** and as of this writing, it’s down to 1,863.
Bad Timing
Second, I believe Fed Chairman Janet Yellen’s decision to raise short-term interest rates to a quarter-percent in December is, in the long run, going to do more harm for the economy than good. Yielding to pressure from Wall Street, which was expecting the rate hike, Yellen bumped up U.S. rates at a time when much of the rest of the world is trying to push rates down with their own quantitative easing programs. In doing so, she’s created a global interest rate tug-of-war. One potential outcome of this struggle is that the dollar will strengthen relative to other currencies, and if it does, that will undermine the Fed’s goal of trying to create inflation to stimulate the economy. In fact, I believe it will act as more of a deflationary trigger.
What’s more, the Fed’s yield curve dilemma also looks to be playing out in a worst-case-scenario. Long before December’s rate hike, I explained that the Fed would not be able to raise rates by any more than a tiny margin because they knew it would flatten the yield curve. The curve is based on the differential between short- and long-term interest rates, and banks need long-term rates to be higher to make lending profitable. But with our 10-Year Treasury being held near 2 percent by factors abroad, the Fed knew that its margin for raising short-term rates was very small. Well, now it’s gotten even smaller because the 10-Year actually dropped below 2 percent for a time in January,*** creating the flattest yield curve in eight years.****
Last month, I pointed out that if factors like deflation and the yield curve worsen, the Fed could end up having to follow in the footsteps of Central Banks in other countries that have raised rates prematurely only to have to lower them again soon after. I also posed the question: “How might Wall Street react to such a move?”
Of course, that’s just one of numerous potential tipping points for a sustained market plunge in 2016. The many others comprise the third major force in this year’s perfect storm. Naturally, China’s struggles are still a concern, and have again been identified as a key factor in the market’s poor performance so far this year. The other culprit has been plunging oil prices – which I think will continue to be a major force of market instability for three reasons. One is that the Saudis will keep the supply abundant. Two is that short-term speculators will continue pushing the price down. And three is the looming deflationary spiral I already mentioned; I think the situation with oil is proof the markets are starting to say, “We’re concerned about deflation.”
History Supports This
As I’ve pointed out many times, historically, long-term secular bear market cycles have three common characteristics: they generally last 20 years or more, experience at least three major market drops in the neighborhood of 50 percent or more, and end only after price-to-earnings (P/E) ratios have shrank back below 10. Well, our current cycle is only in its 16th year, has experienced just two drops so far, and P/E ratios are still at around 20.
So, even if you’re skeptical that the third market drop is going to occur this year, be aware that this perfect storm is going to make for a rocky ride at the very least. Naturally, investors with a lot of market exposure have already been experiencing that ride since January 1st. And brokers and financial advisors who focus heavily on stocks and mutual funds have no doubt been experiencing a significant increase in calls from worried or frantic clients. That’s certainly understandable.
If you’re one of those clients, make 2016 the year that you educate someone else. Vow to spread the word, and to help at least one friend or family member prepare and protect himself or herself from the brewing perfect storm.
*Stock Market Slides Again; Worst Two-Week Start to a Year, Associated Press, Jan. 15, 2016
**S&P 500 History, fedprimerate.com
***10-Year Treasury Yields fall to Three Month Low, marketwatch.com, Jan 20, 2016
****Yield Curve Flattest since January 2008, Nasdaq.com, Jan. 25, 2016

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