December Market Update
The markets closed November mostly in the red, with the one exception of the small cap Russell 2000, which rose 1%. By December 18th, the S&P 500 had moved back and forth across the flat-for-the-year mark 27 times, the most in history, with all of the major indices as of the 17th down for the year except the NASDAQ which closed last week up 3.95%; talk about a lot of sound and fury signifying nothing! Part of this movement can be attributed to the world’s major central bankers, whose signaling to the markets has become increasingly convoluted. The lack of clarity and instability is serving as a headwind to longer-term growth as market participants, wary of the lack of visibility, operate in more of a hunker down mode. In the U.S., the market is unclear as to what the Federal Reserves will do over the coming months and why; economic conditions are weaker now across a broad range than just six months ago, yet the Federal Open Markets Committee (FOMC) chose Wednesday to raise rates by 0.25%. On the one hand, well done on the hike as they’d been telling the markets they would do so for quite some time, on the other, odd timing given the various signs of weakening, but I appreciate the hike was necessary lest they loose more credibility.
The markets demonstrated just how much they depend on central banker largess on December 3rd, when both the Dow Jones Industrial Average and the U.S. Dollar Index experienced their biggest one-day declines since 2009 when the European Central Bank (ECB) cuts its main interest rate by less than expected.
That move was then reversed in a joyous move to the upside Friday December 4th, when ECB Chairman Mario Draghi assured the markets that the ECB could and would do much, much more as needed. A sigh was heard around the world and equities rebounded. I suspect a little chitchat had ensued between the ECB and the Fed, with the ECB agreeing to give the Fed some wiggle room by not weakening the euro as much as it could have had it lowered rates even more. The week of the 14th the down-trend resumed, with the S&P 500 falling nearly 4% over the week and dropping below both its 50-day and 200-day moving averages with an RSI (Relative Strength Indicator) signaling the index is in oversold territory. This move was precipitated by problems in the high yield, (junk bond) market, which finally hit a tipping point. The markets have also been heavily influenced by just a handful of high-fliers, with FANG (Facebook, Amazon, Netflix and Google) accounting for 3.6% of the S&P 500’s return for 2015 as of December 11th. Last week the markets attempted another rally, which quickly fell apart my midweek, the all the major indices closing the out the week in the red.
Looking at sectors through the end of November, there is a rather wide divergence in performance, with Energy and Transportation unsurprisingly the worst performers. Looking a bit deeper into heath care, the Biotechnology sub-sector is on track for its worst performance in five years, presenting a challenge for the Nasdaq which has benefitted greatly from many of the biotech high-flyers in yet another example of why it doesn’t pay to blindly chase the out-performers from prior periods.
On a global perspective, Germany, France, Japan and China are still in positive territory in their primary indices year-to-date, while most of the rest of the world is flat to negative.
However, all major global indices are negative over the past six months.
We’ve also seen a trend towards lower levels of market liquidity, as is evidenced by decreasing depth. Market depth measures how many forward contracts can be bought or sold before the market moves approximately 1 point. If over time it takes fewer participants to move the market by the same amount, market depth is declining. Over the past two years, as indicated in the next chart, market depth has declined by over 60%. This means the market is less able to handle large shocks. When a surprise hits the markets now, there is a more dramatic response than there would be with greater levels of liquidity.
As I mentioned earlier, the major move downward in the past two week has been driven in large part by the problems in the high yield markets reaching a tipping point. On Thursday, Third Avenue Management announced that it is liquidating its $1 billion Focused Credit junk bond fund (ticker symbol TFCVX) and will be blocking investors from redemptions in the process. The fund’s collapse marks the biggest failure in the U.S. mutual fund industry since 2008. The fund lost 27% so far in 2015 and has seen its assets under management decline by about 2/3rd over the past seven months.
The pain spread to other parts of the high yield world, with HYG iShares iBoxx USD High Yield Corporate Bond Fund (HYG) and SPDR Barclays High Yield Bond Fund (JNK) suffering their worst one-day performance in four years. The plunge in high yield has been kicked off by pain in the oil and commodity sectors, such as steel, which I’ll look at further later on in this piece. For those who keep their wits about them, all this pain will result in an abundance of opportunities. Howard Marks, Chairman of Oaktree Capital, recently remarked that opportunities to purchase distressed debt have not been this good since the period following the collapse of Lehman Brothers in 2008.
Bottom Line: December is typically a strong month for equities, but so far this one hasn’t fallen in line. Traditionally, the second half of the month is the strongest and with most of the indices now in oversold territory, a late Santa rally is certainly possible, although with the current market fundamentals, I think it improbable. The Fed’s rate hike decision on December 16th coupled with the strains in high yield bond market will make it more expensive for companies to issue debt, which means less funds available for share buybacks. Those buybacks have provided an awful lot of price support for stocks, support which is likely to wane.
