Real Threat to 2016 Stock Market? It’s Neither ISIS Nor Federal Reserve
Posted: December 22, 2015
Boxers love to distract opponents with a threatening left jab, then hit them with a right hook.
The stock market is doing something similar.
Investors are worried and distracted, wondering how much the Federal Reserve will raise interest rates. They are spooked by jihadism in general and the Islamic State in particular.
Those are the left jabs. In my judgment, neither the Fed nor ISIS is a major threat to the stock market in 2016. What is a threat, in my view, is the high level of stock valuations. When stocks are expensive, it’s much harder to achieve good gains than when they are cheap.
The Fed
The Federal Reserve Open Markets Committee raised short-term interest rates last week for the first time since 2006. The market gyrated but ended the week little changed: The Standard & Poor’s 500 Index fell 0.31 percent for the week. That modest reaction made sense because the Fed telegraphed its intentions clearly in advance.
Edson Gould, a stock market commentator from the 1940s through 1970s, devised a rule he called “Three Steps and a Stumble.” It posits that the stock market usually does fine when the Fed starts to increase interest rates but begins to struggle the third time the Fed does so.
The theory behind the rule is that the Fed generally raises rates when the economy is strong and it wants to prevent inflation. As former Fed Chairman William McChesney Martin put it, the Fed’s job is “to take away the punchbowl just as the party gets going.”
Gould’s rule always made sense to me. But I would go further: I see some reasons it might take more than three rate increases to slow down the stock market this time. The Fed has indicated it will proceed slowly and incrementally. In Gould’s day, half-point rate changes were common. Today’s Fed is more likely to hike in quarter-point increments.
Bond holders probably should worry, since bond prices move inversely to interest rates. But I don’t think the stock market has much to fear from the Fed in 2016.
Islamic State
People find ISIS frightening, and for good reason. The terrorist organization takes pride in the grisly practice of beheading enemies. It has no trouble targeting civilians. And the organization is shadowy: It’s hard for us to know exactly who our enemies are, or where they are.
Yet our country has confronted much tougher opponents. Hitler was equally evil and treacherous and had a much stronger industrial economy behind his war machine. The Soviet Union was armed with nuclear weapons, had a sizable economy and was open in its intention to defeat and destroy the United States.
The U.S. stock market persevered — and at times thrived — during the Cold War, the Korean War, the Vietnam War, the Cuban Missile Crisis, the terrorist attack on the World Trade Center and the Pentagon, and two Iraq wars. The truth is that stocks are driven more by earnings and interest rates than by geopolitical events. Geopolitical threats certainly affect the market, since they color the public mood and affect people’s economic choices. But they are rarely the dominant factor.
High valuations
What worries me — the potential right hook to investors’ jaws — is the high level of stock valuations. The S&P 500, a decent proxy for the U.S. stock market, sells for 23 times earnings and 3.6 times book value.
To be sure, those ratios have been this high or higher before. But most of those times, such as 1987 and 2000, were followed by periods of bad stock performance.
I do not expect a crash or severe bear market in 2016. My best guess is that it will be an up year, punctuated by normal market declines. (A normal year contains about three declines of 5 percent or more, and one decline of 10 percent or more.)
The reason I am somewhat optimistic is that I think the nation’s economic recovery is still gathering steam. If I’m right, earnings will rise enough to justify today’s rather rich valuations.
But if I’m wrong, we could all be in the soup.
Years during which there are presidential elections historically tend to be normal years, with a total return on stocks in the 9 to 10 percent range. Typically, the return is back-end loaded, coming mostly in November and December, as the uncertainty associated with an election gets resolved.
I think that’s fairly likely to be the case in 2016. But the market loves to defy the people who try to predict it, so we will have to wait and see.