Why is the market so nervous? While there are several reasons to be concerned, perhaps the two most important factors that the market must digest before the volatility subsides are: How will negative rates affect foreign banks, and how deep and wide the oil slide will affect the other sectors of the world’s economies. Let’s take a quick look at both.
Negative Rates:
The Bank of Japan recently joined with central banks in Sweden, Switzerland, and Denmark, as well as the European Central Bank, in imposing a negative rate. This tool is being used to combat the growing risk of deflation and stagnant economic growth. The total of negative rates is similar to those of very low, or near zero, positive rates. They’re designed to spur banks to lend more to consumers and businesses by reducing the financial benefits, or, in the case of negative rates, increasing the costs they derive from parking their money at the central bank and should lead to higher demand for loans.
A negative rate also weakens a country’s currency, bolstering its exports by making them cheaper for overseas buyers. That lifts industrial output and the domestic economy. It also makes imports more expensive for consumers, nudging up inflation.
A below-zero rate encourages the bank and its consumers to shift money into higher yielding assets such as stocks, goosing the market and making consumers feel wealthier which can lead to higher spending.
Why would anyone pay a central bank to hold its money? The easiest answer is that banks have billions of dollars in deposits. These deposits can’t be easily converted to cash. It would have to be stored in vaults and safe warehouses incurring storage, transportation, and insurance costs. Another issue is that banks are required to keep a certain amount of money at their country’s central bank to clear checks and settle payments.
On Thursday February 11, 2016 the Federal Reserve Chairperson, Janet Yellen, was asked specifically if the Fed was considering negative rates. She answered that it is premature to assume the Fed would utilize negative rates, but they had considered it in 2010 and are looking at them again in the event the Fed decides they are needed.
Markets:
This isn’t just an energy problem. Earnings expectations for 2016 have been cut for roughly 70% of the companies in the S&P 500. Analysts have taken down estimates by 20% on average. That is a dramatic adjustment from October 2015 when the average company in the S&P 500 was expected to grow earnings by 10% or more. Typically transportation and industrial sectors are viewed as leading indicators as to what to expect in the economy. The transportation companies are expected to show an increase in revenue as goods and commodities are shipped. The transportation sector is down 24%. Meanwhile the industrial sector, the folks that make the products that are sold, has declined 14.5%. Over the past year economists have been calling for a pickup in both sectors, but there has been no follow through in reality and the stocks are showing a ramp up in fear. The market shrugged off Janet Yellen and is saying “we are worried” to the point of pricing in a recession in the U.S.
With the fear feeding on fear frenzy we see in the market there is a repricing of assets going on. Simply put, folks are not willing to pay as much for a dollar in earnings as they were a few months ago. Couple that repricing with a lowering of estimates and you can see how a stock that once earned $4 per share in earnings and traded at 18 times earnings was at $72. With the adjustment in willingness to take risk folks are willing to pay 14 times earnings which would bring the stock down to $56 then pile on a 20% reduction in earnings to $3.20 per share times 14 and viola you now have a stock trading at $44.80 that just two months ago was trading at $72 or a drop of almost 38%. Now, I am not predicting the market will drop 38% but you can see how fear coupled with lower earnings outlook can certainly cause a very fast and very dramatic repricing in the market.
According to Robert Shiller, in his book, Irrational Exuberance, the historic S&P 500 PE Ratio mean is 15.57. We believe that over time, prices tend to revert back to the mean. So the current forward PE Ratio of 15.77 as reported by Y Charts seems to be in line unless of course, companies begin to lower their earnings estimates for the coming months and year. If that happens, the market could continue to correct.
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