Circumstances are not much better for small-cap stocks and emerging market stocks. The iShares Russell 2000 ETF (IWM) sports a P/E of 20.6 according to Morningstar. It has fallen 6.3% from its late June pinnacle and sits slightly below its long-term 200-day moving average. In another words, Canary Numero 3 is having difficulty vocalizing.
Vanguard FTSE Emerging Markets (VWO) may provide value-du-jour with is P/E of 14, yet China’s recent currency devaluation and Russia’s oil price losses make it difficult for investors to see a forest for the trees. After all, VWO is sitting near 52-week lows and has been in a steep downtrend since May. (The fourth of the four canaries isn’t singing.)
With all four of the classic canaries unable to serenade, the historical probability of a sharp correction for the broader U.S. market increases significantly. What’s more, just like the September-October pullback of 2014, market internals have been deteriorating at a noteworthy pace, whether one is looking at waning breadth of bullish stock participation or widening credit spreads between investment grade and higher yielding corporates/junk corporates.
It follows that a sell-off not unlike the one that occurred in September-October of 2014 is extremely likely to transpire here in 2015. However, there are several differences this time around. For one thing, revenues have declined for two consecutive quarters, making valuations even more questionable than in 2014. In a similar vein, earnings have gone flat. Historically, stocks tend to fade when corporations are less capable of producing top-line and bottom-line results (as opposed to merely beating the analyst estimates).
What’s more, this time around, there’s less certainty of the Federal Reserve defending stocks at the 10% correction level. Granted, Bullard employed a “do whatever it takes” strategy to send stocks skyrocketing last year by bringing up global economic uncertainty. It would be extremely easy for the Fed to use an excuse that economic weakness in Europe, Asia, Australia, Latin America – pretty much everywhere – requires that they tighten at a sloth’s pace. For example, they raise rates at one-eight of a point rather than one-quarter, or they execute a one-n-done quarter-point for 3-6 months. That would likely encourage risk assets to get back on track. Nevertheless, until there is clarity on Fed policy, all of the signs point to “risk-off” outperforming “risk-on.”
Downside risks remain elevated until the Federal Reserve shines light on its game plan going forward. Even if the path for tightening is described as ultra-slow and measured, investors will need to weigh just how much the higher costs of borrowing might adversely impact the cost of debt servicing for corporations; that is, we may see further erosion of profitability from an earnings picture that is already flat.
People, companies as well as countries tend to forget that debt is still debt. If the overall cost of servicing debt is lowered through rate games, and the debts are increased because families/corporations/nations are taking the worm on the fish hook, it does not mean that the hook itself won’t cause severe damage or death. Again, non-financial corporations are more leveraged at 37% than they were in 2007 at 34%. Higher borrowing costs from the U.S. Federal Reserve? That’s going to be more than an inconvenient challenge.
Gary Gordon is president of Pacific Park Financial, Inc.