Predicting market performance in any given year is a lot like predicting heavyweight fights; you assess each fighter's history, weigh it against their opponent, read the "tale of the tape," and put your money down.
For 2016, my market prediction is the same as Mr. T's Clubber Lang from "Rocky III": Pain!
Asset classes and markets all over the world are going to get rocked by volatility "body blows." And just like any fighter who takes too many of those, the markets' doubling over is almost guaranteed.
Unprepared investors are going to get hurt. Here's who they'll have to thank for it – and how we'll dodge the blows.
Socialized Risk with Privatized Gains
In a nutshell, we're here by means of massive manipulation. Central bank manipulation.
Instead of letting free markets clear excesses and allowing deleveraging to work its way through economies and bank balance sheets after the latest crisis in 2008, central banks dug deeper holes – where they buried interest rates and big bank losses.
According to data compiled by David Stockman, the former Director of the Office of Management and Budget under President Ronald Reagan, central banks have overseen an unprecedented "$185 trillion of worldwide credit expansion over the last two decades." In other words, "global credit expanded by nearly four times the gain in worldwide GDP."
In the United States, in particular, these credit distortions manifested themselves most prominently in the oil sector and in financial engineering by listed companies.
For instance, West Texas Intermediate crude topped $145 a barrel in the summer of 2008, just before the credit crisis hit its boiling point. At that time, oil industry capital expenditures (capex) exploded, based on the (mistaken) belief that Indian and Chinese crude demand would continue, and global demand for American shale oil would rebound.
Of course we know that's not what happened.
Low interest rates really helped fuel capex in the notoriously expensive-to-finance oil patch. In just 10 years, oil industry capex went from $250 billion a year in 2004 to $700 billion a year in 2014.
Globally, mining companies followed the same path, increasing capex on the back of low interest rates to ramp up production to meet "expected demand."
And that's how oil and mined commodities became overinvested, and why we've experienced huge amounts of stockpiling, overproduction, and imploding prices.
But that's only part of the problem…
On the other hand, U.S. corporations, instead of ramping up capital expenditures with cheap money, have been using low interest loans to buy back their shares to lift earnings-per-share multiples and support their stock prices.
The transformation of C-suites into stock trading rooms resulted in more than $3 trillion worth of U.S.-listed companies' shares being bought back in the past five years.
So now we have oil and mined commodities prices collapsing, and stock prices that have been artificially pumped up for years are beginning to retreat.
Volatility is about to explode.
Now, the large sovereign wealth funds, which once increased their assets exponentially thanks to increased revenue from oil and commodities, are facing wicked budget deficits as that revenue implodes. They're going to have to sell hundreds of billions in assets into increasingly volatile, sickly global markets – and they probably won't have much luck with it.
In spite of the fluffed up earnings-per-share multiples that caught investors' attention and boosted U.S. stocks to all-time highs in 2015, analysts – who in March 2014 predicted earnings of $137 for the S&P 500 by the end of 2015 – ratcheted down consensus earnings estimates by 25% to $104 by 2016.
Now declining earnings estimates – coming on the heels of leveraged buybacks that pumped up stock prices and the realization that trillions of dollars were hoarded to generate future revenue – are about to add exponentially to stock market volatility.
Then there's China.
More than two decades of unfettered growth, aided and abetted by a growing shadow banking sector devoid of adequate credit monitoring facilities or reserves, resulted in a fantasy economy believed to be immune from either business or credit cycles.
Whether it's the millions of unoccupied apartments built in China's growth frenzy, or the billions of tons of its stockpiled commodities, or the still-producing steel mills and manufacturing plants pumping out products sitting on loading docks headed nowhere, reality is hitting the Chinese economy.
Then there's everything else markets are facing – this is not even a full list:
- Rapidly growing Middle East tensions
- China's island building and militarization in the South China Sea
- Diverging central bank policies
- Rising interest rates in the United States
- A stronger U.S. dollar
- Decreasing liquidity in global markets
- Peaking profits
- Cybersecurity threats
The net result will be increasing volatility – make that extreme volatility – in 2016.
What Investors Can Do in a Volatile 2016
Investors who won't be able to withstand repeated volatility body-blows will need stop-loss orders 5% to 10% below where their portfolio positions reside now. For some investors, it's better to be on the sidelines sitting on cash waiting out a storm than trying to ride it out and hoping losses will be made up in your lifetime.
On the other hand, if you're a heavyweight fighter and you know you can rope-a-dope volatility and use it to your advantage, this year is going see you crowned world champion. Yesterday I shared with Money Morning readers a few of my favorite investments for a volatile 2016 right here.
As a trader, I'm thrilled about the coming extreme volatility. The more the merrier for me and my newsletter subscribers. We've been waiting for it, it's here, and it's going to get intense.
Learn more about Shah Gilani's products here – his free newsletter where he updates readers on investment opportunities twice a week, and his paid investment services, Short-Side Fortunes and Capital Wave Forecast.
About the Author
Shah Gilani boasts a financial pedigree unlike any other. He ran his first hedge fund in 1982 from his seat on the floor of the Chicago Board of Options Exchange. When options on the Standard & Poor's 100 began trading on March 11, 1983, Shah worked in "the pit" as a market maker.
The work he did laid the foundation for what would later become the VIX - to this day one of the most widely used indicators worldwide. After leaving Chicago to run the futures and options division of the British banking giant Lloyd's TSB, Shah moved up to Roosevelt & Cross Inc., an old-line New York boutique firm. There he originated and ran a packaged fixed-income trading desk, and established that company's "listed" and OTC trading desks.
Shah founded a second hedge fund in 1999, which he ran until 2003.
Shah's vast network of contacts includes the biggest players on Wall Street and in international finance. These contacts give him the real story - when others only get what the investment banks want them to see.
Today, as editor of Hyperdrive Portfolio, Shah presents his legion of subscribers with massive profit opportunities that result from paradigm shifts in the way we work, play, and live.
Shah is a frequent guest on CNBC, Forbes, and MarketWatch, and you can catch him every week on Fox Business's Varney & Co.