S&P 500 tumbles 6% on China growth fears, volatility

No one’s ever achieved financial fitness with a January resolution that’s abandoned by February. – Suze Orman

There is an old saying that as January goes, so goes the year and if last week is any indication, 2016 could be another difficult year for the stock market. Both the Dow Jones Industrial Average and the S&P 500 Index suffered their worst start to the year ever as U.S. stocks followed China’s stock market lower on renewed fears that the Chinese economy is slowing faster than initially thought. On Monday, China reported weaker than expected manufacturing data, contracting for the tenth straight month. To combat slower economic growth, Chinese policymakers took steps to devalue their currency, the yuan, in order to boost exports and reignite growth. As China’s stock market plunged, a new circuit breaker system designed to limit losses was implemented and trading was halted twice and then suspended. This only exacerbated the situation by making the problem worse and by Friday, Chinese regulators abandoned the use of circuit breakers. All of these developments undermined investor confidence and created more uncertainty over what policies Chinese officials might implement next. Heightened geopolitical tensions between Saudi Arabia and Iran as well as reports that North Korea had successfully detonated a hydrogen bomb also caused jitters among investors.  In the U.S., economic data was generally mixed last week but all of the employment-related data was strong. Jobless claims fell and remained below 300,000 for the 44^th consecutive week, a sign that the labor market remains healthy. The ADP private payrolls report showed that 257,000 jobs had been created while the December government employment report released on Friday showed an increase of 292,000 new jobs, much better than had been expected. The October and November numbers were also revised higher. The unemployment rate remained at 5% and average hourly earnings actually fell by one cent as wage growth is still muted. While the stock market initially cheered the report and was up substantially in pre-market trading, the gains evaporated throughout the day and the market closed lower. This jobs data confirms that the U.S. economy remains strong, but investors are likely to remain focused on developments in China, where uncertainty could lead to more volatility in the near-term.

Last Week

Both construction spending and factory orders in November fell slightly and the December Institute for Supply Management (ISM) Manufacturing Index dropped to 48.2, below expectations and below the 50 threshold that indicates contraction. Manufacturing only represents about 12% of the U.S. economy, though. The ISM non-manufacturing or services sector index, by contrast, registered 55.3 in December, comfortably in expansion territory.

Minutes from the most recent Federal Reserve meeting showed that members were divided on whether or not inflation would reach their 2% target. While Fed policymakers expect four interest rate hikes of 25 basis points each by year-end, some members were wary of any further increases if inflation remains low. Contributing to low inflation, the price of oil fell to below $35 a barrel last week as inventories remain high.

For the week, the Dow Jones Industrial Average dropped 6.2% to close at 16,346 while the S&P 500 Index declined 6.0% to close at 1,922. The Nasdaq Composite Index fell 7.3% to close at 4,643.

This Week

The producer price index (PPI) for December is expected to decline slightly due to weakness in energy and food prices. Industrial production for December is also forecast to show a modest decline, similar to the drop in factory orders and construction spending last week. December retail sales, on the other hand, are expected to post a slight increase. The January Michigan consumer sentiment index is also expected to show a small increase over the reading last month.

This week officially kicks off the fourth quarter earnings season as aluminum giant Alcoa releases its profit report on Monday. The rest of the week will be dominated by financial companies as JP Morgan Chase, U.S. Bancorp, Wells Fargo, Citigroup and PNC Financial Services are due to report. Two other prominent companies on the calendar are CSX and Intel.

Portfolio Strategy

Although last week was the worst beginning for both the Dow and the S&P 500 in history, investors can take comfort in the fact that since 1950, most negative starts have been followed by positive returns for the year. In many ways, the sell-off in stocks was reminiscent of the August stock market correction in which investors feared that China’s currency devaluation would have negative consequences for global markets. Instead, China stabilized, the U.S. economy continued to grow and the S&P 500 Index rebounded strongly to erase the losses. While no one has a crystal ball, this same scenario could happen again. The S&P 500 now trades for less than 16 times estimated earnings for 2016 and stocks look attractive relative to Treasuries, investment grade bonds and cash. This benchmark also has an earnings yield (inverse of the price earnings ratio) of 6%, which is higher than bond yields and inflation. In addition, the current dividend yield of the S&P 500 is 2.3% compared to only 2.1% for the 10-year Treasury. This has seldom happened in the past. To be sure, many strategists have reduced their earnings estimates this year as low oil prices will reduce profits in the energy sector and a strong dollar will have a negative effect on earnings of exporters. This expectation could already be reflected in the market. While third quarter corporate earnings beat lowered expectations, it is entirely possible that fourth quarter earnings could do the same thing. For the stock market to regain its footing and recoup last week’s losses, both quarterly earnings reports and company guidance will have to be positive.