Stock Markets Decoupled From the Economy?

The stock market wants to crash, or at least correct, but there is something that has not allowed this event to take place. The stock market is supposed to be a barometer for the health of a nation's economy. Its value derives from the expected future earnings of all companies it is comprised, and when we examine the US economy, there has been a major decoupling from wall street and main street; regular folks have not seen the same prosperity.

The bull market rally is now seven years old and has seen equities triple in value. Over the last three quarters, we have seen an earnings recession, that is, year over year returns in the negative. The upcoming earnings season expects companies to see earnings fall 8 per cent from last year's first quarter, but the stock market maintains its valuation. The reason: low interest rates.

We have now entered a global economy where many nations are at zero or negative interest rates, which has never happened in history. And as a result, trillions of dollars invested in low-yielding assets seek better returns in the stock market. This massive demand for higher yielding assets outpaces the selling pressure that traditionally occurs in an earnings recession. Money needs to grow and it needs to grow more than inflation, but dozens of top-tier nations have bond yields that can barely match inflation ten years out. The 10-year Canadian bond rate is 1.23 per cent. The 2015 inflation, according to the CPI, was 1.13 per cent. The Bank of Canada targets inflation of 2 to 3 per cent. In the US, the 10-year bond is yielding 1.69 per cent and its last inflation rate was calculated at 1.00 per cent. The US Fed also aims for about 2-2.5 per cent inflation.

We are days away from Alcoa (AA) earnings, which is traditionally the first day of earnings seasons, but we are just a few short weeks away from the April Fed meeting. Which set of events will impact the stock market more? On days with an FOMC meeting or the release of minutes, the stock market has major volatility in every case. Whether it be dovish or hawkish, the markets rise and fall according to what Yellen and her colleagues do. That is a cause for concern. Whether it be computer traders or money managers, their reactions set a significant tone for the remainder of the week or month. And it also re-affirms the impact an interest rate decision has. The trillions of dollars that have entered the stock market because they cannot make money outside will leave when interest rates rise. And how much of the stock market's value is at a premium because of low interest rates?

The historical price-to-earnings ratio of the S&P 500 is around 17. It is currently estimated at 22.8. If the market were to head to its historical valuation, that would see a market reduction of almost one-quarter. Startling and not unrealistic. We have already seen two corrections in the last 9 months, and unsurprisingly, both corrections recovered within weeks, but if there is a third correction and it is triggered by an interest rate rise, it could be the start of the end of the bull market rally.

Other reasons to support the theory that the market will fail in 2016 comes from its technical patterns. Weakness in many indicators, such as the MACD and OBV, and overbought conditions measured by the RSI, as well as failed attempts at ceilings, could signal the start of another leg down. Cheap option prices have created a great opportunity for investors to protect their necks. The implied volatility of an option rarely favours the long straddler, but we have seen consistently oscillations that make option sellers reluctant to take positions.

On April 6, 2016, an analyst for Bank of America-Merrill Lynch was on CNBC's "Fast Money" and said that the S&P 500 would outperform other benchmarks, which we believe included the STOXX 600, NIKKEI, and other international indices. That's great news for North American investors, however, she also mentioned that their firm believes there is an equal chance that being in cash will outperform the S&P 500.

Let that sink in for a moment. BAC believes that not investing for 2016 could be more profitable than investing. That is not often a phrase said by a firm, especially when firms only make money on transactions. When a firm backs that capital preservation is equal to owning stocks, that raises some red flags. It might just be one rogue analyst whose views don't add up to much when the rest of the industry says otherwise, but it could also be the one rogue analyst who decides it is time to make bolder predictions that do not profit the firm and help the investor.

The truth: we could be wrong. Every trader and doomsday predictor could be wrong. But the idea of selling your stocks if you have owned it through any or all of this extended rally is not wrong. And taking profits is always a good idea when analysts, professionals, money managers, historical trends are all uncertain as to what investment decisions are best for 2016.