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2016 market outlook: Fasten your seatbelts

For the markets, these are indeed turbulent times. But while there are sectors to avoid, others offer opportunity. So says John Stephenson, portfolio manager and president of Stephenson & Company Capital Management Inc. in Toronto, and a regular contributor to The MoneyLetter. Mr. Stephenson identifies consumer staples, consumer discretionary and technology as three sectors to watch and picks three stocks to buy for 2016.

2016 Market Outlook Markets have been for sale lately. Oil’s sharp fall to seven-year lows has rattled stocks and exacerbated already choppy and nervous markets. The recent further slide in crude prices was prompted by a report from the International Energy Agency saying the global over-supply of crude could worsen in 2016. Continued strong production by the Organization of the Oil Exporting Countries (OPEC) and extra oil from Iran hitting the market next year (as sanctions are lifted) will swell the global inventories by 300 million barrels a day.

In the third week of December, the benchmark for U.S. crude oil, West Texas Intermediate (WTI), fell below US$36 a barrel. This pressured stocks, with the S&P 500 Composite Index logging its biggest weekly decline since August.

Energy market outlook

Falling commodity prices have investors worrying that oil and gas companies won’t have enough money to pay back all of their debt. This has stirred up fears in the high-yield bond market. Further fanning the flames of unrest was the recent announcement that the Third Avenue Focused Credit Fund was freezing withdrawals from a US$788 million credit mutual fund.

Further declines in the price of crude oil—already far below break-even levels for the majority of U.S. shale producers of between US$50 and $60 a barrel—will exacerbate the energy market outlook for wider disruptions across the oil and gas industry. This would trigger a further plunge in energy capital expenditures and increase credit risk, leading to a more broad-based tightening in credit standards.

2016 interest rate outlook

The unrest in the commodity, stock and junk bond markets has continued even after the much anticipated rate increase by the U.S. Federal Reserve. The Fed ended its seven-year experiment with near-zero interest rates on December 16 and emphasized a plan to lift the benchmark rate slowly over the next three years. While ultra-low interest rates have boosted equity markets in recent years, investors were reassured by the Fed’s relatively upbeat outlook on the world’s biggest economy and its go-slow path to future rate hikes. In answering a question that had been vexing investors for many months, the Fed’s 25 basis point rate increase spurred the S&P 500 to a 1.5 per cent gain on the day.

A bumpy ‘liftoff’

But that euphoria was short lived. Just a day after the Fed’s rate decision, another sharp drop in energy shares clipped a three-day winning streak for U.S. stocks. Lower crude and other commodity prices saw further sharp price swings in the aftermath of the Fed’s rate announcement, dragging stocks down with them. The U.S. dollar surged to its highest level versus major peers since 2005 as the Fed’s divergence from other central banks boosted its appeal and further weighed on stocks.

Market outlook for high-yield bonds

The retreat in stocks after the Fed announcement came amid fretting over a number of issues. Some investors remain concerned about the fragility of the high-yield bond sector as the Fed introduces tighter monetary policy. Others worry that the weakness in oil prices is a signal that global growth is indeed shrinking. For some, the stronger dollar represents a powerful headwind for U.S. exporters, which will weigh on future earnings.

Market outlook: China slowdown, commodities rout

The recent Fed rate decision removed a measure of uncertainty on financial markets and added to optimism that the world’s largest economy is on a firm footing. However, it did little to allay concern that global growth remains vulnerable to a slowdown in China and a related rout in commodities. Oil continues to trade near levels last seen during the global financial crisis, stoking worry that junk-rated energy producers won’t be able to remain solvent.

The Bloomberg Commodity Index, which tracks everything from lean hog and coffee futures to natural gas, has hit a 16-year low.

2016 market outlook for interest rates

Despite the good news from the recent Fed rate decision, there is still some uncertainty surrounding the decision. The Fed remained vague about the factors it will monitor to signal subsequent rate increases and the so-called Fed dots were not brought down, suggesting that Fed still intends to hike rates four additional times in 2016. (The prediction of the fed funds rate by each Federal Reserve governor is plotted on a chart. These are called “the Fed dots”.) Because of this uncertainty surrounding the Fed’s most recent action, investors quickly returned their focus to oil prices and high-yield bonds, where concerns are mounting.

Stock market opportunities . . . once commodities bottom

While the market will likely remain somewhat unsettled for a few more months, as commodities find a bottom, investors should use this opportunity to position their portfolios for the year ahead. Once commodity prices do bottom, the link in investors’ minds between weak commodity prices and weak global growth will finally be broken. Investors should expect 2016 to be punctuated by an incrementally higher U.S. dollar, higher rates and stabilizing commodity prices. This relative stability should result in a modest re-rating and higher earnings trajectory for stocks.

What I recommend

With growth scarce, investors should continue to overweight their portfolios towards certain areas: stable, growing investment opportunities in the areas of consumer discretionary, technology and consumer staples. While valuation for these sectors doesn’t scream buy, they are attractively valued versus historical multiples when compared with the broad market.

Growth stocks almost always trade at a premium to value stocks and this time around, the premium is one of the smallest ever. With rates in the U.S. on the move higher, stocks will benefit from a rotation from bonds to stocks, helping to lift valuations modestly for companies that can demonstrate top and bottom line growth.

New tech versus old tech

One trend for the U.S. stock market that looks promising is the rise of new technology. Defined by innovative business models, this contrasts sharply with old technology, including firms active in more commoditized areas that are facing competitive threats. Margins for old tech should remain under pressure.

Technology is broadly divided into three subsections: devices, Internet and software. Within devices, smartphones and tablets have replaced personal computers in recent years, leading to an explosion in mobile data traffic and cell phone usage. Within the Internet portion of technology, consumers are increasingly embracing online retail at the expense of brick and mortar business. In software it is all about application software businesses, which are increasingly shifting toward cloud-based recurring subscription revenue models in favour of licensing.

Visa: High margins plus new growth opportunities

One company that I like that is increasingly being viewed as a technology company is Visa Inc. (NYSE─V), the leading payments processor. The company has new growth opportunities through Visa Europe and in China. These are expected to create the potential for close to mid-teens growth in earnings per share over the next few years.

Margins are very high, at around 60 per cent. In addition the company recently announced new partnerships with Costco Wholesale Corp. and The United Services Automobile Association (USAA), which alone have the potential of creating nearly $120 billion in additional purchase volumes. I have a buy rating and a 12-month price target of $86.50 a share for Visa.

Adobe Systems: Cloud will drive revenue and margin growth

Another stock that is all about a cloud-based recurring revenue subscription model is Adobe Systems Inc. (NASDAQ─ADBE). Management recently suggested that there were more than eight million users of the Adobe Creative Suite who have yet to migrate to the company’s more up-to-date and cloud-based Creative Cloud offering, suggesting there is a lot of runway for increasing margins and revenues. I have a buy rating and a 12-month price target of $108 a share for Adobe Systems.

Delta Air Lines: Benefiting from low oil

While weak oil prices may be giving traders fits, it’s a boon to airlines. My favourite airline is Delta Air Lines Inc. (NYSE─DAL), which continues to put up impressive numbers. The company has maintained its commitment to balancing supply and demand, which is critical for the health of the airline industry.

The stock is very inexpensively valued, trading at less than nine times 2016 estimated earnings and also boasts a ten percent free cash flow yield. I have a buy rating and a 12-month price target of $62.50 a share for Delta Air Lines.

The market outlook for 2016

With weak global growth, investors should continue to be underweight on the more cyclical and economically sensitive sectors—namely the energy, materials and industrial sectors. Imbalances should continue to weigh on the Chinese economy, while the market outlook for Europe sees another year of tepid growth and the U.S. is on track to have its tenth consecutive year of less than three percent growth in gross domestic product (GDP).

In a “slower for longer” economic environment, revenue growth should be modest. This, in turn, will put pressure on chief executive officers to deliver earnings per share growth through continued stock buybacks and expense management, which will push margins higher than their historic norms.

In 2015, the market punished the energy and commodity-related sectors, while rewarding new technology and health care stocks, as well as the consumer staples sector, which demonstrated revenue growth in a challenging market. In our market outlook for 2016, consumer discretionary stocks should continue to outperform, as well as the consumer staples and technology sectors. Sectors such as energy, materials and infrastructure should be avoided as they represent too much of a call option on global and China growth—and these are likely to disappoint in the year ahead.

 

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