OVERNIGHT

Chinese manufacturing continues to plague hopes for a return to a stronger economy. The spillover effect hurt Asian shares overnight, the WSJ reports. Here's the story.

Shares across Asia tumbled Monday, the first trading day of the year, after the latest signal that China’s economy is stalling. The Shanghai Composite Index fell 3.4%, the smaller Shenzhen Composite is down 4.5% and Hong Kong’s Hang Seng Index fell 2.1%. Japan’s Nikkei Stock Average was down 2.6% while South Korea’s Kospi was down 1.6%.

Markets around the world were closed Friday for the New Year’s holiday.

ENLARGE

China shares are lower on the first trading day of 2016. PHOTO: AGENCE FRANCE-PRESSE/GETTY IMAGES

The losses in the region deepened after a private gauge of Chinese manufacturing activity continued to weaken. The Caixin China manufacturing purchasing managers index fell to 48.2 in December from 48.6 the previous month. A figure under 50 indicates contraction.

“I think this will raise expectations of more government action to support the economy,” wrote Andrew Sullivan, managing director at Haitong International Securities, in a note, adding that manufacturers continued to trim their staff numbers.

China’s manufacturing sector remains plagued by overcapacity, falling prices and weak demand. While an official gauge of Chinese manufacturing, released Friday, edged up to 49.7 in December from 49.6 a month earlier, signaling a slight gain in momentum, the figure indicates factory activity is continuing to contract.

As nearly everyone knows China is one of investors' major concern going into the new year. So the above is not the auspicious kick off to 2016 many we're hoping to see. Yes, it's early and it's only one indicator, but perception, not old men, rule.

NEVERMORE

In Edgar Allen Poe's "The Raven" he mentions nepenthe, a pain killer, the drug of forgetfulness in Greek mythology. Versed might be the modern-day version. But the problem with pain killers, God bless 'em!, is they mask the real problem.

This weekend's edition of the WSJ runs a piece about 2016 and what 12 critical thinkers think. One of them is Nassim  Nickolas Taleb, the well-known author and former Wall Street trader, "The Real Risks to Worry About."

 How should we think about financial risks in 2016?

First, worry less about the banking system. Financial institutions today are less fragile than they were a few years ago. This isn’t because they got better at understanding risk (they didn’t) but because, since 2009, banks have been shedding their exposures to extreme events. Hedge funds, which are much more adept at risk-taking, now function as reinsurers of sorts. Because hedge-fund owners have skin in the game, they are less prone to hiding risks than are bankers. 

The point about hedge funds being less prone to "hiding risks" is questionable for many reasons, not withstanding their performance the past few years (See a companion article in the same edition:  "Wasted Opportunity:Hedge Funds Falter) and the well-publicized corruption issues over the years.

The comment about banks is also suspect if for no other reason than their history of selective amnesia, a point Taleb concedes with banks "have not gotten better" in measuring risks. One could easily argue that tax-payer financed bail-outs are the public version of nepenthe.They mask the real problem.

This isn’t to say that the financial system has healed: Monetary policy made itself ineffective with low interest rates, which were seen as a cure rather than a transitory painkiller. Zero interest rates turn monetary policy into a massive weapon that has no ammunition. There’s no evidence that “zero” interest rates are better than, say, 2% or 3%, as the Federal Reserve may be realizing.

I worry about asset values that have swelled in response to easy money. Low interest rates invite speculation in assets such as junk bonds, real estate and emerging market securities. The effect of tightening in 1994 was disproportionately felt with Italian, Mexican and Thai securities. The rule is: Investments with micro-Ponzi attributes (i.e., a need to borrow to repay) will be hit. 

Though “another Lehman Brothers” isn’t likely to happen with banks, it is very likely to happen with commodity firms and countries that depend directly or indirectly on commodity prices. Dubai is more threatened by oil prices than Islamic State. Commodity people have been shouting, “We’ve hit bottom,” which leads me to believe that they still have inventory to liquidate. Long-term agricultural commodity prices might be threatened by improvement in the storage of solar energy, which could prompt some governments to cancel ethanol programs as a mandatory use of land for “clean” energy. 


His comment about Dubai might well be true until the recent "divine vengeance" uprising.

We also need to focus on risks in the physical world. Terrorism is a problem we’re managing, but epidemics such as Ebola are patently not. The most worrisome fact of 2015 was the reaction to the threat of Ebola, with the media confusing a multiplicative disease with an ordinary one and shaming people for overreacting. Cancer rates cannot quadruple from one month to the next; epidemics can. We are clearly unprepared to deal with such threats. 

It's just a difference of opinion, but we would also take issue with Mr. Taleb's scolding of those who scolded others for over-reacting. We're not virologists, but we've been around more than one viral rodeo, probably in a  much more assembly line way than he, irrespective who and what his sources are. Over-reaction mostly from the media is part of the DNA of these outbreaks.

This is not to say it can't happen, but the probabilities are quite small, a subject we suspect Taleb is quite familiar with. In fact, we would argue that the last point in his piece the blackout and what is to come buttresses our point more than his.

Finally, climate volatility will produce some nonlinear effects, and these will be compounded in our interconnected world, in which disruptions are more acute. The East Coast blackout of August 2003 was nothing compared with what may come. 

What we do agree with is his comment about the Fed, no cure just a transitory pain killer. So we will leave you with two stanzas from Poe's masterpiece.

Then, methought, the air grew denser, perfumed from an unseen censer
Swung by seraphim whose foot-falls tinkled on the tufted floor.
"Wretch," I cried, "thy God hath lent thee—by these angels he hath sent thee
Respite—respite and nepenthe, from thy memories of Lenore;
Quaff, oh quaff this kind nepenthe and forget this lost Lenore!"
            Quoth the Raven "Nevermore."

"Prophet!" said I, "thing of evil!—prophet still, if bird or devil!—
Whether Tempter sent, or whether tempest tossed thee here ashore,
Desolate yet all undaunted, on this desert land enchanted—
On this home by Horror haunted—tell me truly, I implore—
Is there—is there balm in Gilead?—tell me—tell me, I implore!"
            Quoth the Raven "Nevermore."

BUMPY OR FLAT?

If there's a Santa Clause rally or absence thereof investors anticipate each year, look no further than January for what's called by many the January effect. In short, it's: so goes the first month of the year, so goes the rest of it.

Flat is the term being used to describe 2015, not an uncommon description since the last flat year for stocks was 2011. Rehashing all the possible market headwinds investors face is a bit like trying to figure out a cauldron of witch's brew. No one is quite sure what the ingredients are and when or if the side effects will appear.

The list one could conjure is long and longer. China, divergence-convergence, the dollar, the Fed, the yield curve, recession, global instability, energy, consumers, manufacturing, toss in whatever you want. You probably won't be too far amiss.

Like any addictive substance the market has it's own symptoms. After the consecutive up years, flat markets are a kind of withdrawal. Is this the start of something more serious? And like the Santa Claus rally the January effect symbolizes a form of investor optimism. Call it hope, sort of a road map of what's ahead. Like three-quarters time, the direction January takes is suppose to be accurate 75 percent of the time.

Here's an interesting read on the matter from MarketWatch as we move into next week. Bumpy or flat, it is what's it's going to be. Your job, as always, should you choose to ride along, is to figure out which. Maybe you're like my new puppy flying around the place like a Nascar driver. Every morning he wakes up ready to play, today, centerfield.

Everything he does is all-in, including sleeping. Not many of us can say that. The globe turned out not to be flat. And so too maybe 2016 won't be either.

Stocks could get a boost next week from the so-called "January effect," when stocks that were sold

IN THE OIL PATCH

It's a six letter word and it begins with the letter b and ends with the letter l.

Okay, here's a hint--energy, as in oil drillers. That's an appropriate description in the eyes of many as another drilling company files for bankruptcy in Texas as a reult of the drop in oil prices. As noted by a story posted on fuelfix.com/blog/2016/01/02/swift-energy-becomes-40th-north-american-driller-in-bankruptcy That's brutal.

HOUSTON – Swift Energy Co. has become the latest U.S. shale driller to succumb to the brutal downturn in crude prices, seeking Chapter 11 bankruptcy.

The Houston driller filed paperwork on Thursday to become the 40th North American oil producer prodded into bankruptcy court as crude exporters Russia and Saudi Arabia keep prices depressed by pumping crude all-out, jockeying for a bigger corner of the global oil market. It was the 20th driller headquartered in Texas to file for bankruptcy in the past year.

Swift Energy, founded in 1979 by Aubrey Earl Swift, had trimmed 60 percent of its capital budget, cut 20 percent of its workforce and reduced its office space to cope with the 68-percent slide in U.S. crude prices over the past 19 months. But like several small rivals, Swift is running out of financial levers to pull.

“The recent collapse in oil prices is among the most severe on record,” Dean Swick, Swift’s chief restructuring officer and a restructuring consultant at Alvarez & Marsal, said in court filings. “Independent exploration and production companies like Swift have been particularly hard hit because they rely primarily on sales of oil and gas to generate revenue.”

In a restructuring deal subject to bankruptcy court approval, Swift has agreed with its creditors to convert its senior debt to equity. Company officials were not immediately available for comment on Saturday.

And here's piece from just four years earlier: stateimpact.npr.org/texas/2011/11/29/by-the-numbers-drilling-in-texas/       

PHOTO BY MIRA OBERMAN/AFP/GETTY IMAGES

County Sheriff Gary Painter stands next to a pump jack outside of Midland, Texas in 2008

Are you curious how many new wells went into the ground over the last year in Texas? How much oil and gas was taken out of it? New numbers from the Railroad Commission of Texas, which oversees drilling in the state, were released today:

• More Permits, More Wells. The commission approved 1,771 drilling permits last month, compared to 1,515 last October. That includes “1,567 permits to drill new oil and gas wells, 57 to re-enter existing well bores, and 147 for re-completions,” according to a commission press release.
• Oil Production is Up. The daily average for oil production in Texas was 1.01 million barrels a day for September. For the month, 30.33 million barrels of crude oil were produced, compared with 28.15 million barrels of crude the September before.

WHERE"S THE INCOME?

The front page story on the latest Barron's leads: "The Top 10 Income Ideas For 2016."

There are still plenty of places to find decent income in stock and bond markets, even with many key interest rates at or near historically low levels. Investors can get yields of 4% to 9% on a range of investments, including junk bonds, utility stocks, telecom shares, and real estate investment trusts. These look appealing in an environment of sub-2% inflation, 1%-to-3% Treasury yields, and minuscule yields on bank deposits and money-market funds. 

Recall that all of those-- utilities, junk bonds, REITs and telecom shares spent much of 2015 under pressure. The part about sub-2% inflation we are willing to debate later. One of the lead stories in today's WSJ reads: "Drug Prices Jolt Middle Class." There are two things about that story, one surprising, the other not so. 

The surprise is there's some pretense that a middle class still exists anymore. As for the other, in "big  pharma," as it's known, what's new? And on that no inflation nonsense, see our recent post financialspuds.blogspot.com/2016/01/and-they-want-to-tell-you about price gouging, a ploy hardly unique to big daddy pharma.

• Yield-oriented sectors of the stock market didn’t generate outsize returns in 2015 despite generally favorable earnings, as investors favored dividend-free or low-yielding growth stocks like Facebook, Amazon.com, and Alphabet. The result is that price/earnings ratios are lower now than they were 12 months ago in utilities, REITs, and telecoms. • A big issue is whether bonds and yield-oriented sectors of the stock market can do well in 2016, with the Federal Reserve likely to continue lifting short rates. The Fed may prove to be a head wind, but the central bank is expected to raise short rates to only about 1% by year-end 2016, and such an increase may be already partly discounted in the market. 

This is the fourth straight year that Barron’s has sized up income-producing investments in both stock and bond markets. What looks best for 2016? 

Topping our list are junk bonds, now yielding almost 9% on average after a weak year dominated by a crash in the energy and commodities sectors. Other areas that look good include dividend-paying stocks, with yields at 3% or more in a range of industries, as well as utilities and REITs. Municipal bonds, which are coming off a solid year in which they bested Treasuries, look good, not great, for the year ahead. 

Pipeline master limited partnerships are on the minds of many individual investors following a 40% sector crash in 2015. Despite the losses, the sector doesn’t look like a bargain, given tougher business and financial conditions in an environment of low energy prices. What follows is our view of 10 income sectors in order of their appeal.

It's one of those pick and choose scenarios and there's much to choose from. Municipal bonds not so long ago were disliked and still don't yield much. Yet in 2015 there were one of the few shining stars in the fixed income area.

Once upon a time a popular television commercial asked: "Where's the beef?" Today, after all this ZIRP, it's where's the income?




 

AND THEY WANT TO TELL YOU

And they want to tell you there's no inflation. But as we keep saying it depends on what you're talking about, who gets to define it and whom it affects. Here's an example of one of today's most downtrodden commodities, natural gas. It's cheap. Real cheap and been that way for a while along with its hydrocarbon cousin oil.

Pacific Gas & Electric is one of the country's largest utilities serving a large part of customers in the northern part of the country's most populous state, California. Keep in mind the term customer here includes all five of the segments you see in the chart above. For an account of an inexplicable, excessive rate hike--some would say rate gouge-- and New Year's Day gift to those consumers read the following. It will make those already fond of big corporations even fonder.

wolfstreet.com/2016/01/01/happy-new-year-americas-largest-utility-jacks-up-rates-the-most-since-2006-despite-total-collapse-of-natural-gas-prices/

THE OTHER SIDE

There's a lot of negativity about commodities in general and gold in particular going into 2016 with many strategists predicting equities are the place to be. And well they might. One of the MSM themes about gold, however, is how poorly its been doing. But that, like many things, is relative.

It's not our point here to push gold. We own the stuff and we will continue to own it. We also own silver, a metal that in many ways has been more debauched than gold. We're just bringing you the other side.

• Some big names still have big holdings in gold. The Moltly Fool points out that John Paulson and his hedge fund group Paulson & Co. own about $900 million worth of shares of the SPDR Gold Trust. Another investor showing confidence in gold is Ray Dalio, founder of Bridgewater Associates, who has said, “If you don’t own gold, you know neither history nor economics.” Paulson and Dalio seem to be demonstrating gold’s use as a hedge against uncertainty in fragile markets.
•  Gold has been falling hard since 2013, being pulled down right alongside the rest of the commodities complex. However, as John Rubino points out in a Seeking Alpha article, this is only in U.S. dollar terms. As seen in the chart below, gold is behaving just fine in Canadian dollar terms, up 7 percent over the past year and which helped offset the negative returns of Canadian stock market which fell 11 percent. Rubino writes, “Protection from currency trouble is why people own it (gold), and why in the vast majority of places its owners are very happy.”

 
 The same holds true for many other weak domestic currencies. Gold priced in Brazilian real surged 31 percent while the Brazil’s top 100 stocks lost 10 percent as shown in the chart below. While the U.S. dollar strengthened with the much-hyped Fed hike in interest rates, history shows that the dollar typically does not get stronger after the first rate hike, so for U.S. investors, now could be an opportune time to rebalance your portfolio of assets.

• Gold bears are claiming that the major banks haven’t been buying gold. Zero Hedge reports that Goldman Sachs expects the price of gold to fall to $1,000 per ounce, while others, including BNP Paribas and ABN Amro expect gold to fall even lower. Zero Hedge points out that when popular sentiment has shifted away from gold.
• According to a Bloomberg report, the U.S. dollar is headed for its biggest monthly loss since August (against the yen) and since April (versus the euro) following the Federal Reserve’s decision to hike interest rates for the first time since 2006. At the same time, the Surprise Index which is a Citigroup measurement of how U.S. economic indicators compare with forecasts, heads for a second monthly decline.
• A group of 10 Wall Street strategists announced their forecasts for 2016, as published on Zero Hedge this week. Five strategists say to avoid materials, four strategists warn against energy, while nearly all were bullish on financials and technology. The forecasts, originally sourced in Barron’s, were brought to light during a Bloomberg TV interview with Marc Faber earlier in the week. Faber stated that the U.S. is headed into recession and rather than be bullish on U.S. equities (as a majority of the strategists were), to instead “be realistic.” 

 advisorperspectives.com/commentaries/20151231-u-s-global-investors-hope-for-the-new-year-3-asset-classes-for-2016

MARKET VEXATIONS

For much of the U.S. market 2015 was not a good year. With six of the 10 S&P 500 sectors down, however, the index was off just 0.7%, not all that bad. The market befuddled many throughout the year owing to the Fed's indecisive action, China and falling energy prices, to name a few of the year's market vexations.

So now it's off to 2016 and whatever vexations it has to offer. With that said: we wish all a good year ahead on all counts.

U.S. stocks had their worst annual performance since 2008, closing out a rocky year that tempered investors’ expectations for gains in 2016.

The Dow Jones Industrial Average, a basket of 30 stocks, lost 2.2% in 2015, while the broader S&P 500 fell 0.7%.

The S&P’s loss ended three years of double-digit gains for the index, but was far from the nearly 40% dive it took in 2008, a year of financial crisis.

The year wasn’t grim across the board. The tech-heavy Nasdaq Composite Index rose 5.7%. Netflix and Amazon.com, the top-performing stocks in the S&P 500 in percentage terms, rose 134% and 118%, respectively. The consumer discretionary sector, which includes stocks such as Starbucks and Expedia, led the S&P 500 with an 8.4% gain.

But broadly, the market struggled. While an extended slump in commodity prices helped drag the stock market into negative territory this year, six of the 10 sectors in the S&P 500 posted losses. wsj.com/articles/global-stocks-set-to-close-year-with-a-whimper

FULL EMPLOYMENT'S MARKET INFLUENCE

There's some debate about what constitutes full employment. From what we read employers are doing everything they can to keep overheads down and that includes hinting more part-time and temporary workers. There is also those energy patch jobs that disappeared and the yet to be fully-felt minimum raise recipients and how employers choose to deal with that.

Indeed, the annualized return of the overall stock market is 50% lower once full employment is reached and many sectors (e.g., Chems, Shops, Durable, Other, and NoDur) produce returns which are only about one-third of what they are when the unemployment rate is above 5%. Full employment brings new challenges for the stock market. Continued economic growth typically produces cost-push pressures eroding profit margins and inflation and interest rates usually begin to rise.

Although full employment does not necessarily end a bull market, it does tend to significantly lower future stock returns. Full employment also typically brings a leadership change in the stock market. Before the economy reaches full employment, returns across the stock market are much higher compared to when the economy is at full employment. Overall, the annualized U.S. stock market total return averaged about 15% when the economy was at less than full employment compared to only about 7% once full employment is reached.

Second, the dispersion of sector returns within the stock market widens considerably once the economy reaches full employment. Before full employment, the stock market sector return differential is only 4.27% (i.e., the difference in annualized returns between the best performing sector and the worst sector . However, the sector return differential widens considerably to 9.31% once the economy operates at full employment.

barrons.com/articles/what-the-low-jobless-rate-means-for-stocks

TIME WILL TELL

The S&P 500 has its own built in indicators at various times. Back in the Internet boom days, tech stocks made up a significant percentage of the index. Here’s another chart you want to keep an eye on, the energy weighting of the S&P 500.

As you can see back in 1998 when oil traded at $10 a barrel it was barely 6% of the index where it trended sideways for some time. Again, in 2008 a similar pattern developed. No single indicator is perfect, but we can tell you both times when it made up almost three times the percentage of the index from where it is today, hardly anyone thought much about selling.The opposite pattern holds true for the low percentages of the index. We don't know how low it can go and neither does anyone else. No doubt you'll hear many warnings about value traps; they do exist. We don't deny that.

 
Around that time we attended a conference where television guru Lawrence Kudlow was all puffed up about the low energy and gold prices, indirectly pointing out gold was dead in its mine shaft. Gold was a little above $200 an ounce at the time. In late 2002 gold started on its nearly 15-year bull market run. At the beginning of this century oil was an MSM value trap. So was gold.

May the force be with you is a popular saying these days. That should be abstract enough not to offend anyone's beliefs or disbeliefs. Some of us were fortunate enough at the time to get trapped in the profit value of the two. Believe us it was difficult to enjoy with MSM lined up so solidly on the other side of that trade for all those years. But as they say: If it doesn't kill you, it makes you stronger.

Some people will tell you it was the market forces that topped gold out. Others harbor a different tale. High gold prices typically translate into failing confidence in fiat paper. Everybody needs an easy, available villain. For the climate change crowd it's energy, human or otherwise. For central bankers it's any and all threats to their printing presses.

Time will have its own tale about those printing presses.

cnbc.com/applications/cnbc.com/resources/files/2015/12/16/