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Beneath the Turbulence, Some Stabilizing Trends

Stocks have taken a beating, but economic fundamentals in the U.S. remain strong. Look for volatility, and a rebound.

The stock market has opened the year with its worst performance in history amid China’s woes, cratering oil prices and slumping corporate earnings. The good news? Analysts say it will ultimately rebound, as the U.S. economy continues to grow moderately and earnings bounce back, leaving the market little changed for the year as a whole.

“Stocks will probably continue to struggle in the near term, but I’m less negative for 2016 overall, as I don’t see a recession in the next few quarters,” says Michael Sheldon, chief investment officer for West Hartford, Connecticut–based Northstar Wealth Partners, a division of LPL Financial.

When it comes to earnings, analysts expect fourth-quarter profits for the Standard & Poor’s 500 to show a 6 percent slide, following declines in the two previous quarters, according to FactSet Research Systems. After that, they expect earnings to rebound, registering an increase of 6.7 percent for the year as a whole.

Continued economic growth will spark that earnings recovery, analysts say. Gross domestic product has increased at an annualized pace of 2.2 percent since the Great Recession ended, in 2009. Whereas growth is unlikely to accelerate much, it should still help stocks stabilize, says Russ Koesterich, chief investment strategist at BlackRock. He predicts an expansion of about 2.5 percent for this year.

Consumers and the service sector will help boost the economy, Sheldon says. Employment continues to grow, and consumer confidence remains high. Meanwhile, the Institute for Supply Management services index registered 55.3 percent in December. Though that’s the lowest level since April 2014, a reading above 50 percent indicates that the sector is growing.

The fall in stocks so far this year stems from China’s economic weakness, earnings weakness and falling commodity prices. Those factors could continue to pressure the market in the next few weeks, analysts say. As for earnings, analysts’ expectations for fourth-quarter results have declined by 20 percent since the start of the year, according to FactSet, as the strong dollar, global economic weakness and slumping oil prices weigh on results. Apple reported Tuesday that its revenue total ($75.9 billion) fell short of analysts’ expectations in the fourth quarter. The company expects its sales to decline this quarter for the first time since 2003. Greater China accounts for 24 percent of Apple’s revenue.

The U.S. industrial sector is getting hammered by the drop of oil and other commodity prices. The Bloomberg Commodity index has slid to a 25-year low. And the dollar’s strength has put a damper on U.S. companies with operations overseas. The Bloomberg Dollar Spot index has climbed 9 percent over the past year.

“Investors have to expect more volatility until there are more signs that global economic growth is stabilizing,” says BlackRock’s Koesterich. Euro zone GDP increased just 1.2 percent annualized in the third quarter, and Japan’s GDP grew 1 percent.

The widening of yield premiums for junk bonds over Treasuries also bodes ill for stocks, as it signals credit trouble for lower-rated companies, analysts say. The Bank of America Merrill Lynch high-yield spread totaled 7.88 percentage points Tuesday, up from 5.39 points a year ago. “Typically, when spreads widen, equity market volatility rises, and we’ve seen that this time around,” Koesterich says.

Analysts say the stock slump could ultimately total as much as 20 percent from the S&P 500 index’s May record high of 2,135. That would put the index at 1,708. It closed Wednesday at 1,860, down 9 percent for the year to date and down 13 percent from the all-time peak. But analysts don’t expect equities to stay down for long.

On the valuation front, price-earnings ratios have dropped this year, thanks to the stock market’s decline, but they still remain a bit above historical averages. The trailing P/E ratio for the S&P 500 registered 16.2 on January 20, compared with its five-year average of 15.5 and its ten-year average of 15.7, according to FactSet. However, other measures of valuation, such as free cash flow yields and dividend yields, don’t indicate overvaluation, Sheldon says. On balance, he thinks, valuations appear neutral to modestly expensive.

When it comes to the Federal Reserve, most analysts expect it will raise interest rates two or three times this year. They say that shouldn’t hurt stocks much, because the Fed has emphasized it will tighten at a very gradual pace. The central bank implemented its first rate hike last month, pushing the federal funds rate target to 0.25 to 0.5 percent.

Nicholas Colas, chief market strategist for Convergex, thinks the central bank will boost rates just once or twice in 2016. If the Fed announced that prior to the fact, stocks would soar, he says. But if that stance becomes clear only over time, which is much more likely, it won’t have much impact, he says.

So, overall, you can expect a lot of volatility but not much of a sustained trend for stocks this year, analysts say. “We’ll probably end the year little changed, but after a very dramatic trip,” Colas says.

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