Six Easy Predictions for 2016

There is still something to learn from these tried and tired and (sometimes) true annual predictions.

Every year journalists, pundits and shysters feel compelled to make predictions. They may have different reasons for issuing these missives ranging from deadlines, to proving they are deep thinkers or need so headline grabbing marketing material. Here are the lessons we can learn from the usual mainstream calls. Plus, one bold stock prediction you won’t believe!

It Will Be a Stock Picker’s Market in 2016

This tried and trite phrase is always trotted out annually by active money managers. The irony is it’s emphasized by those who underperformed the indices or their particular benchmark as a way of saying last year was anomaly and this year I’ll do better.

The double irony is that a “stock pickers” market is probably the last thing most money managers actually want because let’s face it, the majority of them are lousy at it and they know it.

That’s why most of them are “closet indexers” meaning they basically hug the benchmarks with slight variations by adding/subtracting a few names and adjusting the weightings in hopes of gaining a few basis points of outperformance.

If you don’t think this true then consider the triple irony that 2015 was the most uncorrelated year since the 1999-2001 period surrounding the dot-com bubble and active money managers, including those best of breed hedge funds, has their worst year of both absolute returns and relative returns to their benchmarks in nearly a decade.

In the year following the financial crisis the recovery lifted most equities higher – 2013 in which the S&P 500 gained 25% was the broadest and most correlated bull market in over 45 years. Meaning even those throwing darts did well. Or during the downturn, in which most asset classes from stocks, commodities and real estate fell, they did equally bad.

But in 2015 lack of correlation was not only extreme across asset classes, but within sectors themselves. It should have been a stock picker’s paradise but as noted above there were very few funds of any type that could crow about beating the market.

Here are two graphs that illustrate the divergence not only across asset classes but within the stock market. The first shows the Nasdaq 100 (QQQ) vs. the Russell 2000 (IWM) the Energy ETF (XLE), Emerging Markets (EEM) and Commodity Index (MSCI).

Performance comparison in 2015 12.28.15

This next chart courtesy of shows why the QQQ out performed and that even within that it was only a handful of stocks, the well tale about FANG gang of Facebook, Amazon, Netflix and Google, carried the indices higher. If you weren’t heavily weighted in those names you probably had a lousy year.

Fang vs. NYSE 12.28.15

If you stock pickers, hedge funds and “smart beta” strategies didn’t make hay in 2015 then I don’t know when they will.

The lesson of this perennial prediction: calling for a stock picker’s market is “be careful what you wish for.” Don’t worry stock pickers, just the like the Chicago Cubs, you’ll get’em next year.

My real prediction is once stock picking will again it result in a bagel performance for most money managers. Oh wait, that’s already the hot new stock picking acronym for 2016.

2. There Will Be an Increase in Volatility

Here’s another well-worn prediction that is both generally true and mostly meaningless. Have you ever seen a guest come on CNBC and predicts an extended period of lower volatility? This week Barron’s has a featured article Prepare for Rising Volatility in 2016.

Expectation for higher volatility in the future on the default mode whether stocks are currently catatonic or crashing; if it’s former then the calm can’t last, if the latter then the chaos will continue.

The fact is both are true. Volatility is mean reverting meaning over time it will settle back into its long term average but it is punctuated by unpredictable spikes to extreme levels. Those spikes can very short lived or last an extended period.

Of course given a long enough of time frame there will be periods of elevated volatility. This is the VIX’s natural term structure is one of contango or in which later dated futures carry a premium to the near term or front month. Here is the current term structure in the expectations is for the VIX to climb steadily over the next few months.

Vix Term structure 12.26.15

Of course this slope gets completely bent into backwardation when we get a spike volatility. Over the past decade the VIX has averaged four spikes above 25 per year and one spike above 40 per year. When they come and how long they last can vary widely.

The lesson for this prediction: Don’t try to time market volatility or look at the chart. It is a statistic that is mean reverting over time. In between it we swing between extremes. They only thing we know for sure is that it can’t go to zero.

3. Money Will Continue to Flow Into Passive Exchange Traded Funds

Given the challenges of being a “stock picker” discussed above I have to believe for good reason shift away from actively managed mutual funds and into passive exchange trade funds will continue. Take a look at the money flow trend since the financial crisis through the first half of 2015.

ETFs vs Mutual Funds flows 12.15.15

The number one being the underperformance of said funds. But reason 1a, is the high fees attached to actively managed funds. Investors are finally becoming wise to the fact that assuming reasonably well balanced approach the number one determinant driving long term returns is costs.

Assuming an average annual return of 8% per year the total returns between fund charging 1% and one charging 2% annually would be 450% vs 210% over a 20-year period. That’s massive 240% spread is most likely the difference between a comfortable retirement and ramen noodles every night.

The lesson for prediction; most investors should stick with the long term plan of using low cost exchange traded funds to track the broad market. Their main “activity” should be asset allocation and rebalancing on no more than a quarterly basis.

4. The Fed and Interest Rates Will Not Matter

We’ve spent the past three years plus analyzing every word the Fed has said and trying to predict their every move. I don’t think that will change, as each upcoming meeting, which occur about every six weeks, we be previewed to death and then beaten again in a post mortem.

The difference is we now do have the lift-off of zero out of the way and both the stock and bond market reacted completely opposite than the consensus expectations; bonds rallied, banks stocks tanked and the dollar weakened.

Rates will stay low for a while and stocks and bonds will respond to real economic and fundamental business conditions, not the next 25 basis point move.

The lesson for this prediction: You don’t need to fight the Fed, or even ignore it. Just don’t be beholden to it.

5. Chipotle Will Become a Value Trap and Fall 50%

I’ve been a long time bear on Chipotle (CMG) and I lost a money shorting it at various times from 2010 to 2012 when the stock tripled. I finally stepped aside through all of 2013 and 2014 telling myself to wait until the momentum and growth run their eventual course. The time is at hand and share will fall in 2016.

I recently stepped back with bearish positions my Options Wizard Newsletter and this article in September and then here in October prior to its third quarter earnings report.

The returns have been great as the stock gapped down following disappointing earnings and has now accelerated lower in recent weeks in the wake of the E Coli outbreaks. The stock is now down some 30% from the October levels.

CMG Chart 12.26.15

I’ve lock in some gains and still have a bearish stance through some option LEAP spreads. But I will look to aggressively redouble my short exposure if shares climb back to the $600 level as I think they could then drop by as much as 50% over the next 18 months.

Simply put Chipotle is set to become a value trap. The stock was already running into valuation and trend challenges prior to the e-coli outbreak. It traded at 46x earnings but sales growth had dropped towards the mid-single digits. With over 1800 locations it can’t roll out as many new stores per year. There is much more competition. The notion that its food is healthy has been discredited from both a caloric or dietary standpoint and more importantly from a safety issue.

But there will be plenty of people trying to find bottom. This weekend the Wall Street Journal ran an article already walking investors down the “buy the dip” path by emphasizing that other restaurant companies in the past have usually recovered pretty quickly after foodborne disease outbreak citing “how in December 2006 when reports began to surface of people becoming ill with E. coli that health authorities linked to Yum Brands (YUM) Taco Bell chain and more than 70 people ended up getting sick. Same-store sales at Taco Bell fell only 5% in the fourth quarter of 2006, and recovered soon after.”

The big difference is that at that point YUM was already trading at just 14x earnings whereas CMG was trading above 40x. And Chipotle is already experiencing a 25% to 30% decline in sales which it expects to continue for at least the next two quarters as it still has located the source and needs to completely revamp its food purchasing and processing structure.

The massive growth phase behind it Chipotle and its shares will continue to trend lower as its stock readjusts to a historically normal multiple in the 15x to 18x range. It currently trades at 32x so assuming nothing changes (and I believe it could actually have declining earnings for years to come as it is no longer the brand it stood for) we are looking at 50% decline or to near the $250 level.

The lesson for this prediction: Sometimes it takes an external, or exogenous event to provide a catalyst but ultimately valuation matters. Despite the recent decline in price the shares remain overvalued. Don’t get caught holding this bag.

6. Listicles Will Continue to Make Headlines

I actually don’t have a number six, and you probably lost count by now anyway. But just as I relied on a numbered list to title this article so will every other writer and publisher from Buzzfeed to the New York Times will increasingly use the format to lure readers. It’s catchy, provides expectations and lends itself to both mobile and clicking through photos and videos.

And you always have to have one item , in our case #5, that can be put in the headline that “will blow your mind!”

The lesson from this prediction: I’ll explain with six of the most mind blowing stats you’ve ever seen… next week.

Until then, have a great one and we’ll do it again next year.

— Steve Smith

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About the Author: Steve Smith