The global economy may be growing, but that doesn’t mean smooth sailing for stocks and bonds in 2016. The market experts on our panel see a potentially rocky year ahead; here’s how they—and you—could profit from it.
After more than six years of rising stock prices and sky-high bond valuations, investors braced themselves for a tumble in 2015. Instead, they got a seesaw year in which major U.S. indexes stayed relatively flat—even as China’s slowdown, plummeting oil prices, and a looming interest-rate hike gave them night sweats. There was plenty of anxiety and volatility, and not much clarity.
To supply some of that precious commodity, Fortune convened our annual roundtable of market experts to talk about where investors might make money in 2016. Our panel included James Chanos, president of $2.5 billion hedge fund firm Kynikos Associates; Kate Warne, investment strategist at brokerage Edward Jones, which oversees $888 billion; Deven Parekh, managing partner at Insight Venture Partners, a tech-focused venture capital firm that has raised over $13 billion; Savita Subramanian, head of U.S. equity and global quantitative strategy at BofA Merrill Lynch (BAC), which has $1.9 trillion under management; and Shawn Driscoll, portfolio manager of T. Rowe Price’s $5.2 billion global natural-resources equity strategy. Here, edited excerpts from their discussion.
Moderator: Joshua M. Brown, CEO, Ritholtz Wealth Management
Joshua M. Brown: Ladies and gentlemen, as of this week the S&P 500 is essentially flat for 2015. Earnings are basically flat, and revenues are actually down 4%. We have stock market multiples that are slightly elevated, but that’s because rates are very low. Do we think that this is probably the way things continue for a while?
James Chanos: Well, it’s even worse than you said, Josh, because earnings not only are down, but actual GAAP earnings are down for the S&P 500, and more important, the dispersion is even not as great as you think. Excluding oil, earnings are up slightly, but without share buybacks, they’d be down per share. And that’s the other key thing: We’ve had financial engineering keeping earnings per share up for a while.
Kate Warne: We have all the companies talking about how they’re making earnings in the rest of the world, but when they bring them back into dollars, they’re down. Part of it is the drop in oil. Part of it is the stronger dollar. If you take those two things out, we don’t have strong earnings growth, but we actually do have some earnings growth, and that’s actually really important.
Deven, as a tech investor do you have a view on that?
Deven Parekh: Insight is obviously focused more on technology, and we’re still seeing relatively strong growth in the underlying investment. If you look across almost every sector of GDP, nothing has had the growth that that sector has had over the past five or six years. By some estimates, the software market alone has roughly quadrupled in size over the past 10 years, to $400 billion–plus. The other thing that we see is that non-tech revenue growth has been challenged. A lot of earnings growth has come from expense reductions. That story can only last for so long.
Kate, you’ve said without earnings growth, it’s tough to make a bullish case based on current stock prices. Where will we see growth come from?
Warne: We don’t expect to see such a large drop in oil prices over the next year. Nor do we expect such a strong rise in the dollar. The rest of earnings growth, yes, is partly due to financial engineering, but is also due to cost cutting and to some of the mergers we’re seeing. I think we see single-digit earnings growth next year if those two factors hold.
Savita, what’s the view from Bank of America Merrill Lynch on earnings growth?
Savita Subramanian: Next year could be a better year, for these two reasons: We’re forecasting about half as much dollar strength next year as what we saw this year—that’s less of a drag on S&P earnings. If oil prices stabilize, that could again represent a removal of this massive headwind that we saw this year.
Shawn, you’re in the resources space. You’ve been bearish on energy and other commodities. Do you see more of the same? We went below $40 on crude in November.
Shawn Driscoll: I would say there’s more pain to go in oil, and that’s why I probably have a different view than some of the people here about how 2016 is going to shake out.
I see oil going down to operating cash costs, which we think are $25 to $30 a barrel. We think the oversupply will persist for 2016. It was roughly 2 million barrels a day. We think it’s going to be roughly 1 million barrels a day in 2016. When oil prices hit the $10 low in 1986, OECD [Organization for Economic Cooperation and Development] days of inventory were at about 70 days, and our models would suggest we’re going to hit that in June or July.
And frankly, if we see that, there’s worrying signs in the high-yield market. Energy and metals and mining represent about 20% of the high-yield index. I could see tightening in credit conditions as a result of a credit event around commodities, and my guess is 2016 is going to be pretty disappointing as a result.
If crude oil sees $30, what does that do to stocks? Conceivably the headlines would be about carnage of North American–focused producers, and there might be geopolitical ramifications as well.
Subramanian: Sure, it’s not a great scenario. I think that we would see a little bit more of the same of what we’ve seen over the past six years, which is that the market has basically assigned premiums to two areas. One is safe dividend-yield or defensive bond-like stocks, and the other is idiosyncratic companies like tech, like biotech, which have no cyclicality but just have really strong growth way out in the future.
So we would pay up even further for companies that are divorced from the economic cycle?
Subramanian: Exactly. We could see multiples go through the roof for those two areas of the market.
Warne: I think that the other thing to ask is how long oil prices stay in the 30s, because you do get a lot of production capacity shutting down—at that point, you have many producers who aren’t covering their costs. Then what you’ve got is a situation where you finally get the capacity reduction that everybody has been waiting for.
Shawn, do you share that view, or do you think it’s a more prolonged downturn?
Driscoll: In 1986, we hit $10, and within 12 months, we were back to $20. But it was a long bear, and I think if we’re right, and there’s an event in the credit cycle, that’s going to take a little while to wash out. I think the new 10-year normal for oil is about where we are, 40 bucks. I think the real oil price over 150 years is in the 30s in 2013 dollars. Productivity and new technologies have changed the cost curve and collapsed it. We do not believe that oil prices can re-enter a new secular bull market until productivity rolls over and the cost curve re-steepens.
So, Jim, I want to go to you on commodities. Crude oil is down 63% from its peak. Since 2011, silver is down 70%. Gold is cut in half, just about. Copper is down 55%. Can you actually have global economic growth with raw materials having literally no floor?
Chanos: We’ve done a lot of work on the commodity cycle and found some interesting numbers, to frame what happened in the ’90s and then into the millennium. Global capital spending for the big publicly traded miners went from $4 billion a year in 1991 to $14 billion a year in 2001. And that was really good growth in the ’90s. China entered the WTO [World Trade Organization] in ’01. And then the game went on steroids. Global mining capex went from $14 billion a year in 2001 to $125 billion a year in 2012.
That is basically the story of emerging markets and China over the past 15 years. And it’s not just China: 30% of global GDP is either China or the people that sell to China, i.e., Australia, South America, Africa. So a third of the globe is now basically downshifting (depending on your view of China’s accounting) either dramatically or at least at a reasonable glide path. That’s going to be a drag on general global growth because China is one percentage point of global growth, and the rest of emerging markets selling to China is about one point. That’s a pretty strong headwind. I think we underestimate the knock-on effects that China’s 15-year, once-in-a-lifetime urbanization meant for the rest of the world. It was an immense stimulus program, and it’s winding down.
We keep saying tech is this idiosyncratic engine of growth. Facebook is now a $300 billion market cap company. Google is past $500 billion. Are there enough opportunities that haven’t been fully exploited? And where else can investors find growth?
Warne: I think lower commodity prices are benefiting not just tech, which isn’t very commodity intensive, but consumer staples, consumer discretionary companies.
I’d look at companies like Pepsi (PEP), where basically you’re still getting that growth, not because there’s lots of demand growth but because there’s lower commodity prices coming in.
More broadly, look for companies that can consistently deliver earnings growth due to their sustainable competitive advantages and that also have a track record of raising their dividends. Consumers are nesting and connecting, so look at Lowe’s (LOW), which is benefiting from the housing rebound and faces limited online competition. Visa’s (V) above-average growth should continue as consumers worldwide shift away from using cash. Novartis (NVS) has one of the best drug pipelines in the industry, and the aging global population means rising demand for all three of its business lines.
Deven, where are the opportunities for the investor looking at 2016 and saying, “I want growth, but I don’t want to feel foolish if the cycle does turn?”
Parekh: You mentioned that in tech the rich are getting richer. And that’s true in certain subsegments. Internet advertising (like Facebook (FB) and Google (GOOG)) would be a great example of that.
But software provides a different case in point. If you look over the past five years, and you analyze the market in three categories—the top 10 companies in revenue, and then 11 through 100, and then the rest of the industry—companies one to 10 over the past 10 years have lost market share, 11 to 100 have basically been constant from a market-share standpoint, and the rest have picked up about 11 points in market share.
The entire pie has doubled in terms of actual dollars over the most recent five years. There are very few industries where you can have that much growth in emerging companies, have the total pie grow, and also where every sub-sector has grown.
So what areas within software should investors be looking at? Is it cloud? Is it CRM [customer relationship management]?
Parekh: We focus on enterprise software, and then we focus on consumer Internet. We believe there’s still tremendous opportunities in both sectors.
We talked about this a little bit earlier, about how everybody wants to talk about software, whether it’s eating the world, or it’s disruptive. I view software much more as enabling the world. There’s not a business process that software doesn’t enable: Whether you go to the ATM in the morning or you get into a cab, software is touching a bigger and bigger percentage of that interaction.
If you talk to Fortune 500 companies—and we spend a lot of time talking to them—all of them say their highest return on investment, from a capex standpoint, is in software.
And so they’re all generally increasing IT budgets. IT budgets have been on a 15-year growth path. I think they’ll be on another 15-year growth path. There will be industries like oil and gas which will probably invest less in IT in the short-term, but you’re always going to have one industry going through a cycle.
The reason why I’m not as bought into everything having to be disruptive is illustrated by consumer [financial tech]. There’s a whole world of consumer-focused fintech that’s been funded—for example, lending clubs and funds transfers businesses. These companies are aiming to disintermediate areas of Citibank’s (C) and other large banks’ overall broad-based business.
One of the things that people underestimate is that financial brands still have value. We’re not investors in Lending Club (LC), but if you were to ask them which is one of their fastest growth channels, they will tell you it’s direct mail, which is not really sexy. And if you think about their unaided [brand] awareness, my guess is it’s not very high.
However, if you think about Citibank’s unaided awareness, it’s extremely high. So what are banks doing? They’re not under-reacting to this disintermediation; they’re actively coming up with better technology solutions to provide similar services to their consumers, or acquiring the startups with the same business models but next-gen technology. This is true across lots of industries.
Shawn, in energy and resources, where can we make money next year?
Driscoll: There are a couple of ways that I’m trying to create alpha in our strategy. One of these is gas LDCs—[local] distribution companies that provide natural gas for heating purposes. The infrastructure to get the gas to your house is really old, and the need to replace those pipelines from the 1970s allows these companies to grow their rate bases.
There are upper-single-digit growth companies that will do well in a turbulent economic environment. You’re getting 3%-plus dividends on top of the underlying business growth. Atmos Energy (ATO) and NiSource (NI) are the two we like the most in this area. I think both are potential [acquisition] targets, where we have the possibility of capturing significant upside in a single day.
The other area that I like long term is the specialty chemical area. They’re at the end of the chain as far as petro-chemicals are concerned. So their inputs are theoretically falling, but they sell brands to consumers—they don’t have to lower prices. One of our biggest specialty chemical holdings is RPM International (RPM), which sells coatings primarily into the U.S. construction market through big-box retailers. It owns brands like Rust-Oleum and DAP. It also plays well into our structural view that the consumer wins at the expense of commodity producers. It has raised its dividend 41 years in a row.
Savita, where should we go in 2016?
Subramanian: Look, I mean everything that everybody has talked about suggests pretty strong disinflationary forces on the markets. Uber is putting pressure on taxi prices. Hotels are being hurt by Airbnb. Demographics is another disinflationary force at play, where the elderly spend less on stuff like clothes and cars and more on health care.
I think that companies with pricing power are going to win, and pricing might be more important than it’s ever been in a disinflationary environment. And what’s kind of surprising is that a lot of companies with pricing power reside in these big global brands. Companies like Disney (DIS): Even through the worst recession that your middle-class American has ever felt, we were still willing to pay 6% price increases a year to take our children to theme parks.
The last thing you’ll stop spending money on is your kids.
Subramanian: You’re going to continue to spend on your kids because they whine, and you want to make them happy. That’s just one example. But any company that can really price is where you want to be.
Your research recently pointed out that there have been seven consecutive weeks of outflows from small-caps. And you’ve said that’s corresponding with weakening fundamentals for the companies themselves and the view of a likely rate hike not being necessarily great for these companies. Is that a theme that you think continues?
Subramanian: Yeah, I think we could be in a bull market that’s again led by larger mega-cap companies. Small-caps are the ultimate credit plays within equities. They rely on capital to grow, and as that cost of capital increases, we’re seeing hiccups in the credit market. We’re seeing issues—fundamental growth within small caps has been anemic.
Interestingly, stocks with credit sensitivity are starting to take it on the chin. Note that S&P 500 companies with high-yield debt are trading at a discount to S&P companies with investment-grade debt for the first time since 1994. The market is getting rational again—we are being compensated for taking risk and are paying up for safety. And I think this environment will continue.
Jim, what do we do with our money next year?
Chanos: Well, since I’m a glass-half-empty kind of guy, I’m going to tell the viewers and the readers maybe some places they should avoid. Nobody’s talked about health care, and although health care costs have begun to slow as a percentage of total economic growth and as a percentage of GDP, one of the things that’s happened in 2014 and 2015 is that the actual consumer is paying a higher part of it.
Either because companies continue to cut benefits or because of the ACA [Affordable Care Act], Obamacare, co-pays are higher. And people actually pay more out of pocket. That is having an impact, and it’s going to have a political impact, of course, on 2016 as well. I think the days of real easy unit and pricing growth in health care may be behind us, and those are very elevated prices right now.
So who is the most affected by that? Is that large pharma? Is that biotech?
Chanos: Anybody that’s been dependent on raising prices aggressively as their business strategy is going to be under a microscope, we know that. And I think that, increasingly now, people are going to look at the downside of the ACA. We were short health care in 2010 going into the [passage of Obamacare]. We read the bill, we covered our shorts. I wasn’t smart enough to go long; we didn’t see it was going to be an immense positive for the industry going forward. Those days, the easy growth days, are behind us now, and now we’re beginning to see some of the negatives.
Parekh: Just to echo Jim’s point, I’ll give you a 30-second story: I had to have an MRI, and the insurance company called me and told me that if I used provider A, it would cost $900. If I used provider B, it was $3,000. They asked whether I minded using provider A? They were 10 blocks apart. I asked the agent why I should do this because in this case, I had no co-pay. His answer was that going to the cheaper provider was the only way we’re collectively going to reduce the cost of healthcare. If you think about it, this is an unbelievable answer from somebody from a call center, but in reality this answer was enabled because of technology.
And that MRI was booked the same day. I think that effect, the pricing transparency, technology, is going to come to almost every market.
A version of this article appears in the December 15, 2015 issue of Fortune with the headline “Where Do We Go From Here?”