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Summary The U.S. stock market and financial system will not suffer meltdown in 2016. But a recession in 2016 is a real possibility. However, a 2016 recession is not likely to be a deep one. You may want to think about your portfolio for a fairly static economy. When I began work on this article on Sunday, December 13, the popular press was awash in doomsaying triggered by the Third Avenue Focused Credit Fund event. In the few days since then, markets have calmed down; the Fed has raised its target rate by 25 basis points, without adverse market reaction; and the brouhaha has generally subsided. Columns in The New York Times and The Wall Street Journal by respected pundits have sought to allay investors’ fears. (See James B. Stewart here and Jason Zweig here .) I have persevered with this article nevertheless, for two reasons: Meltdowns do not go in a straight line, and in most cases they take many months. That considered, the calm of the moment does not provide answers to the questions that have been raised. Going into 2016, many of us are trying to determine our investment posture; as part of that process, we are trying to decide what assumptions to make about economies and markets. There are many pundits forecasting doom and some forecasting excellent things, with many in the middle as well. The Third Avenue event causes rational investors to ask whether it (and the economic and technical forces that caused it) has changed the way we should look at 2016. Possible Snowball and Contagion Effects The closure of Third Avenue Focused Credit Fund on December 10 rattled both credit and stock markets. Will the impact extend in breadth and time as a trigger to a full-scale correction? And will the credit market impacts lead to a U.S. recession? Although I wrote last week that the Focused Credit Fund probably was unique in its level of illiquidity, it nevertheless is possible that its closing could be significant because contagion can reach far beyond the reasonable zone due to a snowball or cascading effect. And once markets correct, they tend to continue going in the same direction and to over-correct. In addition, some pundits are noticing “eerie” associations with Bear Stearns and Lehman Brothers, for whatever such things are worth. The rational conclusion should be that the Focused Credit Fund was unique in important ways, including in the weakness of the credits that it invested in and the illiquidity of its portfolio. But part of the problem with the Focused Credit Fund was that the lowest end of the credit scale performed far worse than the upper end of the high yield market over the last year. I discussed this in my regular column at NexChange.com. What is happening to high-yield bonds? As the following graph from the St. Louis Fed shows, over the last year, CCC-rated bonds have increased in yield from about 7% to about 16%, which implies enormous capital losses, the amounts depending on the duration of the bonds. The higher end of the high yield market has held up much better, but it is in negative territory for the year. (click to enlarge) It would be quite rational for many high yield fund investors to change their minds about the desirability of owning that asset class at this point in the credit cycle. Many investors in high yield funds have been reaching for yield in ways that they are uncomfortable with. They know that high yield bonds can decline in value, and the mindset of many is that they hope to get out before the really bad stuff happens. Now that the really bad stuff has happened to the low end of the asset class, maybe it is about to happen higher up as well, so they want out. If that coincides with the Fed raising rates, as it does (which gives them hope of better returns on less risky investments in the future), the impetus to get out may be confirmed. If many people redeem their high yield open-end mutual fund shares, that will force many such funds to sell bonds, which will tend to depress the prices of those bonds. That might induce more stockholders to redeem, which would keep the snowball rolling. Indeed, that is a likely scenario, at least for a while. But open-end funds are a small part of the high yield picture. There also are high-yield ETFs and hedge funds that invest primarily in the asset class. Those types of funds raise different issues from the open-end funds. ETFs actually may be systemically safer than open-end funds from a liquidity point of view. That is because ETFs do not permit shareholders to redeem their stock; instead, shareholders sell their stock to someone else, who becomes a shareholder at whatever price the two agree on, usually through the medium of the stock market. For every seller, there has to be a buyer. Therefore the ETF does not have to sell any portfolio holdings when a shareholder elects to sell. The stock price of the ETF may decline, but its internal liquidity is not affected. I do not see the ETF as a destabilizing force. Indeed, its structure may even reassure the markets, and the largest high yield ETFs (BlackRock’s (MUTF: BHYAX ) and JPMorgan’s (MUTF: OHYFX ) seem to be holding up quite well, even as they have declined in price. Hedge funds are more like open-end mutual funds than they are like ETFs. That is, their shares are not traded, so when an investor decides to redeem, the hedge fund has to sell portfolio securities. However, hedge funds do not offer to redeem every day. Usually they offer to do so once a quarter-and only with significant advance notice and in limited quantities. Therefore hedge funds could play a minor role in the snowball effect of declining high yield bond prices, but they are unlikely to play a major role. Some hedge funds may decide to liquidate, as a couple seem to have done recently. One of the things I think we learned in 2007-2009 was that hedge funds could liquidate from time to time with little impact on the market as a whole. Hedge funds in the aggregate are now larger than they were then, but as a percentage of the total securities market, they probably are not a significant factor. To repeat, hedge funds do not permit redemptions daily, so they seldom have to liquidate portfolio securities in a great hurry, other than to meet margin calls. Meanwhile, other forms of high yield debt, such as leveraged bank loans, may come under increased pressure. Leveraged loans already are stuck in the pipeline and the regulators are nattering at the banks about risk. Will they unload those loans at a loss? Or will they hold them and take the regulatory heat? The impact on investment grade bonds Will there be a significant impact on the investment grade bond market? The answer is NO. That is because the investment grade bond market trades at fairly small spreads to Treasuries, and investment grade bonds are not likely to be regarded as poor credit risks for which there is no market. Look at what happened in 2008-2009. Although credit dried up for riskier companies, it did not dry up for high-rated companies, which have had almost continuous access to the bond markets (perhaps with few weeks of hiatus in late 2008). Thus far, it looks like the pressure of the high yield bond bust should not have great systemic significance. But we still need to ask who is holding what kinds of debt in highly leveraged accounts. I am going to digress slightly here to discuss what we have learned (or should have learned) about asset bubbles over the last seven years since the Great Recession and accompanying financial crisis. If the Third Avenue event is gong to trigger a significant financial meltdown, then it will do so because there was a bubble in the pricing of some large asset class or classes. (Bear in mind, please, that we already have suffered through pricing implosions in oil and gas and in natural resources used in construction. Any additional price implosion will come on top of those implosions, whose effects are still working their way through the debt markets, with large amounts of actual losses still to be recognized.) Asset Bubbles and Their Dangers: What Have We Learned? Since 2008, numerous conferences and constant study and discussion have sought to understand the nature of asset bubbles in order not to permit a repeat of the housing bubble of 2003-2006. I have participated in some of the conferences and written some of the papers. To be candid, I think we have learned a lot less than we should have learned, given the amount of effort that has gone into the process. For example, we have no good definition of a bubble and no good way to decide when one is inflating. But we have learned some important things. One of the most important things that at least some of us have learned from studying asset bubbles is that the fall in the price of the assets is not what causes the systemic problems. It is the degree of leverage enjoyed by the holders of the assets. That is, how are the assets financed and by whom? Are the assets financed with debt or with equity? If with equity, people or institutions lose money, but there is no significant cascading effect. If, on the other hand, the assets (including bonds and other debt assets-one person’s debt is another person’s asset) are financed with debt and are highly leveraged themselves, then there can be an enormous cascading effect, as sales of the assets cause their price to decline, which causes margin calls, which causes more sales, more price declines, then still more margin calls. That is what happened to mortgage-based securities in the fall of 2008. They were held largely by highly leveraged entities. Are there asset classes that today are held significantly by highly leveraged players? A second thing that at least I have learned from the study of bubbles is that their bursting is systemically dangerous only when accompanied (preceded?) by a serious recession. We all should recall that the recession of 2007-2009 was 10 months old before Lehman Brothers failed, and the stock market top occurred 12 twelve months before that event. The financial crisis of fall 2008 did not cause the recession that began in 2007. As I interpret the data, it was the recession that joined with the high leverage in financial institutions to cause the financial crisis. Reinhart and Rogoff’s This Time Is Different is the best study of financial crises, as far as I know. I have not gone back to check, but thinking about my two readings, I do not recall any financial crises that were not accompanied by recessions. And in correspondence with me, Prof. Rogoff has disclaimed any intention to imply that the financial crises cause the recessions. He has made no finding to that effect. Either one may come first, it appears, and either one may cause the other. An important implication of this learning is that the high price of an asset class by itself does not, historically, cause recessions and financial crises. It is borrowing against such appreciated assets from highly leveraged important financial institutions that causes the big damage to financial systems, which in turn usually exacerbates an already-existing recession. Does it look like high-priced assets are leveraged with highly leveraged financial institutions? The following set of graphs that I have copied from John Cochrane’s Grumpy Economist blog, and he copied from The Wall Street Journal, comes originally from the Federal Reserve Board. Professor Cochrane is worried about the same high leverage in financial institutions that I am worried about. You can see from the first graph that asset prices are in territory that at first may look scary. In total, several asset classes may be higher than will turn out to be warranted by underlying values. Many people say these asset classes are in bubble territory. I cannot tell whether they are in a bubble or whether the prices accurately reflect future value. They do look, however, like they are high by historical standards, and therefore one should be wary that they may be overpriced. But look at the next graph, please, the one in green. It shows that in historical terms, financial institutions are less leveraged and less mismatched than at any time since the graph’s start date of 1990-and knowing something about banks going back to the 1960s, I would guess that the picture is better today than at any time going back that far. The green graph does not tell us all we might want to know about how the assets reflected in the magenta graph have been financed. Some of them may have been heavily financed. But even if so, if they were financed by financial institutions included in the green graph, those institutions are not highly leveraged by historical comparison. Therefore a fall in the prices of those assets seems unlikely to cause a financial crisis-at least in the U.S. (I do not know whether Fannie and Freddie are included in the financial institutions graph. Probably they are not. But they are highly leveraged, except that in practice they have infinite capital in the form of a U.S. government guarantee, as a consequence of which neither their level of current leverage nor the level of losses they might suffer on home loans is relevant to the discussion.) (click to enlarge) Is this good news about the lower risks in the U.S. financial system due to good management, new regulations, better supervision, or something else? It cannot be due to normal cyclicality because the data in the graphs include a couple of cycles. I nominate two causes: higher capital requirements and stress tests. If we want a safer financial system, then we should encourage the continuation of those policies. They are, in my opinion after being on all sides of banking during about a 47-year professional life, the things that can make the system safer. Much of the rest of the regulatory apparatus is, in my view, a waste of time and money. As a consequence of these improvements, I am confident that the U.S banking system can ride out even a fairly severe recession without needing government assistance and with a minimum of bank failures. That means that when the next recession comes, as it will come some time, the economy is not likely to suffer the double whammy that a financial crisis imposes. That does not mean that banks will keep lending freely in a recession. That is highly unlikely, as an article that I will publish in a few days will show. But the lack of credit availability will be due to the usual causes: weak borrowers and skittish bankers who forget that the most profitable loans are made when the economy looks bad. It will not be caused by the dysfunction of the financial system. What else should we worry about? How could a possible recession relate to a hypothetical financial meltdown? Almost all financial crises involve real estate loans. The 2007-2009 event primarily involved residential mortgage loans. But it also involved commercial mortgage loans at the level of the smaller banks and it was commercial real estate loans primarily that brought down Lehman Brothers. Residential mortgages are fairly easy to get a handle on because the vast majority of them are funded by Fannie or Freddie or the HFA-in short, by government authorities that report regularly and that are watched carefully by think tanks such as the AEI’s International Center on Housing Risk headed by Ed Pinto. Not much risk in housing is going to get past Pinto & Co. I confess that I do not keep up with Pinto’s every report. My impression is that housing prices are again high (see the following graph) and that Fannie and Freddie again have excessive leverage. But since they are now owned by the government, losses they suffer merely get wound into any government deficits, and therefore they will not be part of any financial squeeze. The private securitized mortgage market remains moribund. Against that somewhat comforting background, if look at house prices from an historical point of view, based on the following graph of real house prices from Calculated Risk, we can get a bit alarmed because by that measure, prices are high. A few years ago, I wrote an article on U.S. house prices in which I took 1991 as the base year. In real terms, I asked, how do prices stand versus 1991? They were high and they are high. Suppose we take 1997 as the next base year? Still high. 2000? Still high. In fact prices are near 2004 levels, just before the full lift-off caused by the flood of financing through private label securities. But we are not near the all-time high of 2006. Therefore I think it is reasonable to conclude that if prices go down, they will not go down as much as last time, and the financial system is in better shape to absorb the impact of lower prices on the value of related loans and securities built on those loans. (click to enlarge) Commercial mortgage loans are harder to get a handle on than house loans. Commercial loans are owned not only by banks but also in large amounts by REITs, insurance companies and other institutions. The banks seem to be, as I said, in pretty good shape to withstand losses, though smaller banks tend to be heavily invested in commercial real estate because that is the type of collateral most readily available to them. REITs usually are not highly leveraged. Therefore they should be able to sustain losses without creating a snowball effect. Their investors may lose money, but for the most part, they are not highly leveraged. Insurance companies that have reached for yield in the years ZIRP are harder for me to get a handle on. There may be significant dangers there, especially in Europe. The foregoing discussion of asset classes is by no means exhaustive. But it suggests to me that declining asset prices probably can be absorbed by the U.S. financial system. The stock market also does not seem to threaten the financial system. Although pries are high by historical standards, as are profits, the high prices are made to look very high by the increases in price of the FANGs (Facebook, Amazon, NetFlix and Google) and some similar though lesser known companies. The valuations of some of those companies seem outrageous in traditional terms. And the market as a whole is quite fully priced. But that has been the situation for several years. Indeed, the market as a whole did not increase in price in 2015, so there is no reason to see a pressure-cooker type of condition. Although I have been saying for the last few years that there will be a major correction sometime in the next few years, I actually see less reason for that to occur than in the recent past. The market already has suffered a meltdown of natural resources stocks. It is hard to see them declining much further, though some leveraged companies in that sector will fail. Retail stocks are not very highly valued (and should not be, in my opinion). The high prices almost all are in tech-related areas that have outperformed in recent years. But even if that sector declines in price, it seems not be highly leveraged, it seems not to be held by highly leveraged stockholders, and the losses do not look systemic. That is not to say there will not be a next recession. What is likely to cause the next U.S. recession? But even if we think there will be a cascading effect due to high leverage in some asset classes, there may not be the kind of systemic impact that we saw in 2007-2009. That is because of two factors: As the green graph above showed, financial institutions in the U.S. have more capital to absorb losses than they had in the earlier period. The recession of 2007-2009 was well under way by fall 2008, and it was caused as much as anything else by the end of homeowners’ ability to tap their home equity for general spending purposes. The “household ATM” died between 2006 and 2008, leaving households unable to spend but still having to repay. The following graph from Calculated Risk shows how this works. (click to enlarge) I also explained the phenomenon in the first chapter of Debt Spiral and in a Seeking Alpha article a few years ago. Without the household spending that was made possible by home equity extraction, the U.S. economy would have been in or near recession from the recession in 2002 through to the recession that began in 2007. Here is an excerpt from page 7 of Debt Spiral: In this reading, the U.S. has barely recovered from the so-called mild recession of 2001. If we smooth out the last 15 years, we find little growth in GDP and less growth in the incomes of middle class Americans. The causes of that relative stagnation are hotly debated. My suspects are foreign competition and the failure of the American workforce to keep pace with the educational requirements of work, compounded by the percentage of children born out of wedlock (now around 40%) which saps the beneficial effects of the American family and the energy of the single mothers who bear the brunt of the problem. Nevertheless, the U.S., unlike much of the world, has had an economic expansion over the last five years, and that expansion, though weak by historical standards, is continuing. What could derail it? The expansion has been spurred by robust auto sales (financed by often-unsound auto loans), asset priced rises spurred by Fed policies (now being reversed), declining unemployment and modestly increasing employment (that is threatened by the rising cost of labor that some parties advocate), and high corporate profits (that look like they may level out or decline). The strong dollar also looks like a threat to U.S. exports and, even more important, a threat to domestic companies in the form of increased foreign competition. Weak growth or even outright shrinkage of many foreign economies suggest that one should not look to robust foreign sales for help. Indeed, the high levels of emerging market borrowings denominated in dollars suggest that many emerging market companies and nations will have trouble repaying, as I have written elsewhere. The fevered acquisition activity among large companies that also suggests a late-stage recovery. The big companies are looking to reduce competition rather than to grow organically. And they prefer to buy back stock rather than invest in growing their businesses. Those all are signs that growth will slow further and that a rising stock market is unlikely. If there are outstanding investments, they are most likely to be among younger companies or companies that have sound balance sheets but businesses that have temporarily disappointed. Cam Hui says he is worried about the next recession being ugly because of the Fed’s balance sheet, a possible crisis in China, and possible blow-ups lurking in the global financial system. I pick on Cam because he is so brilliant. But the Fed’s balance sheet will just sit there. It will not be allowed to impede provision of liquidity, and lowering interest rates is, in my not too educated opinion, not all it was cracked up to be. China is unlikely to suffer a financial crisis because, although many Chinese entities are functionally bankrupt due to bad loans, as I have explained , those loans can be carried for quite some time yet. There may well be blow-ups lurking in the global financial system-possibly in Europe or Japan. But they are unlikely to make a big difference to the U.S. economy. Take 1997 as the template. In short, I do not see reason to believe there will be a major recession in the U.S. in the near future. But a statistical recession seems quite possible. Those statistics will not be nice for the people who lose their jobs, and the attendant reduction in asset values will be bad for retirees and others who need asset appreciation. But my guess is that the recession will be brief and not too ugly. But I also guess it will be followed by more less-than-average growth. A better-educated American workforce is what can end the malaise and restore prosperity. (That is the subject of my book, The Education Solution .) I do not see any short-term policy solution-on the left or the right. Both proclaim pro-growth policies. But growth comes primarily from more people who have the skills the workforce needs. So show me where to put my money! Yes, where should we put our money? That’s why you started reading this Megillah (long story) in the first place. Stay the course, as usual, I say. None of this is very new. Long-term, the American stock market is still the best place to be. But if you can figure out what currency is going to be strong in the next rotation, assets denominated in that currency would be a good bet. I do not know what that currency will be. But I would continue to own the kinds of companies that have high profit margins and earn high amounts per employee. They pretty much all have natural moats that allow them to keep their profit margins high. The discrepancy between the high margin players and the low is reflected in the following graph that shows income as a percent of revenue. The red line represents the nation’s top 20 employers. The blue line represent s the nation’s top 50 companies by market cap. As you can see, the big employers have not been a able to increase their profitability since 1980, whereas the most valuable companies have consistently increased their profitability, mostly by using technology to achieve moat-like protections for their margins. By not having to deal with large numbers of employees, they retain greater control over their costs. Net income as a percentage of gross income (Data from S&P IQ, graph by the author) (click to enlarge) The contrast when we consider real income per employee is even greater than when we looked at profitability in terms of sales. The profitable companies have consistently increased their income per employee, while large employers have been stuck at the same basic level. Probably that is because it is hard to increase the productivity of low-level employees without sharing a substantial part of the gain with them. The large employers also tend to be in businesses that are highly competitive, with little intellectual property protection, and consequently low profit margins. Net income per employee (Data from S&P IQ, graph by the author) (click to enlarge) Even if there is a recession in the near future, I do not think that the political forces seeking higher wages for low-end employees will abate. Therefore, although from time to time large employers may represent good value in market terms, because of wage pressures I do not see them being high-growth, high-profit businesses. The ascendancy of the FANG-type investments is not over in my judgment. Thus, although I do not know which particular investments will shine in 2016, I believe they will come from the high-income per employee group. In 2014 that group included, among the top 50 companies by market cap, tech companies Apple (NASDAQ: AAPL ), Alphabet ( GOOG , GOOGL ), Facebook (NASDAQ: FB ), Qualcomm (NASDAQ: QCOM ), and Microsoft (NASDAQ: MSFT ); two credit card giants, Visa (NYSE: V ) and MasterCard (NYSE: MA ); oil giants Exxon Mobil (NYSE: XOM ) and Chevron (NYSE: CVX ); drug companies Pfizer (NYSE: PFE ), Gilead Sciences (NASDAQ: GILD ), Amgen (NASDAQ: AMGN ), Biogen (NASDAQ: BIIB ), Johnson & Johnson(NYSE: JNJ ), and Celgene (NASDAQ: CELG ); and cigarette company Altria (NYSE: MO ). (Note: I do not invest in cigarette companies.) Close behind were megabanks Wells Fargo (NYSE: WFC ) and JPMorgan Chase (NYSE: JPM ). Not all of them were winners in terms of stock prices; for instance, Amazon (NASDAQ: AMZN ), a big market winner, is an outlier with low profitability. And Berkshire Hathaway ( BRK.A , BRK.B ), one of my favorite companies, is a big employer as well as the owner of numerous companies with successful moats. One can find reasons that each of these companies will not be among the FANG class of 2016. High market valuation may hold back tech stocks. Pricing headwinds for products could derail drug companies. Disruptive competitors could steal card companies’ volumes or compress their margins. Continued low prices of natural resources could prevent oil companies from improving. Likely larger reserves for loan losses could hold back the megabanks. Maybe the winners therefore will come from smaller companies that illustrate similar profitability characteristics. I am not trying to predict the winners. I only mean to suggest that the market as a whole is more likely to be stagnant than up or down sharply, which leaves equity investors searching for winners. The debt markets do not look a whole lot more promising: returns on investment grade debt not so great and returns on high yield debt, particularly of the foreign and weaker varieties, looks like they will come under continued credit quality pressure. It has been several years since I have been able to be highly optimistic about some asset class. I guess that continues for now. It may be that some of the beaten down sectors will be the winners. I would put some of my money there. I guess I am forecasting what they call a stock picker’s market, much as 2015 has been, though I am aware that predicting “more of the same” usually misses the big action. Mine is not a great investment outlook, I am afraid. But compared with the forecast of a meltdown, it is not too bad. If you are reading this article because you have money invested or to invest, consider yourself among the fortunate. In a tough — though I still think improving — world, we are the lucky ones. Happy New Year to Seeking Alpha readers from me and my family to you and yours. Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.