By David Gaffen
NEW YORK (Reuters) - Investors were hoping 2016 would be a fresh start after the U.S. stock market sputtered to wrap up 2015. Instead, what they got was rotten.
Major averages kicked off the year with their worst week in more than four years as investors fled the market, and fear is on the rise that a full-blown bear market may be lurking. While that may be overstated, markets do face an unsightly assortment of obstacles. Here are some of the biggest worries on investors' minds, and some factors that may mitigate the downside risk:
CHINA: The volatility surrounding the world's second-largest economy is a primary concern of investors. Attempts by officials there to tamp the selling in equities and the steady devaluation of the yuan have fed worries about capital flight. Moreover, a weakening in the currency could hurt demand for imports, particularly those sold in dollars like oil.
U.S. exposure to China in terms of gross domestic product is minimal - only about 0.7 percent of overall GDP, according to Citigroup strategists - but the knock-on effect for other emerging economies cannot be ignored. Furthermore, Citigroup notes that companies with more than 20 percent of revenues from China, including Apple (AAPL.O), DuPont (DD.N), Texas Instruments (TXN.O) and 30 others, have performed worse than the overall market since the middle of 2015.
THE BULLISH CASE: China's weakened demand cuts the cost of consumer goods and petroleum, and data on driving shows U.S. consumers are spending their savings on gasoline by driving more and spending on entertainment.
INVESTOR SENTIMENT: U.S. stock funds saw their worst week since September as investors pulled more than $12 billion out of equity funds, according to Lipper data. Every sector is down this year.
After just five trading days, more than 40 S&P stocks have already lost at least 10 percent on the year, and sectors normally considered leaders including technology and consumer discretionary are lagging the market.
Furthermore, areas that would be expected to benefit, for instance, from the falling price of oil are struggling as well - the Dow Jones Transportation Average (.DJT) is off by 7.5 percent in January, trailing the S&P 500's 6 percent drop and even worse than energy's 6.8 percent fall.
"Sentiment is so bad in some corners of the market that transportation stocks can't even rally while one of their main costs deteriorates. It's rare to see new lows in transportation stocks and oil at the same time," said Jason Goepfert, president of Sundial Capital Research.
THE BULLISH CASE: Coincident lows in energy and transports have, in the past, happened when the market is notably near a bottoming out.
EARNINGS: Even though the U.S. economy is continuing to grow as evidenced by recent figures on auto sales and jobs growth, albeit at a slowing pace, public company earnings are in recession. Estimates have fallen sharply in recent days, with fourth-quarter results expected to fall by 4.2 percent from the year-earlier period from a 3.7 percent drop anticipated at the beginning of the year.
The forward price-to-earnings ratio, as a result of the market's rapid drop in the last week, has retreated to a more historically average 15.3 level, but stocks often need to become cheaper to entice investors while markets are in a swoon like this. Should profit estimates continue to fall, that will put more pressure on stock price to decline as well.
One side note that is of concern: Citigroup, which reports on Friday, as a result of poor earnings a year ago, is by itself lifting the expected S&P growth rate dramatically, according to Thomson Reuters data. Without Citi, earnings are expected to fall 5.4 percent.
THE BULLISH CASE: Excluding the huge drag exerted by the energy sector, earnings are positive.
DIVERGENT MONETARY POLICY: Strategists interviewed late Friday noted that the Fed's intentions to keep raising rates at a steady clip, compared with the European Central Bank's plans to keep monetary stimulus going, will continue to drive volatility as yields in the U.S. rise and conditions tighten.
The CBOE Volatility Index, or VIX, closed at 27.01 on Friday, its highest since late September, and VIX futures show an ongoing inversion, meaning investors expect more near-term gyrations. Richard Bernstein of Richard Bernstein Advisors LLC said Friday that the Fed beginning rate hikes with the United States and world in a profits recession had not happened since 1980-1981.
"We said many months ago it was a recipe for volatility - guess we were right," he said.
THE BULLISH CASE: The Fed will continue to keep stimulus largely in place with a slow pace of rate increases and massive balance sheet designed to keep long-term interest rates from rising.
CREDIT SENTIMENT: The BofA/Merrill Lynch U.S. Corporate Bond Index's spread has continued to widen, reaching 177 basis points over comparable Treasuries on Friday, a few basis points away from levels not seen since 2012. The equity market, for a time, had ignored a similar rise in high yield spreads, but the decline in high-rated credit is a potentially greater problem, because it indicates reduced confidence in funding corporate spending.
Brian Reynolds, strategist at New Albion Partners in New York, says the weakness in credit and in stocks are, in a sense, feeding on each other right now.
"Credit traders continue to watch stocks like a hawk," he said. New issuance has remained healthy and should continue. Eight big high-grade bond deals hit the market on Friday. But further weakness in credit could signal more bumps for equities.
THE BULLISH CASE: Reynolds believes demand from pension funds for credit deals will keep these markets active, and even several months of churning in the stock market will not derail credit activity.
(Reporting By David Gaffen; Editing by Dan Burns and Cynthia Osterman)