Market Commentary April 2016

Posted on Tuesday, April 19, 2016

A Wild Ride

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By Kevin O'Keefe, CIMA, AIF | Chief Investment Officer

Investors have had a wild ride in early 2016, with one of the biggest intra-quarter market reversals in the history of the Standard & Poor's 500. At the close of the quarter, the index had gained 1.3%, but six weeks into the year, few could have foreseen that such a turnaround was possible.

The moment markets began trading in 2016, fears of a global recession took hold, eventually leading stocks into a correction. But the rally which began on February 11th brought U.S. stocks all the way back and then some, as signs of improving economic conditions eased recession fears, while dovish Fed comments and a weakening dollar helped set a more positive tone.

After underperforming growth stocks for years, value stocks posted positive returns and growth stocks stumbled. Only time will tell whether this was merely a fluke, or perhaps the beginning of a new relative performance trend for value stocks?

Utilities and telecoms were the best performing sectors during the first quarter of 2016; technology, financials, and health care were among the worst. Precious metals stocks, which have been terrible performers since the darkest days of the 2008-2009 financial crisis, had a terrific quarter.

It was a mixed picture for international stocks. Developed markets took a hit, as European and Japanese stock markets fell. But emerging market stocks-an underperforming category for the past several years-had an excellent quarter.

Rising oil prices boosted the economies of petroleum producing countries. Mutual funds focused on Latin America were up solidly for the quarter, making that part of the world the best performing region.

Bear -Bull ImageBonds had a good quarter. Treasury securities rallied early in the year and again in late March. High yield bonds were helped by rising commodity prices.

Tough Quarter for Active Management

Active portfolio managers struggled through the first three months of 2016. According to Bank of America, only 19% of large-cap funds managed to beat the S&P 500 Index in the first three months of the year, a record low since B of A began collecting this information in 1998. Furthermore, the margin by which the average active large-cap growth fund trailed the index was the widest in the 25-year period for which this information is available.

Part of the reason for this was the speed and magnitude of the market's turnaround. Defensive strategies that worked well in the first half of the quarter were suddenly on the wrong side of the market.

Some portfolio managers were more cyclically positioned for a positive economic scenario at the beginning of the year. But then, with the selloff gathering momentum (or so it seemed), many of them took a more defensive position at exactly the wrong time. When the market rebounded-thanks to oversold conditions, dovish Federal Reserve policies, and a weakening dollar-these portfolios got whipsawed.

Looking Ahead

Investors should plan on seeing continuing volatility in the months ahead. Developments in the political arena, oil prices, employment, corporate earnings, and inflation are expected to be the most likely sources of market-moving news.

We believe that cautious optimism is the watchword for stocks, owing chiefly to continuing low oil prices, which, although a negative for the fossil-fuel energy sector, contribute positively to GDP growth. A look at historical numbers suggests that U.S. stocks are currently fairly valued.

A net 215,000 jobs were added during the month of March, but corporations are generally holding off on capital improvements spending, which offers a mixed picture of the expectations of economic growth.

It would appear that companies generally believe it's easier to lay off employees if necessary than it is to sell equipment, and apparently they expect the upcoming earnings season to be weak.

While not a major concern, there are signs that inflation is picking up. The latest government report shows that average hourly wages rose 2.3% year-over-year.

Do Earnings Need to Improve in Order for Stocks to Advance?

It's possible that earnings growth is needed for stock prices to attain new highs. Is that too much to expect?

Investors are hoping for earnings expansion to provide a stimulus for U.S. stocks, but they may have to bide their time. Last quarter's earnings for the 500 largest public companies in the U.S. are expected to fall well short of same-period earnings in 2015, according to FactSet.

This would be the fourth consecutive quarter of earnings declines, and next quarter is not expected to show year-over-year earnings improvement either. Major U.S. stock indexes are basically flat over the past fifteen months, Fed Buildingmainly due to slow economic growth, a halting oil price recovery, and tentative Fed policy. These factors may be causing some investors to remain on the sidelines until and unless something changes-such as signs of improving earnings.

The aging bull market, now seven years old, has partially contributed to stocks being more expensive than their historical averages, while the added effect of earnings declines has extended the average price/earnings ratio further, leaving the S&P 500's current trailing P/E ratio about 15% higher than its 10-year average.

The strong dollar and weak consumer spending have weighed heavily on corporate earnings over the last year, and these factors remain as uncertainties.

Most investors expect the Federal Reserve to raise rates again in the next few months, which should boost the dollar. If Japanese and European central banks make similar moves, that would strengthen the dollar as well.

Despite a sharp bounce off their February lows, oil prices remain about 60% below their June, 2014 highs. The energy sector is expected to be the biggest drag on first-quarter earnings of the S&P 500 Index. However, many analysts expect earnings to improve later this year versus the year earlier period, as energy producers will have had a full year to come to terms with low oil prices.

The consensus earnings forecast is for the S&P 500 Index to generate more than 3% earnings growth in the third quarter, versus the same period of 2015. If this forecast comes to pass, it will be the first quarter of growth since Q1 2015.

Meanwhile, S&P 500 corporate revenues are forecast to grow about 2% in the third quarter, which would be the first quarter of growth since Q4 2014.

The fourth quarter is looking downright rosy. The consensus forecast for S&P 500 earnings growth for Q4 2016 versus Q4 2015 is a whopping 11%, with revenue expansion expected to exceed 4%. But one should keep in mind that forecasts are just that-forecasts, and notoriously prone to disappointment.

So, for investors who are waiting for improving valuations to move money into stocks, the earnings picture is expected to improve significantly later in the year. Forewarned is forearmed.

Fixed Income Allocations Offer Stability

By Charles Sandmel

The bond markets in the U.S. turned in strong performances during the first three months of 2016 as investors retreated from stock market volatility and lack of direction.

The benchmark Bar-Cap Aggregate returned 3.02%. Treasury yields declined unevenly; the 30-year declined 40 basis points (0.40%) and the 10-year yield declined by a half-percent, while the 5-year yield dropped only 7 bps (0.07%). The municipal bond index returned 1.67%, with significantly less dramatic yield declines.

Inflation / Federal Reserve Outlook

It was widely expected that the Federal Reserve would raise overnight interest rates periodically during the course of this calendar year in response to anticipated expansionary/inflationary pressures. But because economic expansion has been muted and inflationary pressure continues to be weak, the Fed did not raised interest rates in the first quarter of 2016. Current conditions suggest that Fed interventions are unlikely in the near term.

Municipal Bonds

Yields remain low on a relative basis and we see little likelihood for increases. Since yields and prices move in opposite directions, the supply/demand dynamic continues to support prices-and depress yields. Last year, most of the new issue volume refinanced old debt, and it looks like that trend continues, with more bonds coming due than are expected to be issued.

We are actively following the convoluted Puerto Rico debt crisis. It has changed so often and so rapidly that almost anything put in writing becomes obsolete before the ink is dry. It is quite likely that most bondholders will be asked or told to forebear prompt full payment of principal and interest, but how long any payments will be delayed and how much less than full payment will be received cannot be known.

The most encouraging news is that the Federal government, after months of delay, is finally engaged. If the recent past is any basis for prediction, nothing definitive about any debt service payment will be known until the day before payments are due. The next key dates are May 1, July 1, and August 1.

The market for Puerto Rico bonds is dominated by sporadic trading at distressed prices; only speculators are bidding. We continue to recommend that Puerto Rico bondholders await an orderly resolution of the crisis, rather than selling into this market.

Green Bonds

The green bond sector continues to grow and mature. Green bonds, defined by their use of proceeds, are gaining significant market attention. One measure of this success is that Moody's Investors Service is integrating green methodology into its rating process where appropriate. Standards for defining and validating the green nature of new bonds continue to progress and global new issuance for the first quarter was reported to be $16 billion.

Setting Realistic Assumptions for Portfolio Returns

Over the past 90 years the U.S. stock market has averaged 10% per year total return. But two important facts must be considered when using a 10% average annual return figure for estimating future returns:

First, the U.S. was the global winner, outperforming all other countries. The average total return for stocks globally was considerably less than 10%.

Second, although 10% was the average annual return, there were many time periods where returns were significantly better than 10% per year, and many that were significantly worse. The shorter the time period you are forecasting into the future, the more allowance you need to make for potentially significant variance from the average.

What about bonds? Over the next several decades, bonds may perform in line with historical averages, but with yields so low at present, one should expect that the next few years will be below historical norms.

Investors pay fees and expenses for their portfolios to be managed. They are also responsible for paying taxes on interest, capital gains, retirement plan and IRA distributions, etc. Don't forget to take these into account when forecasting future expected returns and liabilities (future liabilities should be estimated with an inflation factor).

Planning for the future is neither science nor art. Even the most rigorous methodology is flawed by the simple fact that the future cannot be precisely known. But factoring in all available information is important when doing financial planning.

Kevin O'Keefe, CIMA, AIF is Managing Member and Chief Investment Officer of First Affirmative Financial Network, LLC. He chairs the First Affirmative Investment Committee and is responsible for due diligence and monitoring of mutual funds and separate account managers.

Charles Sandmel is a portfolio manager with Shelton Capital Management. A past director of the National Federation of Municipal Analysts, Mr. Sandmel has been a fixed income portfolio manager for more than 30 years and manages fixed income separate accounts for First Affirmative clients. This information represents the opinion of the contributor and is not intended to provide specific investment advice.

Information was obtained from third party sources which are believed to be reliable but are not guaranteed as to their accuracy or completeness. The indexes mentioned in this Economic Commentary represent unmanaged groups of investment assets, such as common stocks or bonds, and are often used as proxies for various markets. Index performance does not include the impact of cash, fees, or transactions costs. Investors cannot invest directly in the S&P 500 or the other indexes mentioned, but may purchase mutual funds or other products designed to track the performance of various indexes. Investing in municipal bonds involves risks such as interest rate risk, credit risk, and market risk, including the possible loss of principal, and income may be subject to the alternative minimum tax (AMT). Mention of specific companies or securities should not be considered a recommendation to buy or sell that security. For information on the suitability of any investment for your portfolio, please contact your investment advisor. Past performance is no guarantee of future results.