Market Commentary - January 2016
Posted on Thursday, January 14, 2016
A Lackluster Year in Stocks, But the Bull Market Lives On
By Kevin O'Keefe, CIMA®, AIF® | Chief Investment Officer
Looking Back at 2015
Despite a strong fourth quarter, stocks had a lackluster year for the first time since 2008. Calendar year 2015 was a year of near-zero returns or worse-even for broadly diversified portfolios.
The S&P 500 Index rose 1.38% during 2015 including dividends, the smallest total return in the past seven years. More stocks lost ground than gained (281 vs. 220). The energy sector-which are primarily fossil fuel companies-was the worst performing sector, falling 24%.
On the other hand, the fourth quarter was the twenty-third quarter in a row of dividend growth. In fact, 2015 was the fifth year in a row of double-digit dividend growth. Dividends paid by companies in the S&P 500 are now almost double what they were in 2010.
While it should be only one valuation measure, dividends can illuminate potential stock market upside. Historically, except during the very worst of the financial crisis, the S&P 500 companies have paid out about a 2% annualized dividend over the past decade.
In the chart to the right, the blue line reflects the value of the S&P 500 Index (left scale), and the red line shows dividends paid by S&P 500 companies (right scale). The two lines are the result of calculations that compare the overall value of this index with dividends paid by listed companies at a ratio of 50-to-1. As a result, where the lines cross, the yield of S&P 500 stocks is exactly 2%. (Source: Eddy Esfenbein, Crossing Wall Street)
Taking a little longer perspective, the average annual total return of the S&P 500 Index was 12% compounded over the last 30 years-despite the worst single-day crash ever (October 19, 1987) and two severe bear markets (2000-2003 and 2007-2009).
Investors have not wholeheartedly embraced the stock market since the Great Recession. Over the past eight years, flows into U.S. equity mutual funds only increased in 2013, according to Liz Ann Sonders, Chief Investment Strategist at Charles Schwab & Co., and 2015 may show the highest level of outflows since 2008.
But despite numerous challenges, including high valuations, weak earnings, and sluggish global economic growth, investor sentiment suggests that the bull market still has room to run.
What Is CAPE and Why Should I Care?
One of the more useful metrics to assess valuations is the cyclically adjusted price-earnings ratio (CAPE). This is the ratio of the current market price to average corporate earnings over recent economic cycles.
The CAPEs for stock market indexes are not useful for predicting stock market returns over the near term. But for a five-to-ten year period looking forward, CAPEs have shown a reasonably high correlation with future average stock market returns.
At the end of 2015, the CAPE for the U.S. stock market was over 26, which is higher than its long-term average. It's a different story overseas: For the Japanese stock market, the CAPE was 20; for Europe, it was 15; for emerging markets more generally, it was 10-all below these international markets' long-term averages.
Poor relative returns from international stock markets over the past several years have created relatively attractive CAPEs. For investors tempted to throw in the towel on their overseas stock holdings because international investing has been a disappointment over the past few years, a look at these CAPEs might be just what you need to stay the course with your international stocks.
2016: Challenges and Opportunities
With 2016 getting off to a very poor start, investors are understandably nervous. Let's acknowledge the challenges:
Seven years of a near-zero interest rate environment as managed by the Federal Reserve is coming to an end; the global economy is slowing; geopolitical uncertainty is on the rise, contributing to volatility in financial markets; and corporate earnings growth is tepid at best.
What's an investor to do?
- Diversify. Do not try to time the markets based on geopolitical events.
- There are better valuations to be found among international stocks, especially in Europe and Japan. Avoid the trap of extrapolating the last several years' dominance of the S&P 500 into the future. See the commentary on "CAPE" above.
- Do not overreach for yield. Bond yields remain low, while stock categories known for healthy dividends such as utilities have been bid up in price amid investors' quest for income. Multi-asset income strategies and total return strategies might make more sense.
- Crashing oil prices have made it appear that inflation is dead. The current price of Treasury Inflation-Protected Securities (TIPS) indicates that investors have priced in core inflation of 1.55% over the next ten years. (Context: The last ten years averaged 2.3% inflation.) TIPS are relatively attractive if inflation exceeds 1.55% over the next decade.
- A balanced portfolio is less volatile when stocks and bonds are negatively correlated. The 90-day correlation between the S&P 500 and the 10-year Treasury has turned significantly negative, and this is a trend which is likely to persist for a while.
A New Chapter in Wind and Solar Investments
Despite a global glut of cheap fossil fuels, a clean-energy construction boom is gaining momentum.
Installations of wind turbines and solar panels took off last year, thanks to utility companies going on a worldwide building binge. The U.S. Congress approved an extension of tax credits for renewables as part of the December, 2015 $1.14 trillion budget deal.
Goldman Sachs has announced that it will increase its already substantial investments in renewables four-fold. Orders for 2016 solar and wind installations are up sharply not only in the United States, but also in China and the developing economies of Africa and Latin America.
Solar and wind power have been expanding in the U.S. for years mainly because of lower cost. But a significant boost is likely to come in 2016 and beyond as a result of the outcome of the COP21 Summit and the Obama administration's Clean Power Plan, a set of new regulations issued by the Environmental Protection Agency ( EPA) in August, 2015 that requires states to reduce emissions from existing power plants.
Fixed Income Allocations Offer Stability
By Charles Sandmel
The bond markets posted very modest returns during the fourth quarter, and for all of 2015; offering stability in a year of higher equity market volatility. The benchmark Barclays Capital US Aggregate Index returned 0.55% for the year despite losing 0.65% in the final quarter.
Investors appear to have anticipated the Federal Reserve's long-awaited December increase in short-term interest rates, because the market did not collapse after the announcement. While the one-year Treasury yield rose 0.28% over the quarter, the ten-year and 30-year yields increased only two basis points (0.02%). Remember, bond yields and bond prices move in opposite directions.
When the Fed raised rates in December, 2015, it was communicated that further 0.25% increases were likely over the coming year-presumably in response to economic and inflation trends. Fed policy is hard to predict in general, and the task becomes even more daunting in a Presidential election year.
Macroeconomic factors affect Treasury securities more than they affect municipal bonds. Municipal bonds were somewhat stronger performers last quarter; the Barclays Capital Muni Aggregate Index returned 1.50% for the fourth quarter and 3.30% for the year.
Nearly $400 billion of new municipal bonds were brought to market during 2015, but as more than half of that was issued to refund outstanding bonds, the total outstanding appears not to have moved materially from the (latest available) 2014 year-end total of $3.7 trillion. The low net-new muni bond issuance implies a demand/supply imbalance that supported bond prices. Over two thirds of the municipal bonds that are currently outstanding are owned by individuals or surrogates, such as bond funds.
Valuable New Year's Resolutions― The best investment strategy is almost always the one you can stick with no matter how good or bad market conditions may be.
― Make a monthly budget and stick to your budget.
― Save more for retirement, and take advantage of tax wise opportunities.
― Pay off debt.
― Create an emergency fund. Avoid being in a position where you ever have to sell long-term investments in order to meet current obligations. An emergency fund should consist of 3-6 months' worth of living expenses.
― For charitably inclined taxpayers aged 70 1/2 and older: Make tax-free charitable donations directly from IRA accounts.
The "big story" extending from 2015 into 2016 is how the resolution of Puerto Rico's debt crisis will play out. The Commonwealth of Puerto Rico is suffering from a ten-year economic decline. It and its underlying agencies owe about $70 billion. With its weak credit ratings, Puerto Rico is unable to borrow, even after cutting the government workforce and enacting pension reforms.
Due to shoddy financial reporting, it is unclear what resources are really available to meet particular obligations. Since the Governor of Puerto Rico declared the debt "unpayable" in June of 2015, various parties have offered self-interested "solutions," and countless suits and counter-suits have been filed. To date, all general obligation and guaranteed debt service has been paid on time, while the Commonwealth has defaulted on only a small amount of contingent debt.
No state has defaulted on general obligation debt since the 1930s, and that experience may not be applicable to Puerto Rico because its status as a territory is anomalous.
We do not see a definitive resolution to the crisis, but a few things are clear: 1) The crisis is being exploited for political purposes as Puerto Rico faces elections in November; 2) The U.S. Congress has been slow to act and is dealing with abstruse Constitutional questions; and (3) The only bids in the market for uninsured Puerto Rico bonds are from speculators. We believe that holders of Puerto Rico bonds are best served by riding out the crisis until it resolves.
We anticipate moderate increases in short-term yields driven by Federal Reserve action in 2016, assuming that the U.S. economy continues to recover. How the rise in short-term interest rates will affect longer-term bonds is far less clear. We recommend a disciplined investment approach: Avoid undue credit or maturity extension risk.
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.