Thoughts On The Market Part 1

See my Market Update/Investment Newsletter Part 1 below:

Happy New Year!  Well, another year has passed by and what a wild ride it has been. Welcome to stock investing. That tendency for stock prices to vary widely and often is called volatility risk, and despite the stomach-churning feeling it causes, it’s a good thing. In the end, it’s a reminder why equity investors are compensated so much more than bond investors for taking on this additional risk. Put simply: no risk, no return – a concept just as valid today as it was in the 1600s when the Dutch established the first stock exchange.

The range in returns this year is wide. As noted in the chart below, returns by investment class ranged from -26% for MLPS to 1.6% for U.S. large-growth stocks. Overall, U.S. large-caps stocks were barely up this year and, as Barron’s stated this week, “if it were not for Amazon, Google, Microsoft, and Facebook, it would have been down 4%.” The big issue last year revolved around corporate profits (earnings per share). In fact, we had one of the biggest drops in U.S. stock earnings per share in a non-recession time period. Oil was the main driver of this.  Oil prices dropped over 30%, not far from the seven-year lows. Needless to say, low oil prices hurts profits of energy related companies, which caused the overall return of the S&P energy sector stocks, like Chesapeake Energy (down 77%), to drop over 24%. This brought down the reported earnings and stock prices overall in the U.S. indices significantly. At the same time, the dollar strengthened (against the euro over 11%) which hurt U.S. companies exporting products and services overseas. All this combined with the Fed raising interest rates for the first time since June 2006 (almost 10 years ago!) and Chinese economic growth slipping could have been a recipe for disaster, so one would have thought it could have been much worse.

The biggest insight here is no one saw any of this coming. At the beginning of last year, there weren’t many people predicting oil would fall off the cliff or the Fed would wait until December to raise rates. Thus, take everything you are hearing today with a grain of salt.  Humans suffer from the recency bias, which means most people are expecting things like oil prices and emerging market stocks to stay or continue their downward path. However, things could change overnight. For instance, Saudi Arabia could decide tomorrow to restrict supply of oil and raise prices, which would cause the price of oil to double in a day.

What about interest rates? Keep in mind the Federal Reserve increased short-term rates slightly; 25 basis points so not a big move. The longer-term rates, like the 10-year Treasury bond, were actually flat for the year. So, when people say rates are rising, they are typically speaking to shorter/overnight lending rates that won’t necessarily impact longer-term bonds. Most experts expect rates to increase about 25 basis points in at least 2 or 3 of the 8 meetings next year. This will get the short-term target over 1% next year – a low level by historical standards. Many experts expect long-term interest rates to jump significantly.  In fact, this is mentioned so often you would think it’s a forgone conclusion. However, be careful with this assumption. If you look at other countries after a credit crisis or even our country during the depression area, long-term rates will most likely not go up anytime soon. It took over 20 years after the depression for the 10-year Treasury to get back to 4%. What’s more, economist and former Treasury Secretary Lawrence Summers makes a good argument regarding this issue in his latest blog (http://larrysummers.com/category/blog/).  

Keep this in mind when watching and reading the predictions for 2016. I know we’re off to a bad start (at least as I write this) and there are all sorts of scenarios – good and bad – floating around in financial press. We’re being bombarded with acronyms, short names, nicknames, and buzzwords to describe them. Could Britain leave the European Union (i.e., “BREXIT”) or could Greece’s issues percolate once more (i.e., “GREXIT”)? Will the FANG (Facebook, Apple, Netflix, and Google) stocks dominate again this year? Will Dr. Doom’s, Nourani Roubini, dire predictions come true?

All I can stay is to distance yourself from the noise, and focus where the market will go over the next 5-10 years. That’s how top investors invest, and it’s how we think as well. Despite what you may hear about central banks flooding the markets with money and inflating stock markets, most academics agree we aren’t in a market bubble. Based on stock valuations today (as measured by P/E, Shiller P/E, and Book Values), stock investors will see considerable returns over the next 5-10 years in the U.S. stock market, and even more on the international side. Maybe not as much as in past, but a considerable amount.

Jeremy Siegel, the author of Stocks for the Long Run, states we could very well have a generous increase in stock values. He thinks we could see significant growth in the already-depressed earnings if commodity prices increase and consumers continue to spend.

Regardless, the smart players stay disciplined and diversified, which means having a combination of domestic and international stocks and bonds in your portfolio. Don’t be like the ones noted in the latest Fidelity 401k survey: a recent report from Fidelity Investments found that 11% of its 401(k) account holders aged 50-54 allocated 100% of their retirement assets to stocks; mainly U.S. blue-chip stocks. These investors don’t have an advisor to educate them, and they are chasing returns by buying what has done well the past couple of years. 

Smart investors buy things cheap. That’s why your portfolio has value funds, allowing for a quantitative process to identify the stocks selling at a discount. At the same time, we rebalance regularly, which inherently forces one to buy low and sell high. So, in a nutshell, hang tight. It will all pay off.