A quick brief on what is happening today:
Before discussing what happened last year, let’s take a moment to explore the events that are happening currently in the markets. You may have heard that the first couple of weeks of 2016 have represented the worst start of a year for stocks in history. What has changed to cause such a drop? Well, two actions in December have created unintended consequences: The timing of The Federal Reserve increasing short term interest rates from 0% to 0.25% and China’s decision to un-peg its currency from the dollar and manage it to a basket of currencies, allowing it to weaken. Couple this with already high valuations (as we have been pointing out for a very long time now in this blog), and you have the ingredients for a correction. China’s decision and the unintended consequence was the great rush of capital leaving the country, partly due to the unwinding of the “carry trade”. The carry trade can be described as borrowing in the U.S. at close to 0% interest, using dollars to purchase China’s currency (the Renminbi, also known as Yuan) and investing in China’s higher yielding bond and cash markets. It is also very likely that borrowed U.S. dollars found their way into China’s stock market. The carry trade has built up for years and had close to zero currency risk since China’s currency was pegged to the dollar so the two moved very closely together over time. As soon as China changed the currency peg away from the dollar, the currency risk increased substantially and many participants in the carry trade decided to sell the Chinese assets, which involves selling the Chinese currency to bring the cash back to the U.S. in dollars to repay the low interest loan. Remember, the Federal Reserve added $4 trillion to the banking system by purchasing bonds for quantitative easing and it is estimated that over $1.3 trillion flowed into China. The outflows in December were so great that the Renminbi weakened more than the Chinese government could control. The currency movement, which now totals more than 5%, created more panic in the Chinese stock market during a time when the Chinese regulators were introducing circuit breakers to halt trading if the stock index drops 7%. The Chinese regulators have now admitted the circuit breakers were a mistake and have removed them from the stock exchange. It is important to consider that China’s total stock market, due to its small size, is not directly linked to the Chinese economy. A weaker currency will help China with a softer transition from an export driven to a consumer based economy as it will improve exports and reduce demand of imports. However, this makes other countries, such as the U.S., European countries, and Emerging Markets less competitive versus China, so it is logical that this move would affect more than just the Chinese markets. This cocktail of uncertainty is further exacerbated by the decline in energy and commodity prices. China’s task is to keep the pace of weakening under control as it prepares for a market based global currency. About two weeks prior to China’s stock market tumble, the U.S. changed its monetary policy from easing to tightening by raising rates in the middle of December. Higher interest rates attract international investment, which strengthens the dollar but also puts the brakes on the U.S. economy, particularly manufacturers who rely on global exports. Higher interest rates also lower stock valuations, which have a historical inverse correlation with interest rates. When interest rates decline, stock valuations, (like the Price Earnings ratio) increase; and when interest rate rise, stock valuations decline. The monetary policy change, which had been communicated well in advance, is causing valuation concerns in the U.S. at a time when global growth expectations have declined.
We view the recent market pullback as healthy and necessary. We would rather see equity market valuations where they are today, at the long-term average, as opposed to the high valuations that we have been writing about in the blog for a long time. At the present, we still have a healthy yield curve, robust jobs market, and thus far corporate guidance on forward earnings has been positive.
If you feel anxious in any way, we would like to reiterate the following:
- No one, not you, us, your brother-in-law, the guy at the cocktail party, the Nobel Prize winning economist, that guy on T.V., no one can tell the future. This is why we employ a portfolio management methodology based on rigorous academic research and empirical evidence that does not rely on guesswork and inevitably inaccurate prognastications.
- We do not invest to just "make as much money as possible"....this is a road to disaster. We invest to give you the highest probability of achieving your long term goals and vision for your life.
- Patience is a virtue that pays off in investing. Yes, flat markets get boring and we want big returns NOW! However, that is not how markets work, especially with well-diversified portfolios.
- The reality is, due to the rebalancing process we employ, market pullbacks work in our favor as we get to buy stocks at more attractive valuations with a higher expected future return while others sell based on fear and emotion. Bad for them, good for us.
- We all have short memories, but try to remember what happened during the Great Recession to our portfolios (we significantly reduced the downside volatility) and what happened thereafter (the kind of market returns we all get excited about). While the past is not indicative of the future, it certainly is informative and a good reminder about why we invest the way we do.
- Short-term market movement has little to do with long-term fundamentals and investment success.
- Research shows market timing doesn’t work and the average investor earns far less than the market because they trade too often and at the wrong times, mostly based on emotion.
- Market volatility has been muted over the past few years, so the recent uptick may feel more severe than it really is. Recent volatility is well within normal, expected ranges.
- Risk and return are directly related, so if you want higher returns, you must to be comfortable with the higher volatility of stocks.
- Over the long run, inflation is one of your largest risks. In order to beat inflation over the long run and give yourself the opportunity to earn a return for long term success and goal achievement, you must accept the associated risk/volatility.
- The best thing you can do is focus on things you can control, such as your own behaviors (like your spending and saving habits).
- Your financial plan takes this kind of volatility into consideration already.
- Call us. Email us. Send a carrier pigeon. Whatever works for you, but if you feel your emotions getting the best of you, please do reach out. We are here for you.
Now on to the historical results and a deeper look into the fundamentals.
Q4 2015 Market Summary
After a very difficult third quarter, stocks improved during the fourth quarter with most of the strength in the U.S., as the dollar appreciated against many international currencies. The bond market was a bit more challenged as interest rates increased in anticipation of and after the Federal Reserve raised its benchmark short term lending rate from 0% to 0.25%. Also, in the above chart, you will find a summary of the best and worst quarterly returns during the past 15 years for each asset class. Notice the increased level of volatility for stocks and real estate compared to bonds.
2015 Full Year Market Summary
The largest 3000 stocks in the U.S. stock market, which together comprise the Russell 3000 Index, paid enough in dividends to provide a positive total return; but there were big differences between large and small cap stocks and between growth and value stocks. The U.S. large cap stock indices (Dow and S&P 500) hit record highs in May and have dropped 4% from their peaks to finish the year. The S&P 500 had a total return of 1.38% including dividends for 2015, the Dow had a total return of 0.40% including dividends for the year, The Russell 2000 small cap index had a total return of -4.4%. The Russell 2000 Growth Index had a total return of -1.38%, while the Russell 2000 Value Index had a total return of -7.47%. The Russell 1000 large cap index had a full year total return of 0.92% while the Russell 1000 Growth Index returned 5.67% and the Russell 1000 Value Index returned negative 3.83% for the full year. Value under performed growth during the year for both large cap and small cap due to many poorly performing energy sector companies falling into the value category. Small cap stocks under performed large cap in the U.S. while small cap outperformed large cap internationally.
The U.S. dollar strengthened almost 10% against a basket of global currencies, which impacts International Developed and Emerging Markets. Emerging Markets are a small segment of the overall stock market and had a challenging fourth quarter and full year due to the strength of the dollar and the decline in commodity prices, which hurt commodity producing countries. International developed stocks were down just over 3% for the full year.
U.S. Fixed income market returns were down for the fourth quarter due to a parallel shift up in the yield curve. As the interest rate yields goes up, bond prices decline. The 5-year Treasury note gained 39 basis points to end the fourth quarter at a yield of 1.77% and the 10-year Treasury note increased 22 basis points to yield 2.27%. Short-term corporate bonds declined 0.14% during the fourth quarter but gained 1.01% for the year, while intermediate term corporate bonds lost 0.42% during the quarter but gained 1.08% in 2015.
Bonds were slightly positive for the year in the U.S, except for long maturities and high yield. The S&P High Yield Index was down 4.47% for 2015, including interest payments; and captured attention as the high yield spread above treasuries increased above 7%, a level not seen since the Greece debt crisis of 2011. More on this important topic to follow.
A Deeper Look
It has been a challenge to determine the stage of the business cycle for developed economies now that it is almost seven years after the end of the great recession. Does the global growth story have more to run or is economic contraction on the horizon? The World Bank just cut its 2016 global growth forecast from 3.3% to 2.9%. In part due to the large economies of Canada and Brazil, which are now deeper into a recession, along with a slowdown in China. The U.S. economy continues to exhibit strength and the U.S. consumer is purchasing goods made all over the world as the dollar has strengthened considerably against most currencies in 2015, making imported goods less expensive. All developed economies around the world still rely heavily on extremely easy monetary policy and quantitative easing, while the U.S. Federal Reserve moved to a tightening cycle in December; which was a three-month delay from an expected September lift off of zero. The Fed communicated that the U.S. economy is strong enough to overcome weakness in other developed regions and the force of disinflation (lower prices) will be temporary, allowing the inflation rate to move up to its target of 2% in the coming year. China’s move to weaken its currency is deflationary in the U.S. and will likely keep the Federal Reserve on hold from raising rates again, unless there is a recovery in commodity prices.
Job creation in the U.S. is strong and the headline U3 unemployment rate is down to 5.0%, close to the same level as in 2005 (view 10-year chart below from www.bls.gov). The U6 underemployment rate, which includes all workers, has finally moved below 10%, to 9.9%, down from 11.4% last year and from 13.1% two years ago.
The weekly jobless claims data also support a strong jobs market in the U.S. with the 4 week moving average of initial jobless claims reaching a new low going back multiple decades and continuing a strong downward trend line from the end of the great recession in 2009.
There are two primary reasons for stock markets to pull back: recession and rising interest rates. It is difficult to imagine a recession when job creation keeps the unemployment rate chart on a downward trend as shown above. One reason the U.S. stock market did not have a better year is because the 500 largest publicly traded companies (also known as the S&P 500 index) have had four quarters of year over year negative earnings growth, which last happened during the recession of 2008. The negative earnings growth was primarily associated with two factors: the strength of the U.S. dollar reducing corporate profits outside the U.S. and commodity prices hitting new lows, impacting the energy and materials sectors. West Texas Intermediate crude oil (WTI) has dropped from $48 a barrel at the start of the year to $37 a barrel currently, just 18 months ago, it was $107 a barrel. The fallout from such a price change has hit the energy companies responsible for the vast investment in U.S. production over the last five years. The rapid decline in business fundamentals has caused a spike in high yield bond spreads and also caused multiple hedge funds that specialize in energy sector bonds to close down. The vast majority of new oil and gas production is financed by high yield bonds. The high yield bond spread above treasuries for all non-investment grade bonds peaked at 7.33% a few weeks ago and closed the year a bit lower at 6.95%. The last time the high yield spread reached these levels was the European debt crisis in 2011.
The actions from OPEC and other low cost oil producers are to keep production high with a goal of removing high cost producers from the market. There will likely be bond defaults and consolidation in the U.S. energy sector during 2016. Currently, the price of oil is expected to stay low. There is a silver lining in low energy prices, which improves profitability of energy consuming businesses and leaves the average U.S. consumer with more money in their monthly budget. It is important to understand if the drop in oil and the currency wars will affect the already low global growth story. The U.S. dollar is up close to 10% in 2005 against a basket of global currencies after a double digit increase in 2014, which will make overseas earnings less when translated back to dollars for U.S. based corporations and cause any commodity priced in dollars to decline. The broad commodity index has declined 19% in the last year and 50% in the last five years.
Third quarter earnings and revenues for the companies in the S&P 500 index were negative compare to the same quarter in 2014 (year over year). Let’s review what corporate revenue and earnings for the largest 500 corporations might be if we remove the effects of a decline in energy prices and the strengthening dollar. By removing the energy sector and companies that earn more than 50% of revenue from outside the U.S., the negative earnings growth for the third quarter of 2015 (the latest available) changes substantially. Earnings growth (left side of chart) for this sub-section of the S&P 500 is positive 10.1% and revenue growth (right side of chart) is 4.7%. It is clear to market participants that if the strong U.S. dollar and the depressed energy sector stabilize or reverse, there is considerable growth in large U.S companies.
What would help tremendously is a return of revenue growth from good old fashion hard work from an agile workforce on top of earnings growth from productivity resulting from technology advancement. In the coming weeks, fourth quarter earnings will be released, along with 1st quarter 2016 earnings guidance.
Let’s take a deeper look at China’s stock market, which started with a huge move up in the early summer and sharp decline back down during the summer. The decline of over 60% brought down the S&P 500 index (in red) during August and was a big part of a special newsletter released on August 24th (click here to review).
Since China’s currency was pegged to the U.S. dollar, it appreciated significantly against many other currencies in the region over the past two years, which made imports cheaper and exports more expensive, causing a significant drag on China’s economy. China announced a 2% devaluation of the renminbi in August and indicated the renminbi will no longer be pegged to the U.S. dollar but will be managed against a basket of currencies. The renminbi weakened on the news in August, stabilized through September, October and November and started to weaken again in December. It is now trading at 6.59 per dollar, up from 6.4 one month ago and 6.2 one year ago (a 6.3% change).
The move initially helped China’s stock market to outperform the S&P 500 last December and for the full year of 2015. China is a big part of the global growth story and the central government is attempting to move to a domestic spending led economy and away from an export driven economy. The government thought it had bought more time by weakening the currency, however, the massive flight of capital out of China caused a stock market panic that regulators are still attempting to control. The drop in equity prices spilled over to Europe, since China is a large trading partner and a weaker currency helps China and hurts the economies of Europe and the U.S., to a lesser degree. The big issue for the U.S. is that China is exporting deflation (lower prices) at a time when the Federal Reserve has declared victory over reflating the U.S. economy and is now raising rates to fight inflation. If the force of deflation returns, the one rate hike of 25 basis points may have to be reversed. Monetary policy is used to influence the yield curve and Central banks have a great degree of control of the short end; but can only exert limited influence over the long end of the curve by participating in bond purchases.
The yield curve has experienced a parallel shift up in both nominal and real terms (after adjusted for inflation) over the past year with slightly larger shifts at the short end due to the Federal Reserve finally raising the overnight lending rate off of zero to 0.25% in December.
With the short end of the yield curve still close to zero, the yield curve is steep. The Yield curve has shifted down in January with the negative volatility of equities. The five-year Treasury bond now has a yield of 1.64%, down from 1.77% at the end of last year, while the ten-year Treasury bond is at 2.15%, which is down from 2.27% at the end of last year; and the 30-year Treasury bond is now 2.92%, down from 3.0%. If the Fed raises rates four times in 2016, as it has announced; and the long end of the curve does not move, the yield curve may approach an inverted curve, where short term rates are higher than long term rates. In the past, an inverted yield curve predicts recession. On the other hand, if China’s currency weakens to the point that the Fed cannot raise rates, the yield curve will likely shift down and approach the low yields of Europe. A small shift down would be good for stocks but too much deflationary pressure would be bad for the economy. LTWM’s investment team will continue to monitor the shape of the yield curve and the high yield spread for potential problems in underlying economic growth.
The past year was a challenging year for global stock markets, including negative U.S. corporate earnings growth, the significant 2-year appreciation of the dollar, the extreme equity volatility and weakening currency in China, the move off of zero percent interest rates by the Federal Reserve, and the five-year decline of over 50% in commodity prices. Given that U.S stock valuations were lofty prior to the pullback to kick off 2016 and rising interest rates off of zero, it is important to be cautious as both are head winds. Right now, it appears the stock market and currency problems in China will stabilize and not negatively affect global growth expectations, although it is far from certain. The economic expansion in the U.S. does have the ability to continue the reasonably strong results; but we have no roadmap for analyzing the unwinding monetary stimulus by the Fed in the U.S. during 2016. Regardless of the short-term direction, your globally diversified portfolio is built for resiliency during difficult times and maintains exposure to higher risk adjusted equity returns. No one can fully eliminate negative real returns all the time, but patience and discipline with globally diversified portfolios is rewarded over the long run. LTWM’s investment team has maintained current asset allocation targets for all Investment Policy Statements with a bias toward holding cash given that valuations have been high. However, with the recent market pullback, we are putting cash to work in certain asset classes (in alignment with Investment Policy Statements). Of course, if China’s economy stumbles, the yield curve flattens, high yield spread widens or the high yield bond default rate increases more than expected we could move back to this cash bias.
It is important to note that no one can time markets or tell what will happen tomorrow. We aim to capture long term market risk adjusted returns that are in alignment with your financial plan with the goal of maximizing your probability of success.....not to try to achieve the highest return possible every year. Our approach stacks the cards in your favor, whereas the latter approach can have a dramatic negative impact on that probability. As always, please contact us with any questions or concerns you develop. The best place for your focus is not on markets, which you cannot control, but on your own behaviors: spending and saving.
Overheard the other day by one of us, "Dad, you need to calm down. Turn off Fox News and go relax. The sun will rise tomorrow." We could not agree more with that prescription. You can ignore the Chicken Littles, as you have done the planning. Yes, markets go up, and yes markets decline. But that is no surprise, which means we can take it into consideration in your planning. This is WHY we do planning and build resilient portfolios. It is never fun to have negative volatility, it elicits our natural "fight or flight" response. However, as any long term client of ours or reader of this blog knows....that fight or flight response may keep you alive in the jungle but it is the exact opposite of what makes us successful investors over the long run. So, to quote our friends and allies across the pond..."Keep Calm and Carry On". While many fear market pullbacks, we welcome the opportunity to rebalance into and purchase securities at lower prices with higher future expected returns.
1. Standardized Performance Data and Disclosures
Russell data © Russell Investment Group 1995-2014, all rights reserved. Dow Jones data provided by Dow Jones Indexes. MSCI data copyright MSCI 2014, all rights reserved. S&P data provided by Standard & Poor’s Index Services Group. The BofA Merrill Lynch Indices are used with permission; © 2013 Merrill Lynch, Pierce, Fenner & Smith Inc.; all rights reserved. Citigroup bond indices copyright 2014 by Citigroup. Barclays data provided by Barclays Bank PLC. Indices are not available for direct investment; their performance does not reflect the expenses associated with the management of an actual portfolio.
Past performance is no guarantee of future results. This information is provided for educational purposes only and should not be considered investment advice or a solicitation to buy or sell securities. Diversification does not guarantee investment returns and does not eliminate the risk of loss.
Investing risks include loss of principal and fluctuating value. Small cap securities are subject to greater volatility than those in other asset categories. International investing involves special risks such as currency fluctuation and political instability. Investing in emerging markets may accentuate these risks. Sector-specific investments can also increase these risks.
Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, liquidity, prepayments, and other factors. REIT risks include changes in real estate values and property taxes, interest rates, cash flow of underlying real estate assets, supply and demand, and the management skill and creditworthiness of the issuer.
The principal risks of investing may include one or more of the following: market risk, small companies risk, risk of concentrating in the real estate industry, foreign securities risk and currencies risk, emerging markets risk, banking concentration risk, foreign government debt risk, interest rate risk, risk of investing for inflation protection, credit risk, risk of municipal securities, derivatives risk, securities lending risk, call risk, liquidity risk, income risk. Value investment risk. Investing strategy risk. To more fully understand the risks related to investment in the funds, investors should read each fund’s prospectus.
Investments in foreign issuers are subject to certain considerations that are not associated with investment in US public companies. Investment in the International Equity, Emerging Markets Equity and the Global Fixed Income Portfolios and Indices will be denominated in foreign currencies. Changes in the relative value of these foreign currencies and the US dollar, therefore, will affect the value of investments in the Portfolios. However, the Global Fixed Income Portfolios and Indices may utilize forward currency contracts to attempt to protect against uncertainty in the level of future currency rates (if applicable), to hedge against fluctuations in currency exchange rates or to transfer balances from one currency to another. Foreign Securities prices may decline or fluctuate because of (a) economic or political actions of foreign governments, and/or (b) less regulated or liquid securities markets.
The Real Estate Indices are each concentrated in the real estate industry. The exclusive focus by Real Estate Securities Portfolios on the real estate industry will cause the Real Estate Securities Portfolios to be exposed to the general risks of direct real estate ownership. The value of securities in the real estate industry can be affected by changes in real estate values and rental income, property taxes, and tax and regulatory requirements. Also, the value of securities in the real estate industry may decline with changes in interest rate. Investing in REITS and REIT-like entities involves certain unique risks in addition to those risks associated with investing in the real estate industry in general. REITS and REIT-like entities are dependent upon management skill, may not be diversified, and are subject to heavy cash flow dependency and self-liquidations. REITS and REIT-like entities also are subject to the possibility of failing to qualify for tax free pass through of income. Also, many foreign REIT-like entities are deemed for tax purposes as passive foreign investment companies (PFICs), which could result in the receipt of taxable dividends to shareholders at an unfavorable tax rate. Also, because REITS and REIT-like entities typically are invested in a limited number of projects or in a particular market segment, these entities are more susceptible to adverse developments affecting a single project or market segment than more broadly diversified investments. The performance of Real Estate Securities Portfolios may be materially different from the broad equity market.
Fixed Income Portfolios:
The net asset value of a fund that invests in fixed income securities will fluctuate when interest rates rise. An investor can lose principal value investing in a fixed income fund during a rising interest rate environment. The Portfolio may also be affected by: call risk, which is the risk that during periods of falling interest rates, a bond issuer will call or repay a higher-yielding bond before its maturity date; credit risk, which is the risk that a bond issuer will fail to pay interest and principal in a timely manner.
Risk of Banking Concentration:
Focus on the banking industry would link the performance of the short term fixed income indices to changes in performance of the banking industry generally. For example, a change in the market’s perception of the riskiness of banks compared to non-banks would cause the Portfolio’s values to fluctuate.
The material is solely for informational purposes and shall not constitute an offer to sell or the solicitation to buy securities. The opinions expressed herein represent the current, good faith views of Lake Tahoe Wealth Management, LLC (LTWM) as of the date indicated and are provided for limited purposes, are not definitive investment advice, and should not be relied on as such. The information presented in this presentation has been developed internally and/or obtained from sources believed to be reliable; however, LTWM does not guarantee the accuracy, adequacy or completeness of such information.
Predictions, opinions, and other information contained in this presentation are subject to change continually and without notice of any kind and may no longer be true after the date indicated. Any forward-looking statements speak only as of the date they are made, and LTWM assumes no duty to and does not undertake to update forward-looking statements. Forward-looking statements are subject to numerous assumptions, risks and uncertainties, which change over time. Actual results could differ materially from those anticipated in forward looking statements. No investment strategy can guarantee performance results. All investments are subject to investment risk, including loss of principal invested.
Lake Tahoe Wealth Management, Inc. is an investment advisor registered in the States of Nevada, New York, North Carolina, South Carolina, and Texas.