4Q 2015 Commentary – Year In Review
by Richard Siegel, CFP®
2015 was a frustrating year for investors. Nothing really worked, and in order to finish almost flat for the year, one had to stomach quite a bit of volatility. The first official stock market correction in four years began in the spring and lasted into the fall while the capital markets digested mixed economic data, the first interest rate increase in almost a decade, and a heightened fear of global terrorism. Corporate earnings, the lifeline of stock prices struggled throughout the year as the U.S. dollar strengthened against other major currencies and plunging oil prices drove energy and materials stocks off a cliff. Despite all of the uncertainty and adversity, the overall U.S. economy has continued to deliver decent growth and the unemployment rate has improved to levels not seen since before the Great Recession.
|Dow Jones Industrial Average(pr)||-2.23%|
|MSCI EAFE (Foreign developed markets)||-0.81%|
|MSCI Emerging Markets||-14.92%|
|U.S. Aggregate Bond Index||0.55%|
|U.S. High Yield (Junk Bonds)||-5.03%|
|Foreign Government Bonds||-6.69%|
|REITs (Real Estate Investment Trusts)||1.75%|
One of the best economic metrics to illustrate the strength of the economy is gross domestic product (GDP). The four major components of GDP are:
• Personal consumption: examples are autos, clothing, food, education, banking services
• Investment: personal home purchases, business spending
• Net exports: this is a drag on GDP as the U.S. imports more than it exports
• Government expenditures: goods and services, defense spending, infrastructure spending
Personal consumption, otherwise known as consumer spending, accounts for about 70% of GDP. It is therefore safe to say that the U.S. is a consumer driven economy. When people are meaningfully employed and feel confident in their financial position, they spend money on homes, cars, clothing, vacations, and dining out. This spending is good for corporate earnings and supports higher stock prices over the long run. By no means has GDP growth been setting any records, but recent growth in the 2 – 2.5% range with low inflation qualifies as a reasonably healthy, moderate growth economy.
Volatility in the equity market is quite unsettling. During the 3rd quarter of the year, volatility as measured by the VIX index, otherwise known as the “fear index,” spiked to levels that are considered extreme, and was coupled with significant downside momentum in equity prices. Historically, the VIX level averages approximately 18 – 20. The following chart illustrates just how significant the volatility was relative to the last several years.
It is important to note that while volatility is a necessary evil of investing, being diversified in the equity markets can limit the amount of downside risk to which an investor is exposed. Having an allocation in large cap, mid cap, and small cap U.S. stocks across multiple sectors as well as foreign stock investments serves to lower volatility and overall portfolio risk. The three year chart below illustrates how broad global diversification has delivered smoother returns than a concentration in one sector.
Looking globally, the U.S. stock market is probably the most expensive stock market in the world. That said, “expensive” is relative; the U.S. market on the whole is fairly priced based on most measures of valuation, while most foreign markets are trading at discounted levels. Now that the Fed has finally raised interest rates and is discussing future rate hikes in the coming months and years, they are officially transitioning into a tightening monetary policy. Most foreign equity markets have significantly underperformed the U.S. in recent years and their economies are implementing loose monetary policies. We feel that it is time to capitalize on these valuation and economic discrepencies. Over the next few months, we will be incrementally increasing our international equity exposure across our portfolio strategies.
Fixed Income Overview:
The broad U.S. bond market eked out a gain for 2015 as measured by the Aggregate Bond index. This index is made up of high quality treasury, mortgage, and corporate bonds. The strenghthening dollar made a dent in the price of foreign bonds and lower quality “junk” bonds had a very difficult end to the year based on the energy sector playing a significant role in the junk bond category.
The future of bond returns will be determined by the path of monetary policy and inflation. We expect the Fed to take a very tentative approach, raising rates slowly and methodically. This would not put great pressure on the price of bonds. If inflation begins to rear its head and intermediate and longer term rates begin to rise towards their averages, bond prices will experience greater downside pressures, for which we are well positioned. When the Fed raises rates, they are raising short term rates, not longer term rates. As short term rates normalize, yields on cash deposits, money markets, and CDs will begin to slowly move higher. We look forward to earning a yield on cash, and believe this action by the Fed is long overdue.
Our contention is that this economic cycle is not over; bull markets tend to end with excesses in the system: our economy is not overleveraged, the market is not overvalued, and consumers are not overspending. Until one or more of these excesses reveal themselves, the economy can continue to grow, which in turn should drive both corporate earnings and the stock market.
“I will tell you how to become rich. Close the doors. Be fearful when others are greedy. Be greedy when others are fearful.” – Warren Buffett