Q1 2016 Commentary
by Richard Siegel, CFP®
The first few months of 2016 have been extremely volatile for the global markets. Large drops along with big up days have become the norm in the equity markets. Although there are many long term positives, we give the equity markets a “yellow light” based on many of the same trends that were major themes in 2015 carrying over to this year.
- Flat to slightly negative returns coupled with a high level of volatility driven primarily by oil prices and a strong U.S. dollar
- The Federal Reserve constantly in the headlines with the prospect of additional interest rate hikes
- The uncertain nature of the coming Presidential election
- Geopolitics and terrorism
- Mixed economic data: much improved unemployment rate, strong consumer sector, inflation in the 2% range, and a struggling corporate earnings picture
It is worth noting that the “V shaped” rebound in the equity markets during the quarter was directly correlated with oil prices moving from $27/barrel to $40/barrel, the U.S. dollar giving up some ground to global currencies, and the Fed’s dovish comments regarding the pace of interest rate increases.
Interestingly, while the correlation between U.S. stocks and oil prices has been extremely high (over 90%) in recent months, the 20 year correlation is only 25% according to Barclays data.
The market has fully recovered for the quarter from what was the worst ever start to a year. It is a testiment to our clients for riding out the volatility with hopefully not too many sleepless nights. We actually track how many nervous clients reach out to us during market corrections. This barometer let’s us know if we are proactive enough with our communications and if our portfolio strategies are holding up sufficiently in the face of a significant market downturn. During the past quarter, only 4% of our clients contacted us to express their fears related to the market turmoil.
One of the pillars of our methodology is to invest in mutual funds that have a long history of solid upside performance and a strong history of downside protection. When the market is in a correction phase, these funds typically don’t drop as much, acting as a return smoothing mechanism. When volatility is reduced, investors are more likely to stay the course and not panic. Jumping in an out of the market is not a strategy and is detrimental to long term results. Case in point, the S&P 500 was down over 10% within the first two months of the year, while the T. Rowe Price Capital Appreciation Fund (PRWCX) was down approximately half that amount.
Consistent with our “yellow light” theme, we are of the opinion that proceeding with caution at this point is appropriate; the U.S. stock market is fully valued with a forward PE ratio of 16.5, and the sector leadership has been biased toward the defensive sectors which is not an indication of stock market enthusiam. The way we address this is to focus on broad diversification and not allow any single portfolio constituent to exceed its targeted range, essentially selling high and buying low. The table below illustrates just how wide the range of returns for the first quarter was between defensive and non-defensive sectors. Earnings season is upon us and low expectations are already “baked in the cake.” If oil prices can stabilize and Q1 corporate earnings beat expectations, this could be a tailwind for higher stock market levels. We are monitoring closely.
Finally, we tactically added Emerging Markets exposure to our strategies during the quarter. These are markets such as India, Brazil, Mexico, Poland etc. On the whole, the Emerging Markets group is quite inexpensive relative to the U.S. equity market and represents what we believe is an asymmetric risk/return investment opportunity. Not only has the category drastically underperformed for the last several years, it is trading at a price to earnings ratio of 11.
Fixed Income Overview:
Q1 was a very strong period for the fixed income markets around the globe. While equities were getting hammered in January and February, investors were finding safety in bonds. Central bank stimulus in Europe and Japan along with dovish comments by the Fed worked to keep rates low while pushing bond prices higher. In fact in some markets, rates went so low, they actually went negative! Could you imagine having to pay banks to keep your money on deposit? No thanks. From an asset allocation standpoint, bonds did their job, moving higher as stocks moved lower.
We continue to believe the Fed will raise rates at a slow and measured pace. That said, a somewhat defensive posture is warranted in regards to interest rate exposure (duration in the 4 year range) and a somewhat aggressive posture in regards to credit risk exposure (BBB average credit quality). Essentially, the short end of the intermediate term bond spectrum and medium credit quality is what we consider the “sweet spot” from a risk/return standpoint.
As we move into the spring, we expect volatility to remain an issue as earning season is upon us, a historically contentious political landscape will unfold, and “Fedspeak” could spook the markets. Our portfolio strategies are well positioned to sustain volatility, while particitpating in the upside returns of the capital markets with a focus on taking advantage of valuation opportunities across the globe.
“Buying at the bottom and selling at the top are typically done by liars.” – Bernard Baruch