Q3 2015 – Commentary

Q3 2015 – Commentary

3Q 2015 Commentary

by Richard Siegel, CFP®

Undoubtedly, the long overdue stock market correction has finally arrived. It took four years for the S&P 500 benchmark index to revisit this kind of price drop and volatility, but this is the norm, not an anomaly. A “correction” in the market is defined as a 10%+ pullback in prices and typically occurs every year and a half on average. The previous correction in 2011 was highlighted by the first serious whiff of the Greek debt crisis, the Japanese tsunami and nuclear reactor fallout which shut down the 3rd largest economy in the world for a couple of months, and finally the embarrassing credit rating downgrade of U.S debt obligations. I will go out on a limb and say that the current correction is not based on U.S. fundamentals, but rather a technical pullback based on complacency and short-term traders and speculators. It is hard to make a case for a fundamentally driven correction when GDP was recently revised upward to +3.9%, unemployment is down to 5.1%, and housing and auto sales have recently posted strong numbers.

Equity Overview:

Although the stock market volatility has been unnerving over the last several months, let’s examine three different concepts that put the valuation of stocks in perspective.

1) Regression to the mean: This basically means that returns on investments tend to gravitate to their historical averages over long time periods.

Time Period Average Annual Return
87 years    1928 – 2014

9.60%

50 years    1965 – 2014 9.84%
10 years    2005 – 2014 7.60%
15 years    2000 – 2014 4.24%

Strikingly, the last fifteen years has delivered below average returns for stocks. During this time period, there were two major market crashes: the tech bubble 2000 – 2002 and then the credit crisis of 2008 – 2009.  Simply based on regression to the mean concept, stocks should do well going forward to get back to their historical averages in the 9% range.

2) The Rule of 20: The rule simply states that stock valuations are fair when the sum of the price to earnings (P/E) ratio and the rate of inflation is equal to or less than 20. The forward P/E ratio on the S&P 500 is approximately 15 based on next year’s earnings. According to the Bureau of Labor Statistics, inflation is running at 1.8%, making stocks look undervalued.

P/E         =  15

 Inflation =  1.8

  Sum        = 16.8

Even if you use 12 month trailing earnings and assume zero earnings growth for 2016, stocks are still fairly valued based on this rule of thumb.

3) Stock performance during rising interest rates: By all accounts, our monetary policy will be transitioning from an unprecedented period of cheap money to a period of gradually rising interest rates. Very high rates are a headwind to growth as money is expensive to borrow. Additionally, when rates are high, bonds compete with stocks for investors’ capital. The chart below shows how stocks have performed historically in the year following the first rate hike of a tightening cycle.

We feel that gradually rising rates induced by the Fed is a vote of confidence for the strength of the economy and at this time is long overdue.

Fixed Income Overview: 

In a perfect world, bond prices rally while yields fall, providing a hedge against stock losses during a market correction.  This is primarily attributed to investors flocking to the safety of high quality debt instruments. During the past quarter, bonds as measured by the 10-year Treasury bond turned in a meager return. Being that rates are so low, Treasuries can no longer provide the hedging effect that they normally would if rates were higher.  That said, bonds are not part of a long-term asset allocation strategy solely for reasons of protection. Bonds are also important to give a level of stability to a portfolio and provide a return through their yield.

At this time, our clients’ bond holdings are yielding 2.55% on average, while the 10-year Treasury is yielding 2.05%. Additionally, we have positioned our bond holdings to sustain the eventuality of rising rates with minimal volatility. Currently, the U.S. Aggregate Bond Index has a duration (interest rate risk factor) of 5.61 years, while our portfolio strategies have an average duration of 3.52 years, meaning that our bond holdings have approximately 59% less interest rate risk than the benchmark.

In order to accomplish a higher yield and lower interest rate risk, we have elected to invest in bonds with an average credit quality of BBB (medium grade) as opposed to a concentration in higher priced AA government bonds with lower yields. The bottom line is that we view interest rate risk as a bigger threat than credit risk at this time. U.S. corporations are relatively healthy with a tremendous amount of cash reserves on their balance sheets and a very strong ability to service their debt obligations.

Certainly, global equity markets have disappointed in recent months. Here in the U.S., consumer confidence is strong, while investor confidence is at the lowest levels since 2011, both very good signs for rising stock prices. The fourth quarter historically has been strong for the stock market, and with fair valuations, long-term investors should view this as an attractive time to be positioned in a fully diversified portfolio.

If you don’t know where you are going, you might wind up someplace else – Yogi Berra (RIP)