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Alan McKnight, MBA, CFP®
January 21, 2016
Stock market volatility was the order of the day during the majority of 2015. Most major stock market indices were negatively affected by economic stress in China and Greece, coupled with underwhelming corporate earnings reports, falling oil prices and terrorist attacks here and abroad.
A few sectors such as housing and labor, offered favorable news, others, including exports and wages, showed little in the way of positive movement. Nevertheless, despite inflation running below the Fed's target rate of 2.0%, there were enough signs of overall economic growth to prompt the Fed to raise interest rates in December for the first time since 2006.
Of the major indices I have listed below, only the NASDAQ posted a gain for 2015. Even though the markets rallied strongly after a weak 3rd quarter, none of the other indices were able to eke out a gain for the year.
For 2015, the change in value of each of the major world market indices was as follows:
In order to provide some perspective here, the NASDAQ contains over 2,500 stocks, but its performance, most recently, has been dictated by only a handful of those stocks.
The so-called “FANG” stocks (Facebook, Amazon, Netflix and Alphabet/Google) are all held by the NASDAQ and averaged an 86% return in 2015, and even with the recent market slump, these stocks are demanding a higher premium with price-to-earnings ratios of 46.64 for Facebook, 117.80 for Amazon, 401.77 for Netflix and 26.16 for Alphabet/Google. That is rich by almost any measure and could prove dangerous to investors.
In the first two weeks of trading for 2016, each of these stocks have lost 9%, 15%, 5.7% and 7.6% respectively.
NOTE: As I have been compiling data for this 4th quarter 2015 commentary, the equity markets have certainly experienced an unusually turbulent start for 2016! Most of this recent market volatility is a reaction to a slowdown of growth and further currency devaluation in China combined with continued oil price weakness. As you know, we do not make emotional investment decisions for our clients, rather we always offer advice based on each client’s personal situation. We continually monitor the markets for our clients and try to keep a regular line of communication going. We sent out the communiqué on Monday, January 11 entitled: “What is Going on With the Stock Market.” I hope that you found it useful and informative.
Now that the Fed has increased rates for the first time in several years, almost every analyst and publication has a prediction for interest rate movements in 2016. For now, investors can expect more “will they or won’t they?” drama from the Fed.
The staff of Fortune magazine recently assembled its predictions for 2016. They forecast that the federal funds rate at the end of 2016 will be 0.5%, up from 0.25%. They expect the Fed to raise its interest rate targets once in 2016, but only once, as U.S. economic growth stays steady but slow, while inflation and wage growth also remain modest. Fortune sites that fears of seeming “political” during a presidential election year, sluggish growth in the Eurozone and a slowdown of the Chinese economic juggernaut will keep Janet Yellen and the rest of the Federal Open Markets Committee (FOMC) from pulling the trigger more often. They predict the Fed’s vacillation will be one of the year’s longest-running (and least loved) dramas.
Back in December, Fed Chairperson Janet Yellen stated that “The committee expects economic conditions will evolve in a manner that will warrant only gradual increases in the federal-funds rate.”
As for rates paid on bank deposits, they are not getting off the floor just yet. Barron’s writes that “investors should not look for money market yields to rise enough to be discernable without a magnifying glass”. For 2016, interest rates are an issue that investors need to keep a watchful eye on.
China is still the second largest economy in the world. Both the Chinese economy and their stock markets are areas for investors to monitor in 2016. "In many countries the stock market can be seen as a leading indicator of the economy. But that is not true in China," wrote Jeffrey Kleintop, Chief Global Investment Strategist at Charles Schwab. "You really can't get any less related than the Chinese stock market and its economy." Investors are encouraged to focus less on gyrations in China's stock markets, and to pay more attention to the country's economy. There, a gradual, expected slowdown is taking place.
Experts have known for a long time that China's growth would slow as Beijing made reforms designed to shift the country away from building roads, railways and housing to generate growth to an economy powered by consumer spending. That's happening now and economists expect final growth of 6.8% in 2015, and around 6.5% this year. China is a far cry from the potent days when it posted GDP growth of 10% on a regular basis, but it should also be strong enough to maintain employment levels as difficult reforms are implemented. Slowdowns in China can have impacts on investors worldwide, and investors need to pay attention.
International Markets (ex-China)
For most of 2015, economic problems overseas impacted the US and contributed to the Fed's caution with raising interest rates. Though the European Central Bank extended its program of buying bonds, cut a key interest rate to -0.2%, and passed measures intended to pressure banks to lend more, the Eurozone economy grew at an annual rate of just 1.2%, with unemployment sitting at 10.7% and inflation at an annual rate of only 0.1%. Greece began the year electing an anti-austerity prime minister, saw its economy contract to the point where its banks and stock markets were forced to shut down, then agreed to more intense austerity measures to help support its economy.
Bond yields ticked up modestly at the close of 2015, even though many had expected the yield on 10-year Treasuries to rise toward 3.0% by the end of the year, especially with the interest rate increase announced by the Fed early in December. Keep in mind thought that when the Fed is raising or lowering short term interest rates such as the fed funds rate or discount rate, it is mainly going to affect rates on savings and deposit accounts, the prime lending rate, home equity lines, etc. Treasury bond yields tend to be influenced more by economic growth which remaims relatively modest.
The yield on 10-year Treasuries closed 2015 at 2.26% compared to the 2014 closing yield of 2.17%. A strong dollar, continued uncertainty surrounding the global economy, and low inflation made Treasury debt an appealing investment choice, keeping bond prices up and yields down.
The price of oil dropped 33% in 2015, and as oil producing countries flooded the market, oil prices remained below $40 a barrel. While falling energy stocks have had a negative effect on the stock market, the plunge in oil prices helped fatten consumers' wallets, with prices at the pump hovering around $2 or less per gallon for regular gasoline.
As of this writing, oil is hovering right below $30 per barrel, and this continued slide has the global markets spooked. Currently there have been about 200,000 oil related layoffs in 2015, and there are more projected for 2016. The energy sector has idled more than 1000 rigs and slashed more than $100 billion in spending this year in order to cope with the oil bust, according to Bloomberg.
As I mentioned in the earlier portion of my commentary, price-to-earnings ratios are still a key factor in the valuation of equities for many analysts. According to Jurrien Timmer, Director of Global Macro at Fidelity Investments, the outlook for 2016 really seems to be more of an earnings question. The US learning cycle peaked in early 2015, profit margins are near record levels, and more than half of corporate earnings are coming from share buybacks. He feels that it remains to be seen what we can expect from earnings growth in 2016, especially if the sectors that are most tied to the global economy (industrials, energy, materials, etc.) remain depressed. Mid-single digit earnings growth may be a reasonable expectation. That’s where it was in 2013 in 2014 and where it would have been in 2015 if energy had been stripped from the equation.
Valuations are not totally unreasonable when looking at forward price-to-earnings ratios for the S&P 500. Valuations could remain reasonable even if yields rise with one caveat. Such an increase needs to be accompanied by acceleration in earnings growth. Some may consider valuations high, depending on the measure used, but they should not pose a great deal of danger.
Falling oil prices coupled, with the expectation of higher interest rates, helped boost the U.S. dollar, which continued to rise over the course of the year. The US Dollar Index, a measure of the dollar relative to the currencies of most US major trading partners, gained about 9% over its December 31, 2014, closing value. The dollar also benefitted from interest rates abroad, some of which were even lower than those for Treasuries. The strong dollar raised new concerns that countries and foreign corporations hurt by lower oil prices might have trouble repaying debt in currencies that were substantially weaker against the US dollar.
With inflation hovering below 2.0%, gold, historically seen as a hedge against inflation, saw its value drop throughout the year, posting its third consecutive annual loss. The precious metal ended the year at roughly $1,060.50, about 10% below its value at the close of 2014.
Improvement in the U.S. job market was slow but steady. The unemployment rate ended the year at 5.0%, lower than the 5.6% rate at the close of 2014. According to the Bureau of Labor Statistics (BLS), over the past 12 months the unemployment rate and the number of unemployed persons were down by 0.8% and 1.1 million, respectively. Over the prior 12 months, total nonfarm payroll employment averaged a monthly gain of 237,000, adding 2.3 million jobs. Over the year, average hourly earnings have risen by 2.3% to about $25.25 per hour.
Gross Domestic Product
Challenging weather, a strengthening dollar, and lower oil prices slowed growth in the first quarter of 2015 to 0.6%. Economic growth in the 2nd quarter expanded at an annual rate of 3.9% on the strength of increased personal spending. However, the latest figures for the 3rd quarter show growth is once again slowing down to an annual rate of 2.0%, as consumer and business spending figures were revised downward.
Inflation remained below the Fed's stated target rate of 2.0%, but indications are that it is expanding, albeit at a very slow pace. The BLS reported that the all items index rose 0.5% from November 2014 to November 2015--the largest 12-month increase since the 12-month period ended December 2014. The food index rose 1.3% over the span, while the energy index declined 14.7%. The index for all items less food and energy rose 2.0%, its largest 12-month increase since the 12 months ended May 2014. The core personal consumption expenditures price index, relied upon by the Fed as an important indicator of inflationary trends, sat at 1.3% for the year, giving no clear indication that it will approach the Fed's 2.0% target rate.
The Housing Market
The housing market had been relatively strong for much of the year. However, the latest figures from the National Association of Realtors show that sales of existing homes fell in November by 10.5% compared to October, and the year-on-year rate of existing home sales is -3.8%, the first such decrease since September 2014. The median price for existing homes in November was $220,300, which is 6.3% above November 2014. The number of new home sales in November 2015 increased 9.1% compared to the number of sales in November 2014. The median sales price of new houses sold in November 2015 was $305,000 and the average sales price was $374,900, compared to $302,700 and $358,800, respectively, in November 2014.
Manufacturing and industrial production have not been consistently strong sectors this year. The Fed’s monthly index of industrial production was down 1.2% from November 2014 to November 2015. In addition, the latest report from the Census Bureau shows orders for all durable goods in the first 11 months of 2015 fell 3.7% on the year.
Imports and Exports
For the year, the goods and services deficit increased $22.2 billion, or 5.3%, from the same period in 2014. Exports decreased $84.7 billion, or 4.3%. Imports decreased $62.5 billion, or 2.6%. Low prices for oil held down imports, while the continued strength of the dollar was a key factor in the year's sluggish exports sector leading to weak demand abroad.
So Where Do We Go From Here?
Volatility will most likely continue in the equity markets, and investors simply need to proceed with caution NOT fear. Many analysts are concerned that there is growing uncertainty about the sustainability in the path of the global economy that the markets have been over the last seven years. At a minimum this confluence of factors signals a considerable amount of volatility heading into 2016.
The more an investor fixates on daily market fluctuations, the more volatile and risky it will appear. Cyclical declines of 5% to 20% or more are very common. The US stock market has, in the past few years, been extraordinarily placid by historical measures.
As I noted in my 3rd quarter 2015 market commentary:
Don’t try to time or predict the market! Investment decisions driven by emotion can cause problems for investors. Discipline and perspective can help investors remain committed to their long-term investment programs through periods of market uncertainty. The best investors try not to constantly look back and second guess their decisions. They make decisions based on facts. Even the sudden drops of the past month are well within the long-term norm. Fixating on fluctuations in the short term will make it harder for an investor to remain focused long-term investing goals.
Have a plan! Every investor needs a disciplined plan. When equity markets are gyrating on a daily basis it is easy to make emotional decisions that could prove to be wrong.
Focus on your own personal objectives! During confusing times it is always wise to create realistic time horizons and return expectations for your own personal situation and to adjust your investments accordingly. Understanding your personal commitments and categorizing your investments into near-term, short-term and longer-term can be helpful.
A portfolio strategy can assist in helping youweather ups and downs of the market. Corrections are a normal part of investing. With a strong plan in place, many investors need not worry or adjust their approach at all. If you are going to make changes, you should try not to panic and sell equities.
Make sure you have adequate liquidity! When the market is down, cash can be a valuable shock absorber. You may want to consider using the cash portion of your portfolio to delay the need to sell equities while the market is down. Selling equities in a downturn leaves you with less invested when a recovery comes, turning what may be a temporary market decline into a permanent dent in your portfolio. Having cash on hand may help give you the opportunity to participate in a recovery.
Get used to volatility! It’s not going away. Volatility and market declines are a part of investment history. Warren Buffett maintains that, just because markets were volatile doesn't mean that for a long-term investor, which is the prism through which Buffett sees markets, the stock market was necessarily riskier. He advises investors not to confuse volatility with risk.
Of course, as always, discuss any concerns with us. Our advice is not one-size-fits-all. We will always consider your feelings about risk and the markets and review your unique financial situation when making recommendations.
We offer consistent communication, a schedule of regular client meetings, and continuing education for every member of our team on the issues that affect our clients.
A good financial advisor can help make your financial journey easier. Our goal is to understand our clients’ needs and then try to create a plan to address those needs. We continually monitor client portfolios. While we cannot control financial markets, interest rates or geo-political events, we will always keep a watchful eye on them. No one can predict the future with complete accuracy, so we keep the lines of communication open with our clients. Our primary objective is to take the emotion out of investing. We can discuss your specific situation at your next meeting, or you can call to schedule an appointment. As always, we appreciate the opportunity to assist you in addressing your financial matters.
If it’s been more than a year since your last financial review, please give Jan Berkholtz a call at our office to schedule an appointment so we can make sure everything is in order. If you feel the need to discuss your situation before our next scheduled review, please call our office at (770) 951-9001 or e-mail me at firstname.lastname@example.org.
Alan McKnight, MBA, CFP® is Vice President of Kays Financial Advisory Corporation. He has 20 years of experience working with retirees and pre-retirees. He is also an Adjunct Faculty Member and Professor of Finance and is an Ed Slott Master Elite IRA Advisor. He can be reached at (770) 951-9001 or at email@example.com.
This report and Mr. McKnight’s comments are provided as a general market overview and should not be considered investment or tax advice or predictive of any future market performance. Any security mentioned in this report may not be suitable for all investors. No investment mentioned in this newsletter constitutes a recommendation to buy, sell or hold a particular investment. Such recommendations can only be made on an individual basis after an assessment of an individual investor’s risk tolerance and personal circumstances. Past performance of any investment mentioned is not a guarantee of future performance. Statements regarding the investment concerns and merits of any company and fair market value computations are strictly the opinion of Kays Financial Advisory Corporation. Employees of KFAC and KFAC clients may have positions and effect transactions in the securities of the issuers mentioned herein.