Each quarter we have supplied our clients brief comments about the economy, the markets and our thinking about both. We assemble these comments after we have had an opportunity to review the last quarter’s events, and consider their ramifications going forward. As they are a snapshot in time, these comments can become dated quickly, and so should not be considered investment guidance, nor should they be considered comprehensive of all of our thinking.
Below is that which we have advised our clients after the end of the fourth quarter in 2015.
Fourth Quarter 2015
Though the Fed raised rates in the Fourth Quarter for the first time in nearly a decade in the face of slow but sustained U.S. growth, the S&P 500 rose 7.0% while the Russell Mid Cap Index and US Small Cap stocks both gained 3.6%. The MSCI Index for Foreign Developed stocks gained 4.7% while the corresponding Emerging Market Index rose slightly (0.7%), struggling against continued difficulties in China. The US Aggregate Bond Index fell 0.6%. High Yield and Inflation-Protected Bonds posted losses of 4.9% and 1.2% respectively.
FOURTH QUARTER 2015 COMMENTS
The great growth achieved by China over many years was the product of a building boom promoted and engineered by the Chinese government, and financed by poorly regulated and poorly policed debt and equity markets. Great fortunes were made, though not well-shared. The result was massive industrial capacity constructed, but inadequate demand. Indeed, some argue that with an increase in the sharing economy (see: Uber) and in the use of phone applications in place of buying hard goods, China’s excess capacity may never actually get used.
China’s problems have become the world’s problems, as the temptation of all nations with excess capacity and potential instability is to lower prices sufficient to squeeze out competition, increase demand for their own products, and put that capacity to work. As Chinese nationals nervous about their political landscape have rushed to expatriate their cash by buying foreign assets, China’s currency has fallen and America’s currency has risen. Other governments have cheapened their currencies by lowering interest rates, most recently into negative territory in Japan. Indeed, according to Merrill Lynch, 55% of government bonds around the world now carry interest rates of 1% or less. Downward pressure on prices continues, and inflation globally is so low as to touch upon deflation.
As the U.S. dollar has strengthened, U.S. goods have become more expensive for foreign buyers. Consequently, exports were in decline in 2015 for the first time since the financial crisis. Even Macy’s reported slower sales in the holiday season in part because of lower spending by foreign tourists in their stores. While the service sector continued to enjoy growth and pricing power, prices of durable and nondurable goods subject to foreign competition fell for the better part of 2015, and U.S. manufacturing entered recession. It is under these circumstances that a most troubling concern has arisen, and that is in what seems to be a climb in inventory to levels well above normal and not seen since the last recession.
As the global economy has slowed, so too has the demand for oil and support for its price, an unfortunate development for energy producers of all descriptions, especially since they are multiplying. In addition to the impact of fracking and cost-effective alternatives, the return to the market of Iran and its oil has taken place at just the wrong time, producing a collapse in energy prices and threatening the solvency of energy-producing operations and of the bonds that financed them. As a result, high yield bonds especially suffered losses.
Except when in shock, the markets are forward looking. The decline in stock market prices at the beginning of 2016 reflects a decline in estimated earnings, which in turn are the product of lowered expectations for global growth. The damage to estimated earnings may not be over.
But it would likely be a mistake to act on a belief that stocks have a great deal farther to fall than they already have. First, the prices being paid for those estimated earnings now appear more attractive than they have for many years, given interest rates that are low and likely to remain low. For example, dividends on the S&P 500 are now higher than the yield on a 10-year Treasury. Which would investors prefer to own for the next 10 years? A bond, with no prospect for appreciation and less than a 2% yield? Or a diversified basket of stocks with the prospect for at least some price appreciation and a 2.3% dividend yield in the meantime?
Further, there continues to be a great deal of money on the sidelines. According to the investor Richard Bernstein, individual investors have been sellers of stocks, not buyers. Meanwhile, corporations continue to sit on a massive amount of cash which, in a slow-growth global economy of excess capacity, they are reluctant to invest. What are their remaining options? The companies could increase their dividends, but their largest shareholders neither want to pay the taxes nor have anything else they can do with the cash. That leaves mergers and acquisitions and share buybacks.
Given that the world is so awash in cash looking for opportunity that cash is virtually free, Wall Street’s traditional role of selling shares to raise capital for companies is no longer the money making opportunity it once was. Money is easy to come by, and corporations already have all they need. Instead, as companies engage in share buybacks, Wall Street’s opportunity is in helping their corporate clients find the shares to buy. Under such circumstances, it behooves Wall Street firms in the service of their corporate clients to induce retail investors to sell their shares, not to buy them.
And indeed, it has been retail investors selling and corporations buying. Consequently, though earnings may not have much to grow in absolute terms, earnings per share can grow, as the number of shares in circulation shrinks. Meanwhile, mergers and acquisitions, which last year were running at a record pace, can enable companies to achieve new efficiencies and higher profits even in the absence of broader economic growth.
Finally, no sooner might one surrender to a belief that market forces are downward than the Fed may in fear step in with new stimulus, following the lead of the central banks of Europe and Japan even into negative interest rate territory. And market economies do have at least some important self-corrective mechanisms. For instance, energy prices have stumbled badly, but lower energy prices put cash in consumer pockets while making attractive new opportunities that other producers can take advantage of.
Stocks have received a pummeling and bond prices remain high. But the world today is no worse, and is in many respects better, than it was in the years 2000 and 2008, the former when price to earnings ratios were sky high compared to today and the latter when the financial system was a giant Ponzi, both households and corporations sustained by debt. Investors who remained disciplined recovered from both market declines and advanced. It will remain always the case that it is in moments of fear that the best values are to be had in the purchasing of stocks. It was investors who lost discipline and abandoned ship in the midst of the storms who failed to recover.
The thoughts expressed on this web page provide insight into the investment and/or financial planning considerations of members of C.H. Douglas & Gray, LLC, a firm providing fee-only financial advice in asset management to households and institutions in states in which it is registered. Specific investment advice is available only to clients of the firm. Contact C.H. Douglas & Gray for more information.