A volatile year ends with a whimper

The Dow Jones Industrial Average is made up of 30 large, well-known companies. It is the best known and oldest of the many yardsticks that measure stock market performance.

While not necessarily a household name, the S&P 500 Index—as its name implies—is made up of 500 larger U.S. companies. It captures about 80% of the entire market capitalization (S&P Dow Jones Indices), and is the most often quoted measure of market performance among analysts.

While the S&P 500 made significant advances in 2013 and 2014, this past year action in stocks felt more like 2011, when overseas tremors reached our shores. While 2015’s ride was not as volatile as that of 2011, the S&P 500 did experience its first 10%+ decline in four years (St. Louis Federal Reserve). In both years, the benchmark index ended the year pretty much where it started. 

But that doesn’t mean we didn’t have winners and losers. Technology, health care, and consumer-driven issues posted modest gains (Bloomberg), the relentless drop in commodity prices hit the mining and energy sectors hard, large companies beat smaller companies, and U.S. stocks generally topped international.

Meanwhile, longer-term Treasuries yields continue to hold near historic lows, which signaled there’s still plenty of interest in the most creditworthy bonds.

Ultra-low government bond yields in Europe (Bloomberg) may be attracting overseas investors who are seeking both a relative degree of safety and higher returns. Or, expectations that U.S. growth and inflation won’t significantly accelerate may also be keeping investors engaged in Treasuries.

We did, however, see modest backup in bond yields among investment grade issues (as measured by the BofA Merrill Lynch US Corporate Master Effective Yield—St. Louis Federal Reserve) and bigger problems in high-yield bonds, sometimes called junk bonds.

Expectations of an eventual Fed rate hike probably influenced yields in investment grade issues. But the sharp increase in junk bond yields, especially those with the lowest credit ratings--what I sometimes call the junkiest of the junk--were tied mostly to problems in the energy and mining sectors.

Table 1: Key Index Returns

Source: Wall Street Journal, MSCI.com

MTD returns: Nov. 30, 2015–Dec. 31, 2015

2015 returns: Dec. 31, 2014–Dec. 31, 2015

*Annualized

**USD

Emotional vs. disciplined investing

I’ll touch on some of the issues affecting high-yield shortly, but last year’s lackluster performance in key stock and fixed income sectors is a perfect segue into why long-term goals and sticking with a carefully crafted investment plan have historically been the best way of managing risk and reaching your financial goals.

First, your personal situation, goals, and risk tolerance influence your asset allocation (which is the wonky way of saying your investment plan). If your personal situation has changed, you may want to make a mid-course adjustment to your investment portfolio.

But for many investors, the plan that was designed specifically for you remains the best long-term roadmap.

Let me explain by highlighting a study published last year by DALBAR, one of the nation’s leading financial research firms and one with a 40-year track record.

The study found that over a 20-year period ending December 31, 2014, the average equity stock fund investor posted an average annual return of 5.19%, which compares unfavorably to the average annual return for the S&P 500 Index of 9.85%.

Going back 30-years, DALBAR paints an even gloomier picture, with the average equity stock fund investor earning 3.79% annually versus the S&P 500’s average annual gain of 11.06%.

As the study underscores, “Investor underperformance is present in all investment classes, therefore proving (the word it used in the study) that the failure is not primarily one of poor asset allocation.”

Let me be clear. My goal has never been to match or outperform the S&P 500 Index.

An all-stock portfolio, even one that is fully diversified, is too risky for most investors. I typically recommend a fixed-income component that not only reduces overall volatility but creates a steady stream of income.

So what may be the causes of such woeful underperformance?

Some simply has to do with everyday cash needs and unplanned expenses. But the study concluded that the largest contributor came under what it called “voluntary investor behavior,” which generally represents “panic selling, excessively exuberant buying, and attempts at market timing.”

Prudential took the study one step further and analyzed equity cash inflows and outflows over the last 20 years ending December 31, 2014.

Not surprisingly, investor interest was the highest when shares peaked in 2000 and outflows were largest when prices approached the bottoms in 2002 and 2009.

It’s what happens when emotions get in the way of a disciplined approach.

Honestly, I get it. There is a temptation  to sell when stocks are in downdraft, as we briefly saw last year. But as I have repeatedly stressed, your financial plan takes into account those hard-to-time downturns, which leaves us well positioned when shares inevitably move higher.

China and a look ahead

Last year, international events played a role in hampering sentiment at home. A slowing economy in China provided just the right excuse for late summer’s correction.

China’s rocky transformation from an industrial-based, infrastructure-driven economy to one that is more balanced remains a headwind to sentiment. 

But keep in mind that U.S. exports to China account for less than 1% of the total U.S. economy (U.S. Bureau of Economic Analysis). Hence, it’s hard to imagine a scenario where weakness in China pulls the U.S. into a recession.

Then there is Greece. The troubled nation created headlines and short-term volatility in 2015. While last year’s “solution” is tenuous at best and we may not have heard the last from Greece, eurozone leaders appear to have created a financial firewall that is strong enough to contain the fallout if we see the outside possibility and Greece defaults this year.

But political uncertainty on the continent and a wave of immigrants from the Middle East are creating challenges that must be addressed.

Manufacturing woes and oil

Closer to home, the U.S. service sector has continued to expand at a moderate pace, but manufacturing remains in the doldrums.

Stepping back, most of us recognize that manufacturing accounts for a just a small segment of the U.S. economy. However, it is more volatile and can exacerbate a downturn and accentuate an upturn.

More importantly for investors, S&P 500 performance and industrial production in the U.S. have a fairly close correlation (St. Louis Federal Reserve). Simply put, a healthier industrial economy would likely create a favorable tailwind for stocks.

As we enter the New Year, two stiff headwinds remain–oil and a stronger dollar that is contributing to weakness in exports.

Many of us are being treated to the lowest gasoline prices in years [you might even include here a price you paid or spotted recently]. But consumers are benefiting at the expense of producers, and not just the big oil companies.

Sharp cutbacks in capital spending in the energy sector, coupled with layoffs, are hampering manufacturing.

Yes, low oil and commodity prices help keep inflation in check, but again, that’s creating big problems in the energy and mining sectors.

Junk gets junkier

The well-documented problems in energy and mining have spilled over into high-yield bonds. Moreover, the riskiest bonds, or those which sport the lowest ratings, have seen the largest jump in bond yields.

In less than a year, yields with a ‘CCC’ rating have more than doubled, and the difference in yield between higher quality junk debt (BB) and lower quality junk (CCC) has widened considerably (St. Louis Federal Reserve).

Rattle the bond market and you can rattle the stock market. Yet, measures of credit conditions used by the Federal Reserve indicate financial stresses in the economy remain muted as the New Year begins (St. Louis Federal Reserve).

If oil and the commodity sector begin to bottom and the economy continues to expand at a modest pace, historical analysis suggests that much of the damage in junk bonds is probably behind us.

However, a lack of liquidity in the sector, the outside potential for a broader economic slowdown, and continued problems in mining and energy may generate additional uncertainty.

While the jury it still out, a Fed policy that encouraged very low interest rates, which in turn, encouraged a reach for yield by investors, may have created too much enthusiasm for high-yield debt over the last couple of years.

Seeking clarity in earnings

Finally, let’s end on a more upbeat note.

Corporate earnings are probably the most important variable in determining the direction of stocks over the medium and long term. Yes, other factors can create volatility shorter term, but profits are the lifeblood of stocks.

According to Thomson Reuters, earnings for S&P 500 firms collectively fell by 0.8% in Q3 and are forecast to decline 3.7% in Q4. Much of the weakness can be pinned on a steep drop in earnings among energy companies.

Pull out the energy sector and Q3 profits would have been about seven percentage points higher, according to FactSet Research.

The rise in the dollar has also weighed on profits of multinationals, as they translate sales abroad back into the stronger greenback.

But Thomson Reuters is projecting that earnings will begin rising again in the first quarter of 2016 and accelerate in Q2 and Q3.

Of course, what happens to energy, the dollar, and the economy will ultimately determine the path of corporate earnings. But the forecast for an improving profit outlook, which I don’t believe is fully priced into stocks, gives rise to cautious optimism as 2016 begins to unfold.  

Bottom line

I always stress the importance of an investor being comfortable with their portfolio. One of my goals for my clients is to help them accumulate wealth without taking on undue risk.

Stick to the plan. Markets rise and market fall, but unless there have been changes in your circumstances or you’ve hit milestones in your life such as retirement, stay with the plan. By itself, a long run in stocks isn’t a good reason to bail out of the market.

But you must be comfortable with the level of risk you’re taking as you set out to meet your objectives. If you are not, talk to your financial planner and recalibrate.

Rebalance. Changes in various asset classes may have knocked you out of alignment with your target stock and bond allocations. Now may be the time to take profits on winners and selectively reallocate the proceeds.

Let me end with this comment from Warren Buffett. “Someone is sitting in the shade today because someone planted a tree a long time ago.” For many, we have already planted that tree, so I encourage you to stay with the plan that nurtures and grows your tree.

I hope you’ve found this review to be educational and helpful.  If you have any questions or would like to discuss any matters, please call your financial planner or feel free to give me or any of my team members a call at 781 930 3003.

Now, as we all navigate through the turbulent waters of 2016, I wish you the best, and remember... stay disciplined

Best,

Eric