In 2015, the S&P 500 increased 1%, the MSCI Global Index declined 2%, and the Barclays Aggregate Bond Index gained 1%. Emerging international and small-capitalization stocks struggled, declining 15% and 4%, respectively. Given the strong run in recent years, few may be surprised equity and bond markets took a pause, and in some segments, suffered significant declines. After all, markets have never gone straight up.
Even still, 2015 confounded Wall Street and main street investors alike. Sure, Jamaica’s stock market soared 97%, but the year included very little “don’t worry, be happy” for investors. Perhaps the 2015 torment was because not much worked other than the Facebook Amazon Netflix Google trade. Bonds, most stocks (large and small domestic or international), commodities, and alternative investments were all basically flat to down big. Of 35 asset types tracked by Bloomberg, the median loss was 5%. Even the “Oracle of Omaha” struggled as Berkshire Hathaway declined 12% in 2015. Not alone, many other “value” managers and the highest profile hedge fund managers fell as much or more than Mr. Buffett.
If disappointing returns were not enough, investors also endured increased volatility. Of 252 trading days in 2015, 73 saw market swings greater than 1%. There was also a short-lived 5% plunge at the market open on August 24 and a 12% peak to trough pullback in late summer. Fueling the volatility fire were ISIS, China’s summer market crash, a broad-based commodities implosion, and angst surrounding the first Fed rate hike in nine years.
Whether the 2016 news flow proves more or less formidable remains to be seen. A Presidential election (usually a good thing for U.S. stocks), global war against ISIS, the natural economic cycle, China’s path forward, and important business-related topics such as corporate tax reform and the future of “Obamacare” are all of interest. What we do know, however, is in 2015 our financial markets and people around the world have again shown remarkable resiliency in the face of the tragic and unexpected.
“We may never know where we’re going, but we’d better have a good idea where we are.” –Howard Marks, Chairman Oaktree Capital Management.
The “F.A.N.G. Fingers” of 2015
Nashville Predators’ fans know that when the visiting team commits a penalty, the crowd responds in unison with “FANG Fingers.” Portfolio managers with limited exposure to Facebook, Amazon, Netflix, and Google in 2015 found themselves in the penalty box. These four stocks alone increased 83% on average. Without their contribution, the S&P 500 was down 2% versus up 1%. Put another way, the much watched market “breadth” indicator was historically narrow in 2015. In fact, roughly half of the 500 companies in the index are in bear market territory down 20% or greater from their recent highs.
Anything in the energy, broader commodities complex, and transportation sectors suffered mightily. Overcapacity, reduced demand from China, and some secular challenges took root. The extent of the carnage within these sectors was shocking. High profile and historically successful companies such as ConocoPhillips, Freeport-McMoRan, Potash, Caterpillar, Union Pacific, and Kinder Morgan were all down 25% or greater in 2015.
Some Wall Street strategists expect the F.A.N.G. trade to work again in 2016. While all exciting companies with growing and disruptive solutions, our exposure is generally limited to one of the F.A.N.G.s or via ownership of some broader market indices. Trading at an average “adjusted” P/E multiple of 154X and having appreciated 337% since 2012 on average, we believe the relatively limited exposure is prudent given the investment objectives of most of our clients.
Fed Rate Hike: “The Force Awakens”
The $4.5 trillion question is whether the Fed can stick the landing after a decades long easy money trapeze act. On the surface, the markets seem to have taken the initial December rate hike in stride. Below the surface, pockets of disruption have emerged. For example, “spreads,” otherwise known as the yield investors demand above the “risk-free” Ten-Year Treasury yield, have widened dramatically.
Much of this sell-off and uptick in yield seemed inevitable. MLPs, leveraged loan funds, high-yield bonds, REITs, and certain dividend paying stocks had become popular investments for income-starved investors. For anyone uncertain of the power of the Fed’s low-rate “Force,” consider leveraged loan mutual funds experienced 95 consecutive weeks of net investor contributions leading up to the correction. As quickly as money pours into a trendy trade, it can go. Just since June, what many on Wall Street marketed as “safe” income investments have fallen sharply due to increased fundamental concerns and the simple fact investor outflows have greatly exceeded inflows.
As we often say, there is no free lunch in investing. The reach for yield destroyed many portfolios in 2015. We were pleased clients had limited or no exposure to the most toxic of these investments. Instead, most balanced accounts have sufficient cash with which to go shopping for yields that are much more attractive on an absolute basis and more commensurate with the associated risks. All the while, we must keep in perspective the modest rate “tick-up” represented by the December hike. Yes, the Fed is expected to pursue a “measured” pace for future rate hikes. But, with a Fed Funds rate of 0.25%, we are far from a normal rate environment.
Commodities: Bust, Boom, and Now Bust Again
Ben Graham once remarked, “Wall Street people learn nothing and forget everything.” The resulting tendency is to overinvest in times of optimism and underinvest in times of fear, which would help explain the boom and bust cycle of most commodities.
The current bust now rivals 2009. Over the past decade, easy access to capital and optimistic forecasts for China demand contributed to a dramatic increase in production capacity for most commodities. The U.S. shale revolution, Saudi Arabia’s fervent defense of its market share, and now renewed Iranian supply have only added to the recent supply and demand imbalance in oil markets.
Few predicted this current “lower for longer” scenario. Because the “cure for low prices is often low prices” as capital investment must slow, some credible forecasters are calling for a rebound in oil the second half of 2016. Recognizing the difficulty of forecasting oil prices and commodities in general, we continue to limit our exposure to “best-of-breed” industry participants with strong balance sheets and attractive margins. We will also look to make small investments where current industry headwinds and some non-fundamental selling pressures have resulted in severe market overreactions. After limiting exposure to the sector for years, our recent allocation to midstream MLPs is one example.
Finally, it is important to note the commodities route has contributed to levels of debt distress we have not seen since the Lehman crisis in 2008. We expect the current and future fallout to present compelling opportunities for fixed-income investors. Yet another reminder; cash (or cash equivalents) is king in periods of dislocation.
“In Investing, What Is Comfortable Is Rarely Profitable.” Robert Arnott, former Editor CFA Institute’s Financial Analysts Journal
This time of year, the Wall Street firms issue their forecasts for the coming year. A consistently optimistic bunch, the expectation is for 7.6% earnings growth according to FactSet. The initial forecast was for similar growth in 2015 versus a flattish result. Based on the current forecast, the S&P trades at 16.1X 2016 earnings versus a twenty-five year average of 18.5X and longer-term average of 15.5X. While corporate earnings are increasingly “adjusted” and arguably of less quality, at these levels stocks aren’t cheap but in the aggregate aren’t that expensive either.
International and emerging markets continue to trade at significant discounts to the U.S. markets. Our relatively small tactical tilt outside the U.S. markets fared well in the first half of 2015. However, a strengthening dollar and many emerging economies’ dependency on commodities resulted in non-U.S. markets under-performing for the year. A far from “comfortable” position, we continue to think investment exposure to these markets is a prudent part of a well-diversified portfolio.
“Before Beginning, Plan Carefully.” Marcus Tullius Cicero
There are few substitutes for planning in any pursuit. In investment and wealth management, this means setting long-term objectives balanced against one’s tolerance for risk. If mismatched, individuals are prone to abandon investments in a run for safety or pile on in a desire to keep up. Either shift can prove painful over the inevitable up and down cycles of the market.
We spend considerable time trying to understand the current investment landscape and identify opportunities where the investment reward for the risks is compelling. This helped us move quickly to increase clients’ equity exposure in the financial and U.S. debt crises and steer clear of the trendy income investments that suffered in 2015. Just as important as our work to identify investment opportunities, we seek to understand and regularly update our clients’ long-term investment objectives, financial condition, and risk tolerance. If your circumstances or objectives have recently changed, we want to discuss and update our plan accordingly.
Thank you for your continued confidence. Best wishes for a healthy and prosperous 2016, and please know we look forward to discussing your investment plan and answering any questions you may have.
Tags: Quarterly Commentary
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