The first seven months of 2015 have offered a wild ride in many markets and asset classes, with most stock indices flatlining for the year. January started on a down note, we had a nice recovery to new heights in the springtime, and have had a lackluster summer as of late.
S&P 500 Index (1 year chart through August 7, 2015)
So far this year, particularly in July, we saw markets collide with a whole bunch of unsettling headlines.
- The euro imploded against the U.S. dollar. And recently, we’ve watched the dollar flex its muscle again.
- Greece tiptoed across the default line yet once again, while Puerto Rico edged towards it.
- Stocks in China, which had a raging bull market that peaked in June, were followed by a bust in July (off 30% +).
- Global bond markets flirted with negative yields
- The Fed continues to telegraph that it wants to start raising interest rates sooner rather than later.
- Corporate profits are running into headwinds from the stronger dollar because overseas sales must be translated back into the more expensive dollar.
- Plus, commodity prices have resumed their downward slide, including crude oil (where’s my savings at the gas pump in California?). Thank the stronger greenback and nagging anxieties about Chinese growth, since China had been a voracious buyer of raw materials during the last decade.
- California has blown through a half a billion dollars fighting wildfires, hopefully it won’t cripple the state’s finances on top of a 4 year long drought. What will be the impact long-term on the state’s business environment?
- The U.S. economy just can’t seem to reach escape velocity and breakout of its pattern of slow growth.
- Given today’s U.S. job market report for July, the unemployment rate held at a 7 year low of 5.3%, according to the Labor Department report. It’s the type of progress Federal Reserve policy makers like to see (and investors don’t) in order to raise interest rates as soon as September 17th
For the most part, July stock market indices posted small gains.
|MTD* %||YTD %||3-year** %|
|Dow Jones Industrial Average||+0.40||-0.75||+10.79|
|S&P 500 Index||+1.97||+2.18||+15.11|
|Russell 2000 Index||-1.22||+2.82||+16.32|
|MSCI World ex-USA***||+1.52||+4.25||+8.36|
|MSCI Emerging Markets***||-7.26||-5.71||-1.81|
Source: Wall Street Journal, MSCI.com
*June 30, 2015 – July 31, 2015 **Annualized ***US$
You might have looked at your last brokerage statement (or two) and wondered why you’re no longer seeing the portfolio value increasing like it had been. You may have taken a glance at your 401(k) the other day and wondered why it’s barely budged since Thanksgiving, excluding the contributions you’ve been making every pay period.
You’re not crazy; the U.S. stock market has essentially gone nowhere in over 120 days. While the U.S. markets are not terribly far off their highs, they have traded in an extremely tight range this year. For every area of the market reaching new heights (think healthcare, software, and consumer discretionary), there’s one that’s been dragging the major averages back to flat (energy, materials, and industrial stocks, for example).
Flat markets, like the one we are in right now (you might even say more down than sideways as of late), do not suggest any particular outcome when broad market indices finally break out of their slumber.
There’s a litany of reasons why the rally that began after August of 2011 (our last 10% correction) has hit a wall, some of them I’ve already listed.
The events back in August 2011 surrounded fears of contagion from a European sovereign debt crisis and fears of our U.S. credit rating being downgraded when Republicans balked at increasing the government’s debt ceiling, attempting to tie the issue to a repeal of Obamacare. So, all in all, nothing has changed much on either of those fronts.
Especially after today’s jobs report, one could point to the (long anticipated) imminent start of an interest rate hike cycle as the biggest reason for the current downtrend underway. Coupled with a slow but undeniable rise in employment costs, which threatens profit margins at bellwether companies such as Wal-Mart and McDonald’s.
Then there’s the fact that corporate earnings have stopped growing, putting the pressure on companies to keep up a continued expansion of price-earnings multiples for which there is little to no justification.
And so, in the absence of a robust economy, and in the face of a potentially less accommodating Federal Reserve and peaking corporate profits, we go nowhere. The treadmill continues on as fewer stocks participate in each successive challenge to beat the S&P 500’s all-time record high. Only a handful of stocks and sectors are delivering uptrends on their own. The list of stocks nearing their 52-week low is swelling and the percentage of stocks below their 200-day moving average is beginning to resemble a freeway pile-up at rush hour.
Market watchers have noted that the trading range (difference between the market’s highs and lows) so far in 2015 is among the narrowest ever recorded. The fact that this sort of mass indecision is transpiring just a few percentage points away from record highs is a fascinating development and possibly presages a major turning point in the predominant trend.
Put simply, we’re running out of both breadth and breath. The important thing to remember, however, is that flat markets are not necessarily predictive of what will happen in the immediate future.
Where Does a Flat Market Lead Us?
Let’s look at the historical record to get a sense of what happens when the S&P 500 finishes the first seven months of the year flat. There were some genuine surprises in the data.
There have only been 12 years since 1926 in which the S&P 500 was trading between up or down 2% through the end of July. That’s roughly 13% of the time in a 90-year sample set. So, the first observation we should make is that a flat market this late in the year is relatively rare.
When we think of a flat market, we think of choppiness, but volatility has actually been muted during the years in question. Looking at standard deviation, it turns out that the average volatility of these 12 flat years was substantially lower than the volatility of a typical year in the stock market. The flat years featured standard deviations of just 11.5% versus almost 19% for a typical year.
Here is a range of outcomes worth considering based on how flat markets have resolved themselves throughout history.
Let’s start with the worst case scenario on record, the flat market through July 1930 that ended up horribly to the downside, an August to December plunge of 28.5%. Please bear in mind that this was right after the Crash of 1929, and 1930 was the year that ushered in the Great Depression. And no, a deep depression or deep recession is not in the cards, at least in the United States.
When we look at the next two worst outcomes, we see how much of an outlier 1930’s resolution was. In 1941, the S&P dropped by 17.5% in the last five months of the year, punctuated by the attack on Pearl Harbor in December and our declaration of war. In 1990, another recession year, the S&P fell from the flatline and finished down by 6% as America fought through the first Gulf War, and the Savings & Loans Crisis put a dent in the economy.
In only one instance of our 12 years, 1994, did we see the year end unchanged. By the end of 1994, the stock market closed down 1.5% as markets recovered from the shock of Alan Greenspan’s surprise summer rate hike.
But that’s it for the losses. The S&P 500 declined in only three of the years of our sample and was flat in one. In the other eight years, investors were rewarded—in some cases, very handsomely. In 1942, 1949, and 2010, the S&P 500 delivered returns of between 9% and 13% once the stalemate of the first seven months was broken.
The median return for all 12 flat-market years has been 6%. This is about half of the median return for all years since 1926, but it’s not exactly chopped liver. And remember, this is against the backdrop of substantially lower volatility, on average.
Flat markets do not necessarily suggest any particular outcome when the S&P 500 finally breaks out of its slumber. It’s been down three times, flat once, and markedly higher in the other eight instances. All these narratives on what’s about to happen based on the current trading range should be discounted or ignored. The most common resolution has been a gain with much less volatility than usual, but the outcomes have been all over the map. Cum grano salis.
What does August hold?
Well, August is no day at the beach – at least for the markets. It’s the second most volatile month behind October, seasonally speaking. Since 1950, August has brought more daily swings of 1% or more in the S&P 500 Index than all both one.
What to make of it? The market may be telling us that more volatility along with disappointing overall price performance lies ahead. Investors may have a “risk off” mindset as they head to the beach, more focused on their tans than their investment portfolios.
It has been 1,403 trading day (as of August 7, 2015) since the stock market (as measured by the S&P 500) had a correction. A correction is a 10% or greater decline in the market in a short period of time. The average rally period without a correction is 357 trading days (nearly once a year), according to a Deutsche Bank analysis of stock market moves since the 1950s. The current rally is the third-longest without a correction. The mid-1990s had an even longer stretch of seven years before there was a 10% correction.
While I’m not saying that a correction is imminent, I would say the probability of a 5%+ dip is highly likely. Stock valuations look a bit stretched currently, especially given signs that American economic growth isn’t picking up in 2015 as many had hoped. On top of that, corporate sales and earnings have been so far disappointing, and 2nd quarter earnings reports haven’t dispelled that notion.
Let’s look around the world. Negotiations in Greece and volatility in Chinese markets have dominated headlines. Commodities have fallen quite dramatically, be it crude oil, copper, gold or other basic materials such as iron ore. Many have fallen by 50% or more over the past 12 months. If China’s stock market falls further it could lead to hastening their economic weakness, curbing demand for raw materials/natural resources and creating upheaval elsewhere, especially those economies dependent upon the export of natural resources.
For now, it doesn’t appear a late summer rally is in the cards. It looks like August will be a down month and that for the most part, investors are now circling September 16th & 17th on the calendar – the dates of the next Federal Reserve meetings and the potential of a pronouncement of the first interest rate hike (lift-off) since June 2006.
Markets often climb a wall of worry and this market looks like its legs are weakening as it struggles to make it over the wall; a wall that won’t most likely be breached until after September 17th.
What bears watching are triggers for an extended sell-off — the Federal Reserve botching the amount of the first rate hike (raising rates by 0.50% or 50 basis points instead of the 0.25%/25 b.p. expected); the U.S. dollar getting too strong; and/or the bond market, especially the U.S. 10-year Treasury yield rising too fast.
Waiting on Godot, err the Fed
There is this perverse preoccupation with what the Federal Reserve is going to do with interest rates. Just as has been the case of the last few years, the Fed has become a preoccupation of market watchers.
While the Federal Reserve continues to telegraph it wants to start raising interest rates this year, Wall Street continues to play a guessing game over the timing of the first rate hike by the Federal Reserve. With June (the former favorite in the guessing game) out of the running, September has emerged as the next best bet for an interest rate liftoff.
Please keep in mind that historically the start of a rate hike cycle by the Fed does not signal the end of the bull market.
The first rate hike in the 1990s expansion stifled shares during the first year, but the bull market was just getting warmed up. Following the 2001 recession, the Fed implemented its first rate increase in 2004, three years prior to the market’s peak.
For income producing assets such as bonds, they will continue to come under stress on fears that potentially rising interest rates and continued economic strength will put inflationary pressure on long-term interest rates.
Bonds are supposed to preserve wealth, provide periodic cash flow and hopefully some price appreciation. As of late they aren’t offering much in the way of income, and now there’s a real possibility that investors could lose money.
As the U.S. economy starts to strengthen, equities will almost surely outperform U.S. fixed income.
It remains to be seen whether equities can absorb an interest rate hike without much disruption to stock valuations. Historically, stock prices have reacted poorly to the first rate hike in a tightening cycle. Thus, the first rate hike might prove to be a crucial deciding factor for the equity market’s trend thereafter, at least in the short run.
Yes, shares are currently near an all-time high (and I’ll get to that in a moment), and it can create volatility when short-term traders react to a negative headline. But when the negativity subsides, the more positive fundamentals reassert themselves. And it’s these economic realities that drive long-term market returns, not Fed policy.
While shifting investor sentiment and global developments might continue to complicate the Fed’s stance. Nonetheless, Fed officials have opined that the recuperating U.S. economy seems strong enough to withstand one or two rate hikes this year.
Black Swan? China’s Bubble Trouble
What worries me on the international geopolitical front is China. Even as Greece continues to dominate the international spotlight, China’s equity bubble remains a monumental distraction. Over the past one year, the Chinese indices went off-the-charts as its stock market added $6.5 trillion in value.
China’s stock market has languished for much of this decade, but with encouragement from government officials, retail investors in China jumped in, sending the Shanghai Composite Index up 152% from June 30, 2014 to its June 12, 2015 peak.
Neophyte traders were deluded into believing that recent overwhelming growth would continue in the future. New account openings in China have multiplied 500% in 2015. In May alone, over 12 million new equity trading accounts were opened in China, a figure which exceeds the entire population of Greece.
It’s a meteoric rise by any standards, with a buying frenzy fueled by margin debt. But the index quickly shed 32% of its value in less than one month, forcing the government to implement measures to stem the decline.
Shanghai Stock Exchange Composite Index (1 year chart through August 7, 2015)
However, what’s even more concerning is that valuation levels are now eclipsing the insanity of the last bubble. Moreover, margin debt, which intensifies volatility, is also at record levels. Margin debt has grown over 120% this year to $370 billion. Margin calls amplify selling pressure in downturns, and have the potential to turn market corrections into crashes.
Now with economic growth at its worst since 1990, the last thing that the Chinese economy needs is a market crash. My worry is the “Contagion Effect” – anything that hampers Chinese growth will set off a chain reaction, and the entire world will feel the reverberations. A continued decline in Chinese shares could rattle an already fragile financial system and send tremors in all directions.
But perspective is in order. The U.S. exported $123 billion in goods to China last year (U.S. Census) but that doesn’t even compare to a U.S. economy that is nearly $18 trillion in size (U.S. Bureau of Economic Analysis).
While there are a few firms that depend on sales to China, overall revenue for S&P 500 companies amount to just 2% (based on most recent 10-K filings, FactSet, Compustat, Goldman Sachs Global Investment Research, Business Insider). So while China’s economic woes won’t impact U.S. companies’ sales reports, they have the real possibility of destabilizing the global investment environment.
Bond king Bill Gross sums it up well. China is “a riddle wrapped in a mystery, inside an enigma. It is the mystery meat of economic sandwiches – you never know what’s in there. Credit has expanded more rapidly in recent years than any major economy in history, a sure warning sign.”
While we may see day-to-day volatility that originates from sharp moves in Chinese shares, keep your focus on their government’s longer-term plan to resolve the crisis. I’m watching China since it will impact regional and global markets, much like Greece has year after year.
Back home, the backdrop looks a lot more upbeat. Recovery in the housing market, consistently improving labor market conditions and buoyant consumer sentiment continue to boost economic growth and brighten the outlook for the economy. Consumer confidence, an important gauge of the economy’s health, continues to be strong.
Continued positive sentiment will in turn drive consumer spending, which makes up over two-thirds of the U.S. economic activity. To add to the optimism, GDP numbers are widely expected to turn positive hereafter (3.1% projected in the 3rd quarter, 3.0% projected in the 4th quarter), with the retail sector providing a boost after a tepid first half of the year.
While the U.S. expansion hasn’t been impressive, the economy is growing, and that puts a floor under corporate profits. Further, interest rates remain low and are expected to remain low even when the Federal Reserve gradually begins to raise rates.
While I would be concerned about a shift in fundamentals, as of now, most leading indicators aren’t signaling an impending economic downturn.
About All-Time Highs
Now, let’s get back to the bull market and shares that are near an all-time high. Granted, bull markets are inclined to become more volatile as they age, and this nearly-seven-year-old bull market is well past the average. Skeptics would argue that strong market performance since the economy exited the recession leaves stocks in a vulnerable position. Well, let’s look at the data between 1929 and 2013.
According to Bank of America Merrill Lynch, a 60%-100% rise in the S&P 500 Index over the past five years had absolutely no predictive value of how stocks would perform in the next 12 months.
In other words, you might as well flip a coin when trying to predict where stocks might go over the next year.
My philosophy that it’s almost impossible to predict how the market will perform over the next year. That’s why discipline and patience have historically rewarded the long-term investor (think Warren Buffet).
“The financial world is a mess, both in the United States and abroad. Its problems, moreover, have been leaking into the general economy, and the leaks are now turning into a gusher.”
~ Warren Buffet (New York Times op-ed piece, October 2008)
While stocks wouldn’t bottom for five more months, Buffet was quite clear.
“Over the long term, the stock market news will be good. In the 20th century, the United States endured two world wars and other traumatic and expensive military conflicts, the Depression, a dozen or so recessions and financial panics, oil shocks, a flu epidemic, and the resignation of a disgraced president. Yet the Dow rose from 66 to 11,497.”
We all know that fear doesn’t last forever, and neither does complacency. The Dow Jones Industrial Average went on to surpass 14,000 in 2007 and 18,000 late last year.
I subscribe to his sentiment when he says he doesn’t have “the faintest idea as to whether stocks will be higher or lower a month, or a year, from now.” His longer-term approach is one that I am fairly comfortable with.
Whether one jumped feet first into a diversified portfolio of stocks in 2000 or late 2007, investors who stayed calm and stuck with a disciplined approach may have gotten bruised, but they are ahead today.
What to Do?
I rarely recommend an all-stock portfolio for any client. Many need more conservative investments that produce income and offer a degree of stability when economic storm clouds gather.
A more conservative stance probably won’t keep up with broad-based indexes in a raging bull market, but it has historically prevented an unsettling slide (in investment lingo, “upside/downside capture ratio”).
As I’ve stated in the past, I tailor my recommendations to a number of variables. While I recommend a plan that puts you on the road to your financial goals, let’s do it in a way that allows you to sleep comfortably at night.
As always, it’s worth re-examining one’s investment portfolio. The solution isn’t to exit stocks. Instead, look for opportunities to buy during the dips. Stocks often go up after a correction; it doesn’t mean the bull market is done. In fact, given our tepid domestic economic recovery I believe the bull market has another couple of years to run before it runs out of steam.
However, to avoid volatility, time-tested research recommends steering away from consumer companies with tired brands or facing tough competition and commodity and industrial capital goods producers selling into weak markets and where their pricing is in strong currencies.
Where we end 2015 is far from guaranteed; what seems more definite is that there will be plenty of volatility to deal with before these quandaries get sorted out. Thus investors need to hunt for securities that will hold steady when the broad market starts to blow hot or cold, which is what I try to do.
So calm those jitters, take a back-seat (maybe even have a glass of wine) and enjoy an arm’s-length view of the rollercoaster ride that seems to be today’s market trend.
I want to express my gratitude for the trust and confidence you’ve placed in me and my firm. It is something I never take for granted, and I thank you.
I trust that you have found my commentary to be beneficial and educational. I always emphasize that as your advisor, it is my job to partner with you as you travel down the road to your financial goals. If you ever have any questions about what I’ve conveyed or want to discuss anything else, please feel free to reach out to me.
Wishing you good health, wealth and prosperity.
Eric J. Linser, CFA
August 7, 2015