FAI Investment Outlook 4Q 2015
First Nine Months of 2015: China & Fed Worries Weighed on Stocks.
The slow-growth economic outlook and gentle fluctuation of stock prices during the first half (when stocks earned 3%, including dividends) was overwhelmed in the third quarter by increased worries about China’s drag on global business. The S&P 500 stock index plunged 10.7% in the last week of August alone!
Here’s the S&P 500 chart for the first nine months of the year… you can see that most of the damage took place in late August. Stocks staged a bit of a rally in early September, but that collapsed when the Federal Reserve decided to keep their effective lending rate at 0%, citing increasing worries about the global economy. The stock index finished the first nine months with a year-to-date loss of 5.2%, net of dividends.
S&P 500 CNN Money
The Fourth Quarter Trading Begins… with Energy!
Thursday, October 1st, in a tame news environment, the S&P ticked up by a tiny 4 points; a quiet day. But on Friday, traders were rattled by an unexpectedly negative September jobs report and a surprise reduction of previously reported job gains for July & August. This news suggested a cooling of economic prospects, and the S&P sympathetically plunged 1.2% in 30 minutes!
In those same few minutes, the 10-yr Treasury bond price suddenly shot up 1.2%, driving its yield from 2.05% to 1.92%. (Remember, a rising bond price reduces the yield.) Bond traders were buying on the expectation that if the economy is really cooling, there’s no way the Fed will raise their bank lending rate as had been anticipated. Or, to put it another way, during the first hour of trading money was rushing out of stocks into bonds as a “safe haven.”
But… any investor thinking that there was actionable information in the market’s opening-hour antics was quickly disillusioned! By day’s end, the bond price gain was cut in half! And stocks… well, stock prices closed Friday up 1.2% after having been down 1.2% in the morning!! That’s a swing of 2.4% in value in a few hours! Stocks recovered a further 2% on Monday, October 5!
Does this sudden buying enthusiasm portend a brighter market ahead? Let’s take a look.
Outlook for Stocks
After these recent shenanigans, anyone could opine with confidence that the markets seem likely to be volatile in months ahead… so we’ll say it! Markets will likely be volatile! But we have always been “long-term investors,” so let’s put on our multi-year thinking cap.
Since 1950, U.S. stocks have returned about 11% a year on average; during those 65 years, nominal GDP grew more than 7% a year. But during the most recent 15 years the economy’s nominal growth has been only 4.2% a year. That number is pretty close to what economists expect in the next few years. If that’s all you needed to know, (it’s not!) you might conclude that future stock returns might be closer to 6.5% a year than the historical 11%. And that does seem to us a reasonable expectation for stocks… long term. Of course, the value of publicly-owned shares relative to GDP fluctuates widely over the years. One of Warren Buffett’s favorite valuation metrics is the value of stocks divided by GDP.
As you can surmise from the preceding chart, that ratio is now well above its median of the last 20 years… leaving plenty of room for a “valuation correction,” possibly in the next year or two.
One reason for the elevated stock/GDP ratio is that low interest rates in the developed nations have made bonds unattractive… creating greater demand for stocks. Even the S&P 500 dividend yield of 2.2% is better than the 10 year Treasury yield of 2.0%! This is one reason that FAI’s portfolio profiles continue to own a normal allocation to stocks. If either the economic outlook deteriorates or bond interest rates start to creep up we could reduce our equity exposure somewhat until either stock valuations are more attractive or the economic outlook improves.
Compared with the top of our equity allocation range, we’re comfortable having 10% - 15% of “dry powder” available to buy more stocks if we should experience a big price correction.
Bond yields are important to stock valuations, but corporate earnings growth tends to be the main driver of stock prices over the years; earnings growth has certainly slowed since the beginning of the new millennium. In the eight years since the last cyclical earnings peak (2006) EPS have grown at a labored 3.4% a year pace. This is less than half the earnings growth rate of the preceding 6-year growth phase (+7.7% a year). Goldman Sachs just lowered its 2015 estimate for S&P 500 earnings to $109…that’s 5% below last year’s earnings. Analyst consensus is still for $118 this year, so there could be room for disappointment toward year-end.
While bond yields are held low by the Central Banks in developed countries (U.S., Euroland and Japan), and as emerging economies keep struggling with low commodity prices, global growth prospects are not all that exciting. Nevertheless, there is a real potential for foreign capital to keep flowing into U.S. stocks since conditions are better here than elsewhere… growing foreign demand could boost U.S. stock prices despite sluggish earnings growth. This potential for price gains keeps us from trimming our equity exposure much below our allocation midpoint.
Outlook for Bonds
Since 1950, U.S. treasuries returned to investors an average of 5.8% a year. So, stock investments, returning 11% a year, have been almost 2 times more rewarding than bonds! Adjust for inflation and it’s 7.3% real return for stocks and just 2.1% real return for bonds! Stocks were 3 ½ times better than bonds after inflation!
Over time, stocks adapt better to inflationary pressures than bonds. That’s because companies can protect their profits by raising the prices of their goods and services… whereas most bond interest payments are fixed in nominal terms, and do not rise with inflation. The most-used measure of inflation in the U.S. is the CPI. There are two versions: “All Items,” which fluctuates a lot, and the more stable “Core” CPI which excludes the more volatile food and energy prices. Their latest 12-month averages are All Items: +0.2%, Core +1.8%.
So, a 1.9% treasury yield is very close to zero when adjusted for Core inflation! We think a zero real yield is a temporary condition artificially contrived by our Federal Reserve and the European Central Bank and the Bank of Japan. That means, if Core inflation (our Fed’s preferred standard) is in the 2% ball park and if bond investors require even a 1% real rate of return, we should expect some increase in interest rates.
Rising rates make bond prices fall. If a nominal 10-year Treasury rate should rise from 1.9% to 3.0%, its market price would decline from $100 to $90.60! That’s a lot of price risk to earn a yield that, today, barely covers the inflation rate! On the other hand, if the going rate should decline from 1.9% to 1.5% (keep in mind there are government bonds overseas that actually sport negative yields!) the price would rise from $100 to $103.68!
Except for professional traders, bonds are typically owned as a conservative investment… something to stabilize one’s portfolio and provide dependable income. When rates are artificially depressed, as they are now, there is a meaningful potential for market rates to rise with a consequent loss of value in medium-longer-term bonds. That risk can be minimized by owning bonds with shorter maturities… that is the present emphasis in FAI’s bond portfolios. Short-term interest rates are very low. A 2-year Treasury presently yields just 0.6%... but even that is a tad better than money market funds and most bank savings accounts!
Looking Further Ahead
Here are some data we’re keeping an eye on regarding long-term economic expectations:
• U.S. job growth is only 1% a year and both wages and hours worked have been flat-lining of late. Since consumer spending accounts for 2/3 of GDP, and with the all-items Consumer Price Index virtually stagnant, even a 4% nominal GDP growth rate may be a challenge.
• It’s hard to find anyone outside China with a strong conviction of that country’s year-ahead growth potential; and without some pickup in Chinese demand for commodities, emerging market economies could remain wobbly.
• About 10,000 “boomers” are turning 65 every day! They tend to spend less in retirement (not great for GDP) and tend to invest less in stocks!
J. Michael Martin
October 5, 2015 SP 500: 1987 10-yr Treasury: 2.04%
…down from 2069 3 mos. ago …down from 2.28% 3 mos. ago
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