February 9, 2016
February 9, 2016
Stock markets around the globe started the year on a sour note. The S&P 500 declined 5% in January, its worst January performance since the depths of the financial crisis in 2009. Most foreign stock markets were down by similar amounts. The poor start to the year has led to concerns that another major bear market like 2008-09 may be in store. Here, we share our thoughts on the current investment environment and related implications. We also discuss portfolio adjustments designed to help our clients navigate the challenges and opportunities in the markets in the year ahead.
The investment environment has been unsettled since the start of the year as slowing growth in China and plunging oil prices have rattled investors, leading to a general increase in risk aversion. These conditions suggest greater downside risk than normal. At the same time, the underlying economic fundamentals in the U.S. appear reasonably solid, and we consequently think that a major bear market, although possible, is unlikely. We discuss some of these key economic fundamentals here.
U.S. Economic Growth – We believe the most likely scenario for the U.S. economy is that it continues growing at the same sluggish rate of approximately 2% experienced since the end of the Great Recession in 2009. The economy appears to have enough underlying strength to withstand drag from slowing growth overseas and from slightly higher interest rates. Household balance sheets are in relatively good shape as employment has improved over the past several years and low interest rates have reduced the cost of debt payments. Moreover, banks are in much better shape than they were prior to the financial crisis with less exposure to risky debt and higher capital levels.
Federal Reserve Policy – We expect the Fed to err on the side of moving very slowly in raising rates with no more than one or two quarter point increases in the Fed funds rate over the course of the year. This approach would be consistent with the policy biases of Fed Chair Yellen as well as other influential members of the Fed.
Interest Rates – While interest rates may well be a bit higher by the end of 2016 (10-year Treasury currently yields about 2%), U.S. interest rates are likely to remain low. At the same time, we see the balance of probabilities for interest rates skewed to the upside – e.g., there’s a greater chance that the 10-year yield will rise to 3% than that it will fall to 1%.
As noted, we think the probability of a major bear market this year is low, although this is always a possibility. Major bear markets in the past have coincided with recessions and we believe the U.S. economy has enough underlying strength to avoid a recession this year. We also expect the Fed to become more supportive of U.S. stocks by limiting its plans to raise interest rates, particularly if stock prices continue to slide.
On the bond side, we don’t expect a big change in the level of interest rates this year. In this artificially low-yielding environment, we believe investors are not being rewarded for the interest rate risk inherent in longer-term bonds and we consequently continue to emphasize shorter maturity bonds in client portfolios. We also have a strong preference for higher quality bonds rather than lower quality bonds such as junk bonds.
We have identified several portfolio adjustments that we believe will improve client portfolios within the context of the current investment environment. We anticipate making these adjustments over the next several months subject to capital gains and other considerations. We discuss these adjustments below.
Increase Foreign Stocks – We recommend increasing our clients’ long-term strategic foreign stock allocation to 30% of total stocks. Our research indicates that allocating 70% of the equity allocation of a diversified portfolio to U.S. stocks and 30% to foreign stocks allows investors to capture the majority of the diversification benefits that foreign stocks provide.
Foreign stocks are currently a lot cheaper than U.S. stocks and should provide good long-term potential at today’s values. The table below shows the CAPE valuations of US stocks and foreign stocks. CAPE is a metric developed by Nobel prize-winning economist Robert Shiller that measures the current stock market value (price) divided by the average inflation-adjusted annual earnings over the past ten years. Higher CAPE values imply lower-than-average future returns and vice-versa.
Current and Historical CAPE
As of December 31, 2015
|US Large Company Stocks|
|Foreign Developed Markets (EAFE)|
|Foreign Emerging Markets|
Source: Research Affiliates, Robert Shiller Home Page
As the table indicates, US stock prices, at a CAPE of 26, are high relative to their historical average of 22. On the other hand, foreign stock prices, both developed markets and emerging markets, are low relative to their historical averages. Given these relative valuations, the odds are good that foreign stocks will outperform U.S. stocks over time.
Reduce REITs – REITs provide excellent diversification benefits within diversified portfolios. While REIT prices tend to move in the same direction as the overall stock market, there are times when their prices move in different directions or by much greater or smaller amounts than the broad market. To capture REITs’ diversification benefits, we typically target a REIT allocation of about 8% of US stocks, which is about twice the weighting of REITs within the overall US stock market.
While we continue to like REITs, we’ve observed that REIT values have become increasingly sensitive to changes in interest rates over the recent past. With the balance of interest rate risks skewed to the upside, we prefer to modestly reduce our clients’ REIT allocations at this time.
Reduce Dividend-Paying Stocks – The U.S. equity portion of our clients’ portfolios often contains a dedicated allocation to dividend-paying stocks. We added dividend-paying stocks to client portfolios several years ago on the premise that dividends could become increasingly valued by investors in a low-yielding environment.
As interest rates have declined, dividend-paying stocks have become increasingly expensive, and, if interest rates were to rise, this dynamic could reverse, causing dividend-paying stocks to lag the broad stock market. Given this consideration, we are recommending reducing the dedicated allocation to dividend-paying stocks.
In this article, we’ve provided a review of our thinking on some of the high-level economic and market considerations relevant to our clients in the year ahead. We’ve also discussed three portfolio changes.
What we haven’t discussed is what we’re not changing. We remain confident that our research based approach, utilizing disciplined management and sophisticated investment selection, will remain a successful formula for our clients.