Client Letter: Market Review & What We Are Doing NowSubmitted by Alsworth Capital Management, LLC on February 13th, 2016
Financial markets in 2015 were more volatile than we have seen in recent years and the turmoil was broad based across all asset classes (stocks, bonds, commodities, etc.). Among the major global stock markets, the United States was the best performer, but that’s faint praise given the S&P 500 index’s 1.4% return. What’s more, it was a market in which a handful of large tech companies (Facebook, Amazon.com, Netflix, and Google) generated gargantuan gains and helped propel the index into positive territory, while the equal-weighted S&P 500 index actually fell 2.2% for the year.
International stocks, measured by the MSCI EAFE index were up 5.3%, however, the strong US dollar currency caused the gain to turn into a 0.8% decline after the currency exchange. Emerging Market stocks (Brazil, Russian, China, India, etc.), measured by the MSCI EM Index, declined 6.8% in local currency, but lost an additional 9% to currency exchange for US investors. Commodity indexes were crushed, down on the order of 25%–30% as oil prices hit an 11-year low in December and fell 30% for the year, after plunging 50% in 2014. Energy MLPs, an increasingly popular vehicle for yield seekers (and yield chasers), dropped 35%–40%, wiping out the previous four years’ worth of gains.
Fixed-income offered little respite, with the core bond index gaining just 0.3%. High-yield bonds fared worse, down close to 5%, while floating-rate loans lost 0.7%. Investment-grade municipal bonds were a relative bright spot, with the national muni bond index up nearly 3% on the year.
What’s Up with the New Year?
The volatility has continued into 2016, reminding many investors that they are indeed innately risk averse. As of this writing, the S&P 500 Index is down about 10% from their recent highs and the dependable chorus of media pundits instructing folks to “buy stocks on the dips” is noticeably quieter than I recall at any other point in recent years. The market as thus far registered the worst two week start to a new year in history. The worries gripping the market at present are predominantly China’s economic slowdown and the shocking drop in the price of oil and natural gas.
I have been lamenting for the last several years about elevated stock prices, particularly in the US. I have also expounded on my concerns that market expectations were built upon one-time gifts such as exceptionally high corporate profit margins and leveraged stock buyback programs. While the news of slowing growth in China is significant, I do believe it is being used more as an excuse and that the market correction is as much a result of correcting unrealistic expectations. We have known for a number of years that China could no longer maintain their 10%+ annual pace of growth, since it was driven largely by unsustainable borrowing and unproductive infrastructure projects. They have taken on these projects because it was deemed more important to pull citizens out of poverty than to grow at the slower pace justified by productivity growth. Eventually the pendulum had to swing back and growth is slowing to something less than 7%, perhaps more like 5% (compared to 2-2.5% in the US). I am in the camp that does not believe China will experience a “hard landing” deep recession. They have exceptionally tight controls over their economy and can enact draconian policies that bend real life closer to economic theory than can be realized in more free market based societies. Their debt is also owned predominantly by Chinese citizens so they have little pressure to make drastic sudden moves. The slowdown in Chinese growth is certainly not good news and it will definitely impact global markets, but I don’t believe it is cause for panic.
The slowdown has served to expose overinvestment in commodity based industries like oil, gas and coal. These industries have loaded up on debt and expanded as if the pace of Chinese consumption would persist indefinitely. China had bought up enormous supplies of commodities and produced an exceptional oversupply of products like finished steel that they have no market for. They stopped taking in raw commodities and the price of many commodities has collapsed. Swimming in debt up to their eyeballs, many commodity producers have maintained high production levels so they could generate enough revenue on weaker prices to pay their debt and stay in business. This is also true of state controlled companies in commodity dependent countries like Russia, Brazil, Saudi Arabia and Venezuela where politics adds a layer of irrationality to market forces. They are all hoping that the drop in price is temporary and that they can maintain market share through the cycle. However, with nobody cutting back production, the price keeps dropping lower and lower. Now with sanctions on Iran being lifted, we can expect even more oil and gas to hit the global markets. We are seeing this play out in the US shale energy industry as well. Many shale companies expanded by taking on huge amounts of debt and they now need to produce at virtually any price just to be able to make their debt payments. I have been surprised, along with most investors, at how long the high production rates have been maintained without production cuts or large scale bankruptcy. This stubbornness has further exacerbated the collapse in commodity prices. Eventually it has to correct. Weaker companies will need to go out of business and a supply demand balance will once again be restored. In the meantime, we are seeing much lower prices at the gas pump and in our heating bills.
Normally we would expect the drop in energy prices and commodities in general to be a huge boon for the economy. However, as I have written about in the past, the US shale boom was a big contributor to our growth and recovery from the Great Recession. With the recent weakness in oil and natural gas prices, the pains in that industry have outweighed the gains to consumers. I believe that consumers are also acting relatively restrained compared to previous cycles because they are suffering under stagnant wages, still heavy debt loads and concerns about political instability.
What Are We Doing About It?
Financial market history is a history of cycles (or like the swings of a pendulum), moving from one extreme to another. Market history teaches us that undervalued assets can fall further, and overvalued markets can overshoot even further on the upside. We need only look back to the tech bubble to see one recent example of this. It is simply the reality that comes with being a long-term equity investor. My investment philosophy is based on the belief that fundamentals ultimately drive investment returns. This gets down to the economics of the investment. Specifically, whether we’re evaluating stocks, bonds, real estate, or another asset class, the value of an investment is generally determined by the cash flows the investment or investment market generates over time. This type of valuation, unfortunately, is a very poor short-term market indicator. But over the longer term and over full market cycles (five to 10-plus years), history has shown that valuation is a powerful driver of returns. Buying undervalued assets pays off over time, but you need to withstand the discomfort that typically accompanies it as you wait for markets to turn in your favor.
The U.S. equity market has had a very strong run over the past few years and by most valuation measures is stretched. After six years of generally rising stock prices, investors may be complacent about the potential risk. I believe the reversal of this current cycle may not be long in coming given the relative attractiveness of foreign stock market valuations and the potential for foreign company earnings to improve from currently depressed levels. I am confident we will be rewarded for our current allocations to European and emerging-markets stocks. But we also know that we don’t know precisely when those markets will turn around. We established these positions last year after they experienced steep declines and I will be adding to these positions opportunistically.
On the bond side, with interest rates having begun what the Fed has said will be a gradual upward climb, I have diversified a portion of our bond holdings into flexible absolute-return-oriented bond positions and floating-rate loan funds that are designed to better manage a rising interest rate environment. I also maintain a core strategic holding to intermediate-term US bonds to reduce the volatility of our portfolio caused by the stock investments. These bond holdings have held up well during the recent market turmoil, reminding us of why we include them in our investment plan. I continue to find value in owning alternative strategies that can provide powerful portfolio diversification benefits. Adding these alternative positions, like managed futures, has allowed me to reduce our overall portfolio volatility while also adding more volatile positions like emerging market stocks to the portfolio.
Each client's investment plan is established with heavy consideration given to their individual and family risk tolerance. Our discussions about risk and our tolerance assessments are intended to measure a client's ability to stick to their investment plan through inevitable downturns in the market. We recognize that we can’t time markets or predict the future. We can’t buy into risky investments and catch the upturn then predict crashes and sell everything to cash to avoid downturns. It just doesn’t work in practice. We need to have a plan to manage our emotions and avoid making rash decisions. I will adjust the portfolio and make tweaks here and there in an attempt to manage risk or take advantage of cheap valuations and market irrationality. However, the vast majority of our returns and the majority of our portfolio volatility is going to be determined by the long range strategic investment plan. This plan is predicated on the client's ability to stick to the plan through the declines. There are times that we can misread risk tolerance and it also has a tendency to change over time based on life circumstances, age, etc. Market declines like we have recently experienced are a good opportunity to reassess tolerance and be honest in your introspection. It’s also a good time to remember the advantages of sticking to a well established plan.
As always, I appreciate your time and welcome questions about your individual situation.
Shane M. Alsworth, MBA, CFP®, CLU®, CIMA®
The views and opinions presented in this article are those of Shane Alsworth
Past performance is no guarantee of future results. Investments are subject to market risks including the potential loss of principal invested. Asset Allocation does not assure or guarantee better performance and cannot eliminate the risk of investment losses. The information contained herein is based on sources and data believed to be reliable, but is not guaranteed by Alsworth Capital Management, LLC and is not to be construed as an offer or a solicitation of an offer to buy or sell securities mentioned herein. It is provided as a courtesy for informational purposes only and is not intended to satisfy any compliance or regulatory conditions set forth by any governing body of the securities industry.