Tuesday, January 12, 2016

Happy(??) New Year! - 2016

The Markets-2015
Well, 2015 is in the rear view mirror; and what a year it was from an investing perspective. Let’s look back at the financial markets over the year. The S&P 500 was down .73% for 2015; the Dow Jones Industrial Average was down 2.23%; the Barclay’s Aggregate Bond Index was down 1.84%; and interest rates on the 10 year US Treasury rose from 2.09% in January to 2.27% in December (with a corresponding decrease in bond values). This means that a blended portfolio of 50% stock in an S&P index fund and 50% bonds in an aggregate bond index fund would have returned negative 1.29% for the year.
But that’s not the whole story. When we look at the components of the S&P (the sectors that comprise the index), we find an entirely different story. There was significant difference in the sector performance—as follows:
Sector                                                   2015 Return                        Weight in Index

Consumer Discretionary                           +8.4%                                    12.8%

Healthcare                                                 +5.2%                                    15.2

Information Technology                           +4.3%                                    20.5

Consumer Staples                                     +3.8%                                    10.2

Telecommunications                                 -1.7%                                     2.5

Financials                                                  -3.5%                                     16.5

Industrials                                                  -4.7%                                     10.0

Utilities                                                     -8.4%                                      3.1

Materials                                                   -10.4%                                    2.7

Energy                                                       -23.6%                                   6.4
In addition, there was significant volatility in stock prices in 2015. The S&P 500 index crossed over its flat line beginning value 26 times (positive to negative and vice versa) during the year. Looking at the consumer discretionary sector (up 8.4% for the year), had volatility of monthly changes during the year ranging from +9.0% to -6.6%.
What does this tell us? First, while there is empirical evidence giving credence to passive index investing, such a strategy would not have worked well in 2015. Second, the variation in sector returns implies the opportunity for positive returns exists through active investment management. But what form does that active investment take?

Looking Ahead
One can read all the tea leaves from the past and discuss what has happened historically in similar circumstances e.g. market performance in election years, market performance post interest rate increases, etc. But, if one is pursuing an active management strategy, looking at the current state of affairs should assist in the active management tactics to take going forward. Some macro-economic items to be considered (by no means a comprehensive list) are listed below:

  1. Interest Rates—The Federal Reserve has begun its policy of “normalization” with its first rate increase in December, 2015 (up 0.25%). The Fed’s policy statement from December, and Chairwoman Yellen’s press conference, has been focused on inflation as the primary driver of future rate increases. The Fed’s 2% target inflation has not been forthcoming and has driven speculation of another 1% rise in rates in 2016. However, economic indices offer different (and sometimes conflicting) information that may affect this rise in rates.
  2. Oil Prices—As we begin 2016, oil is currently in the sub $40/bbl. range. This is a boom to some parts of the economy (the general consumer) but a bust to others (oil related industries). There is significant turmoil in the Middle East but the need for oil revenues should continue as many countries are so dependent on oil revenues that reduced production does not appear to be a factor.
  3. Strong US Dollar—The US $ has been strengthen over the last two years, making US exports more expensive to foreign markets and multi-national overseas corporate earnings worth less if repatriated to the US. While this strengthening may slow down, it is doubtful that there will be a significant decline.
  4. US Gross Domestic Product (GDP)—Current projections for economic growth in the US are in the 2-2.5% range; by no means robust but significantly better than the global outlook. The tax cut-spending package passed by Congress in December will add a stimulus to GDP but with a corresponding deficit that will likely increase in 2016 by 1% of GDP. The debt-to-GDP ratio (already at troubling levels) will begin to rise again. (Note: This excessive debt is a subject worthy of its own discussion and more than we can include here!)
  5. Global growth is slowing; especially China which appears to be transitioning from manufacturing and construction into services.
So what does the astute investor do? Economic indicators are giving conflicting advice.

  • Rising interest rates imply decreases in bond values.
  • Unemployment rates are coming down (don’t ignore the calculation methodologies of this number), but the percent of the labor force employed remains at historic lows.
  • The Institute for Supply Management (ISM) December, 2015 manufacturing data showed a contraction for the second month. Overall manufacturing is slowing, but new orders and production increased over November. The ISM manufacturing index for December was 48.2; anything above 50 indicates economic expansion and anything below 50 indicates contraction.
  • Credit spreads (the difference between “high yield” or “junk” bond yields and high quality bond yields) are increasing; this implies a greater risk in the junk bond market.
  • There is a widening gap between corporate earnings and sales results. In the third quarter of 2015, 60% of reporting companies exceeded their earnings per share (EPS) estimate; however, 59% of the reporting companies missed their sales estimates. How did this happen (expense reduction??)? In addition, there is a widening gap between the normal accounting EPS and the “adjusted” EPS being reported by some companies. Adjusted EPS eliminates some “extraordinary” or “non-recurring” expenses which results in a higher EPS. The gap between normal and adjusted EPS has been approximately 30% (normally about 10%) with adjusted being the higher.

What to Do?

Given the above, what’s an astute investor supposed to do?

First of all, consider your goals and objectives. Position your portfolio according to those goals and your risk tolerance. Attaining your goals with a risk level that makes you sleep well at night is more important than “chasing return.” For example, some investors have been increasingly pursuing risker assets in their search for maximum return. But if your goals are funded by a more moderate approach to returns, why take the extra risk. This shift basically involves an “asset-liability” matching strategy (matching your needs from the portfolio against your asset allocation) vs. a “maximum return” strategy.

Second, use these periods of market volatility (a normal part of market activity) to reposition diversified portfolios to your target levels.

Third, continue to maintain a diversified portfolio consistent with your goals and objectives. It is important to note here that diversification may be taking on a new meaning. The traditional “stocks, bonds, cash, commodities” portfolio allocation may require a different perspective; a perspective that provides more flexibility and a wider opportunity set of choices. There other markets available which may provide suitable investments (infrastructure, re-insurance, emerging markets, frontier markets, etc.). Alternative investments and hedge fund techniques (real estate, long-short investing, merger/acquisition, distressed security investing) may be beneficial in a portfolio. However, these investments/techniques have peculiar characteristics (possible lack of liquidity, extremely long time horizons, etc.) which require due diligence before investing.

We, at Paragon Financial Advisors, assist our clients in reaching their desired financial goals with an appropriate risk level. Please feel free to contact us.  Paragon Financial Advisors is a fee-only registered investment advisory company located in College Station, Texas. We offer financial planning and investment management.

NOTE: All investing involves some degree of risk and possible loss of principle. Stock offer greater long term growth potential but may have wider and more price fluctuation while yielding lower current income. Bonds may involve credit/default risk resulting in loss of principle; they historically have provided consistent income. Alternative investing and techniques are specialized situations and should be used only when one understands the risks and restrictions involved. Nothing in this discussion should be construed as a general investment recommendation; appropriateness is dependent on the investor and his/her particular circumstances.

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