By David Urovsky
For investors, it was an eventful third quarter – to put it mildly – as stock indices fell into correction territory for the first time since 2011.
Global stocks dropped during the third quarter as worries about the pace of global growth and uncertainty about the Federal Reserve’s plans to raise interest rates continued to fuel big swings in the markets. The third quarter saw the equity markets erase gains made earlier in the year and dive into negative territory. The Federal Reserve had been telegraphing that a rise in interest rates was likely, but fears that the slowdown in China and some disappointing economic news here in the U.S. caused them to pause. That uncertainty was not received well in the markets and caused a sell-off. The Standard & Poors 500 Index (S&P 500) for the quarter ending September 30, 2015 lost 6.4% while the BarClay’s Aggregate Bond Index increased 1.23%.
We’re sure you were ready to say “good riddance” to a very ugly September. Us too! But, please don’t mistake this predictable seasonal weakness for something that it’s not. This correction was not so unusual and some market participants thought it was overdue.
To us, the recent market turbulence was similar to market corrections in 1998 and 2011. This year, the main culprits were China and the never-ending “will she or won’t she” game surrounding Federal Reserve Chairperson Janet Yellen and interest rates. In 1998 and 2011, the downdrafts started in August of each year, retraced about 50% of the decline only to go down one more time to the approximate level of the previous low. At this point a lot of the selling pressure exhausts itself and historically buyers start to outnumber sellers.
The good news is that a seasonally weak September and early October could set the markets up for a year-end rally. As we know, October to December is historically the strongest period for the equity markets, especially when it comes after a correction in late September.
The corrections in 1998 and 2011 were far different from, and a lot less severe than the technology crash in 2000 and the financial crash in 2008. In the chart below, you can see that the inflection points in 1998 and 2011 were only pauses in a continuing bull market. We think this recent correction is similar.
Since the market lows in 2009, the S&P 500 has increased 184% through September 30, 2015. It has been a tremendous run and some investors wonder if the market is now overvalued. Many people believe that the run up in stock market values has been due to the extraordinary stimulative measures put in place by the Federal Reserve. While that has certainly helped, keep this in mind – during this time company earnings have also accelerated to the point that the price-to-earnings ratio of 15.1 is lower than the 20-year average of 15.8.
Meanwhile, the dividend yield of the S&P 500 is 2.5% while the 10-year Treasury note is only paying 2.1%. So while many investors got nervous about the recent sell-off after looking at their September 30 statements, stocks are not over-valued based on their historical averages and they yield more than bonds. Many investors would like to receive the higher yield and profit from the growth potential stocks have during the next 10 years compared to bonds. Here is our viewpoint: With money markets paying less than one half of one percent, stocks still look relatively attractive as compared to the alternatives.
The price per barrel of oil has fallen off the cliff for the second time in seven years. The recent steepening on that price slide was initiated by OPEC’s decision to produce at maximum capacity. Their decision was both political and economic. From a political standpoint, lower prices hurt their enemies: Russia, Iran and Syria. From an economic standpoint, the Saudis are sacrificing price for market share.
Domestically, expensive long-gestation projects, especially offshore U.S. developments, are being canceled or postponed. At the same time, oil derived from shale deposits here at home is presently in gradual decline. Eventually increased demand will catch up with the lower supply and push prices higher. This may not occur in the short-term, but may be more of a story in the second half of 2016.
Segment-by-Segment Market Rundown
Listed below are our opinions of certain segments of the stock and bond markets.
U.S. Large Cap Stocks:
The dollar has leveled off after significant gains; at least, temporarily. This should help earnings for large cap stocks in comparison with the previous year. Growth-oriented stocks have still out-performed valued oriented stocks to such an extent during the past twelve months that value stocks are looking attractive. There is still some sector rotation, but we believe the trend is still up. There was a stark sector rotation during the third quarter in which healthcare finally started to sell off (-10.7%) and energy (-17.4%) and materials (-16.9%) got hammered. The safe haven – utilities increased 5.4% during the quarter while consumer discretionary stocks (-2.6%), consumer staples (-0.2%) and technology (-3.7%) hung in there fairly well. As noted above, the energy sector has not performed well. We had thought it would have started to rebound by now, but it hasn’t. We are reluctant to advise clients to reduce holdings in this sector at these prices.
Small and Mid-Cap Stocks:
These companies tend to have a smaller percentage of their sales in foreign countries therefore avoiding the negative effects of a stronger dollar and benefiting from a relatively stronger U.S. economy. In my view allocations of small and mid-caps should be at a slightly below average weighting.
European economic data show slower growth in recent months as do Japan’s. However, that is not necessarily bad for stock market performance. As a result of this slower growth, both regions continue to ease monetary policy aggressively. The policies of the European Central Bank (ECB) are following those taken by the U.S. a couple of years ago. We like Japanese stocks because of that nation’s current growth policies coupled with their postponement of increased sales taxes. The dollar has also stabilized in relation to these foreign currencies, which reduces the risk of being adversely affected by the sometimes volatile fluctuations.
Looking at emerging markets, many have had deteriorating economic fundamentals and a strong dollar has further hurt them. As the dollar has recently stabilized, these investments have bounced back sharply. We tend to believe that an investor assumes a lot of risk in this area. If you have an interest in emerging foreign markets, please call us to discuss it. We will not be recommending this sector to most clients.
In deciding whether or not to invest in bonds, and what types of bonds to invest in, it is important to understand the terms maturity and duration and how they may affect certain investments.
The term fixed maturity is applicable to any form of financial instrument under which the loan is due to be repaid on a fixed date. The longer the maturity, the more potential volatility the bond (or mutual fund that invests in bonds) will have. We do not favor bonds with longer maturities.
The term duration of a bond fund that consists of fixed cash flows is the weighted average of the times until those fixed cash flows are received. Duration also measures the price sensitivity to yield, the rate of change of price with respect to yield or the percentage change in price for a parallel shift in yields. When yields rise 1% bond prices will drop approximately 1% for every year of duration. For example, if a bond fund has a duration of 6 and interest rates increase 1%, the value of that bond fund will drop approximately 6%. We saw this in May and June of 2014. Because of this, we believe a shortened average duration of fixed income investments could help reduce interest rate risk.
We have not liked this segment of the market for some time. We feel this is the market segment with the most interest rate risk. We do not believe that interest rates are going to shoot up anytime soon. The velocity of money, a statistic we look at from the St. Louis Federal Reserve shows little to no threat of inflation in the short term. When the U.S. economy starts to improve at a faster rate, we believe interest rates will increase which will hurt this sector of the bond market.
Investment Grade Corporate Bonds:
It is our view that corporate bonds with longer-term maturities have too much interest rate risk and favor short-duration corporate bonds.
High Yield Corporate Bonds:
These are also referred to as junk bonds. High yield bonds are more sensitive to credit risk (default risk) than they are interest rates. They tend to be more correlated to the stock market than the bond market. These bonds had done very well since the credit crisis in 2008-2009, but got hit hard during the fourth quarter of 2014. The high-yield bonds of energy companies were crushed and that brought down the whole sector. We believed that the selling was overdone and were not surprised to see a rebound in prices during the first part of 2015.
Floating Rate Bonds:
These bonds have a relatively high yield compared to other corporate bonds and are not as sensitive to rising interest rates because the yields in the portfolio reset every 30 to 90 days. Like high-yield bonds, they are more credit-sensitive. They offer fairly good yields, but we feel they could have downside price risk with very little upside price potential. Instead we favor short term bonds or possibly dividend-paying stocks.
These bonds can be tricky because the manager of any foreign bond fund must also consider currency risk. The bond fund managers we tend to favor currently utilize investment grade bonds with short durations. They also have a lot of experience with currencies. However, these bonds have proven to be more volatile than we would have liked from a fixed income investment.
Municipal bonds have done very well in 2014 and 2015, rebounding from their poor performance in 2013. We believe they are fairly valued and still worthwhile to hold for investors in the higher tax brackets.
We favor having a portion of the portfolio in gold as a hedge against “black swan” types of events (very bad things, such as current geo-political risks). Gold as an investment in the short term looks to have stabilized and is in a trading range. There does not seem to be a large catalyst such as increasing inflation to move these shares substantially higher in the short term.
Looking ahead to the fourth quarter, uncertainty will no doubt continue to be the watchword in the equity markets. The way we see it, the best way to counter any investment uncertainty is to remain resolute in planning and decision making for the long term.
Next post: How is your financial fitness? Find out with my 8-point checkup.
Morningstar, October, 2015
JPMorgan, Guide to the Markets, 4th Quarter, 2015
St. Louis Federal Reserve website, September 30, 2015
Dow Theory Forecasts, October 5, 2015
Dow Jones Industrial Average is an unmanaged index of 30 widely held stocks.
The S&P 500 is an unmanaged index of 500 widely held stocks.
Investors cannot invest directly in an index. The S&P 500 is an unmanaged index of 500 widely held stocks.
Past performance does not guarantee future results. The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Any opinions are those of David A. Urovsky, President of Wealth Advisors Group, and are not necessarily those of Lincoln Financial Advisors. Expressions of opinion are as of this date and are subject to change without notice. This information is not intended as a solicitation or an offer to buy or sell any security referred to herein. Investments mentioned may not be suitable for all investors.
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David Urovsky is registered representative of Lincoln Financial Advisors Corp. Securities and investment advisory services offered through Lincoln Financial Advisors Corp., a broker/dealer, Member (SIPC) and registered investment advisor. Insurance offered through Lincoln affiliates and other fine companies. It is not our position to offer legal or tax advice. Wealth Advisors Group is not an affiliate of Lincoln Financial Advisors Corp. CRN-1358512-112015