Market Insight - April 2015
Successive waves of volatility sapped investor confidence and raised fear levels throughout the first three months of 2015; despite this, balanced global portfolios made acceptable gains. Markets hit record highs in February, preceded by losses in January and followed by losses in March. The S&P 500 experienced nineteen days with percentage moves of over 1% in either direction; twelve were up days with gains averaging 1.3%; seven were down days with losses averaging 1.45%. The markets went 28 days without back to back gains; this has only happened twice since World War II! Oil prices dropped a further 10% in the quarter, an unwelcome encore to a 50% decline in 2014. and while markets inched ahead, investors pulled over $44 billion from equity funds, the highest outflow since 2009.
How did fear become the dominant driver of markets?
One frequently voiced concern has been valuation; if the gap between expected earnings and prices widens, either by soaring stock prices or slowing earnings, the market begins to look expensive.Yet the current 12 month forward price earnings ratio for the S&P500, 16.7, is only slightly above the five year average of 13.7 and the ten year average 14.1. Still, the year-over-year earnings growth rate for the S&P 500 is now projected to decline by 4.6%, much of which is attributable to the collapse of oil prices and a soaring dollar. The chart below shows the striking impact on stock prices of US multinationals.
Tale of the Tape
The Dow ended the quarter with a less than one percent loss, while the S&P 500 gained 1.77%. Size mattered in 2015; Smaller companies, measured by the S&P Small Cap 600, out performed, adding 3.85%, while mid-sized companies measured by the S&P Mid-Cap 400, gained 5.26%. Real estate investments in the Cohen & Steers Realty Fund added 5.14%, while the biotech sector, measured by the NASDAQ Biotech Index (IBB), gained13.21%, even after a nasty end of quarter selloff. The best performing sector overall was healthcare, the worst performing, utilities. Global investments regained their focus despite the strength of the dollar; the MSCI EAFE developed market index, added 5.4%, while the emerging market index rose a little over 2%.
Bonds and fixed income investments continued their very strong showing in 2015. The total return for the 10 year U.S. Treasury benchmark was 1.48%, following on a 1.93% gain in 4th quarter 2014, while the yield fell from 2.17% in January to 1.937% at the end of the quarter. High yield bonds, measured by the Pimco High Yield Bond Fund, gained 2.38%.
What the Fed said
The media’s fixation on the timing of the Fed’s normalization of Fed fund rates makes little sense to us, and is both distracting and damaging to serious investors. Chairman Yellen’s transparent and data-driven policy should minimize surprises and, in our view, be a net positive for equity values in the long term, well worth any short term dislocation. The Fed would be very reluctant to raise rates unless they felt the economy was strong enough to thrive in a more normalized environment. Historically, stock markets usually thrive in periods of moderately rising Fed interest rates, and only tend to weaken as rate increases taper off.
What about Bonds?
Bonds and bond funds have enjoyed exceptional returns for an extended period of time. Few investors expect this to continue, but a gradual rise in rates scarcely justifies fears of a price collapse. We should remember that rates on most maturities of bonds are only indirectly controlled by the Fed. Intermediate and long term rates, which are of most concern to investors, are set mainly by our expectations for future inflation. In fact, during two of the last major multi-year periods of rising rates (1977-1981 and 2002-2007) bonds, measured by the Barclays intermediate US Govt/Credit total return index, ultimately provided total returns of 5.63% and 4.53% respectively. The real issue and our real concern should be inflation. Out of control inflation can turn nominal returns into negative real returns for bonds, and has the potential to drive down equity returns into bear market territory. Rate increases…We say the sooner the better, Mrs. Yellen.
We think long term investors will welcome the return to a more normalized interest rate environment. Corrections, no matter what triggers them, are part of the ebb and flow through which equity markets translate economic growth into real portfolio gain, and ultimately, build real wealth.