Observations and Outlook January 2017

While 2016 ended on a positive note, market volatility has arrived.

 

Selected Index Returns 4th Quarter/ 2016

Dow Jones Industrials    8.6%/ 16.5%                                       S&P 500   3.8%/11.96%       MSCI Europe   -.4%/-.4%
Small Cap (Russell 2000)  8.83%/21.31%     Emerging Mkts  -4.2%/11.2%     High Yld Bonds   1.37%/15.3%
US Aggregate Bond -2.98%/2.65%   US Treasury 20+Yr   -12.16%/1.4%                        DJ/UBS Commodity 2.7%/11.8%

A brief perusal of the above numbers clearly shows 2016 was a “Risk-On” kind of year with small cap stocks and junk bonds putting up substantial returns.  The U.S. markets in general were the place to be outpacing emerging markets and European shares as well.  What isn’t quite as clear is the fact that investors who were geographically diversified and sought to own lower risk/higher quality bonds are feeling a strong dose of ‘return envy’.  An investor with a 50% S&P 500 and 50% Aggregate bond portfolio saw ‘only’ a 7.5% return for the year.  What is also not seen is that the ‘risk on’ investor spent the first half of 2016 with negative returns with the post-election period accounting for approximately 80% of the year’s total gains.  To summarize 2016 in one word: volatile.   While the volatility ended the year on the plus side, it should give investors a moment to reflect on what they are willing to endure to see outsized gains.

Forecast 2017: Large Swells and Wind Gusts to the North and South

Often after a rapid decline in stock prices, conditions become “oversold”.  In the near term, oversold conditions often lead to a bounce or snapback in prices.  The opposite is also seen when prices advance too far too fast.  The rapid rise in equity prices has put the market into an “overbought” condition and, given the rise in stock prices based on expectations of tax relief and government spending to boost the economy, hope once again springs forth that today’s extreme valuations will be justified with a rapid rise in corporate earnings in 2017.  In the meantime, prices have already risen and like bond prices in 2016 are likely to fluctuate greatly.

Actually, prices in both stocks and bonds have already begun to make large swings down and up.  The year ended up, so the tendency is to assume rapid ‘up’ moves are natural, and of course welcome.   Early 2016 bonds and gold did extremely well as stock prices fell.  The roles were reversed in the second half with bonds and gold declining through the second half, while stocks edged up and the lurched up in the last two months.  So, in fact, we have already begun a period of greater market volatility.   It’s likely to see prices swing between Hope and Anxiety as we await the actual changes and impacts of the change in monetary policy (tightening from the Fed) and fiscal policy (lower taxes, increased deficit spending).

What outside issues might impact global markets?

China Overnight Interbank Lending Rate Soars to 105%

Money markets are the source of short term funding for the financial system.  Recently the HIBOR, Hong Kong Interbank Overnight Rate, has soared to unprecedented levels, yet very little has been talked about in the US financial press. This is the rate to borrow yuan overnight, for banks in Hong Kong- known as the offshore yuan rate.   This was likely due to the PBOC intervening to make is cost prohibitive to short China’s currency.  In the U.S., though,  we seem to be preoccupied with the number 20,000 to observe severe stress in the world’s second largest economy.

Source: fxstreet.com

The last time an extreme liquidity crunch was seen was one year ago, and global equity markets became very ‘nervous’.   This also coincides with the annual reset of how much money China’s citizens can send out of the country.  The Chinese are allowed to take the equivalent of $50,000 per person per year out of the country. There has been a significant weakening of the Chinese yuan vs the US dollar in an attempt to keep the yuan’s strength versus other currencies low.  Foreign exchange takes some effort to get one’s head around, but in a world of paper money, it’s an important factor in trade, profits and interest rates.

China is at the same time trying to slowly deflate a massive real estate bubble, while not effecting other areas of the economy.  Leverage, aka credit, is fuel for higher prices in all assets like real estate and equities, as well as some areas of the bond market (borrow short term, buy long term bonds and earn ‘carry’ profits).   It is extremely difficult to remove leverage and not have prices decline, yet this is what China is trying to do, while also defending its currency.  China is using its massive reserves of Treasuries to manage its currency depreciation vs the US dollar, and going through it at a rapid rate.  IF the rate at which its spending its reserves continues, China, could see its reserves decline by 50% in as little as 2 years, which is very significant.

China being a closed, autocratic society means data can be obfuscated, changed, and outright fabricated with very little complaint.  As such China is a ripe source of potential Black Swans in 2017.  We are already seeing very strange, even for China, developments in its money markets.

The Big Picture

Here it is…….

Take a moment and understand what this chart says.

Given the level of household exposure to equities, or put another way, the percentage of stocks in portfolios, has had a very strong predictive value upon the next 10 years’ returns.  As household become more heavily weight towards equities, the lower the next 10 years returns from equities.  The dashed line ends in mid-2006 because there was return data for the following 10 years, through mid-2016.

Households’ exposure to equities was very low at the 2009 market lows (people tend to sell after prices go down unfortunately), and indicated a forward 10-year annualized return approaching 15%.  If the S&P 500 achieved this, it points to approximately 2800 by mid-2019, an increase of 23% from current levels over the next 2.5 years.  The gap between the dashed and blue lines shows this is not an exact science.

I apologize in advance for the math here.  23% over 2.5 years is about 8.6% annualized.  If the margin of error from our chart above gives us only 13% annualized from 2009, that points to about 2270, an increase of 0% over the next 2.5 years; and if our chart ends up at 11% 10yr annualized rate, we will be at 1987 in 2.5 years, a decline of almost 13%.

A range over the next 2.5 years of +23% or -13% is much lower than the return the market has given us over the past few years.   The past 2 years has seen the S&P 500 swing from 2130 to 1850 to 2280 currently, while corporate earnings have been declining and recently grew back to a level seen in early 2015.  While 2014 was a good year, the past two years have seen major price swings and rewarded investors with only 5.5% annually for the past two years.   It’s my opinion that this kind of earnings levelling off, slowing of annualized returns, compounded by very high current valuations are indicative of a late stage bull market.   Past Price to Earnings ratios (see my blog post Definition of Long Term Investor), and the chart above also point to reduced returns from equities in the next few years.

What Can Be Done

If one suspects returns will be lackluster, and prices volatile, should one endure it?  The solution is at once simple and difficult at the same time given our cultural of equity ownership and the media’s constant focus on one asset class: equities.

Diversifying amongst the other 6 asset classes is a start.  Most advice revolves around 2, stocks and bonds.  If one truly wants to buy low and sell high, one must identify the other areas that are “low”, increase exposure there, and reduce exposure to “high” asset classes.  Not only does this smooth out volatility but can increase long term returns.   Given the outlook for more volatility in stock and bond prices; very low prices (historically and relative to other assets) in precious metals, agriculture and oil; there should be many opportunities to take advantage of short term swings to benefit and move some ‘eggs’ from the equity side into other, non- and lower-correlated asset classes that are currently much lower in price.

Easier said than done, yes.  This is exactly why investors should seek out Investment Advisors willing to do this difficult work and that have a strategy to deal with changing markets.  For more information on how I am doing this for my clients, please contact me.

Adam Waszkowski, CFA 

awaszkowski@namcoa.com

239.410.6555

This commentary is not intended as investment advice or an investment recommendation. Past performance is not a guarantee of future results. Price and yield are subject to daily change and as of the specified date. Information provided is solely the opinion or our investment managers at the time of writing. Nothing in the commentary should be construed as a solicitation to buy or sell securities. Information provided has been prepared from sources deemed to be reliable, but is not guaranteed by NAMCO and may not be a complete summary or statement of all available data necessary for making an investment decision.  Liquid securities, such as those held within managed portfolios, can fall in value. Naples Asset Management Company, LLC is an SEC Registered Investment Adviser. For more information, please contact us at awaszkowski@namcoa.com.

The Definition of “Long Term Investor”

What is the difference between long-term characteristics of the market, and owning the market for a long term and how can an investor benefit from knowing the difference.

The phrase “Long Term Investor” is used quite often, and there are many definitions.  The IRS defines a long-term investment as anything held more than 1 year.  Most people though would agree that long-term refers to a much longer time frame, usually at least 5 years.  However, when we read about equity market statistics, we are shown 30 and often 70 or even 100-year time spans.  I saw a recent article with a 500-year time span.  Given the average human life span, and that our peak earning and accumulation years are from our mid-40s to mid-60’s, most investors actually have about a 20-year time horizon of accumulation.

A “long term investor” isn’t one who buys and holds for a long span of time.  A long-term investor recognizes the long-term characteristics of equity (and other) markets.  For example, over the very long term (+20yrs), earnings per share follow GDP growth, the average 20yr annualized return is just over 7% (with dividends adding to this), and that over shorter periods of time, actual returns can vary greatly from the average.  The long-term investor also understands that the averages over the more volatile shorter periods of time are the pieces that create the 20-year average. One can see the volatility, or range of returns, over shorter periods below.

1-3-5-10-20-yr-avg-returns-schwab-ctr-for-financial-research      Source: http://www.investopedia.com/articles/stocks/08/passive-active-investing.asp?ad=dirN&qo=investopediaSiteSearch&qsrc=0&o=40186

The periods when we most often hear the phrase “I’m a long-term investor” being used, unfortunately, are when stock markets have experienced a significant decline.  To assuage the pain of real or paper losses, investors will often claim this characterization, with the unspoken assumption that ‘it will come back’.  And it always has, if you waited long enough.   From Charles Schwab Inc., via Investopedia.com we can see that yes, over very long periods of time, 20 years in this case, the market always has a positive return.

The chart below shows us the extremes. The low seen in 1979 to 1982 at about a 3% 20-year annualized returns, and the late 1990’s, from 1998 to 2001 which saw 20 year annualized returns over 13%.  While still positive, it’s much more helpful for an investor to invest over the right period! But how can one tell when ‘the right period’ might be at hand? Or even better, when the ‘wrong time’ might, so one can avoid a period of poor returns.  While not widely disseminated, missing the bad times has a far more powerful impact than staying invested, per this study by Meb Faber of Cambria Investment Management https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1908469

avg-20-yr-returnsSource: https://www.quora.com/What-is-the-average-S-P-500-return-over-20-years

So, while it is clear that, ‘in the long run’, if you wait long enough you will have positive returns.  From the chart above we can see that there are periods when long term returns are well below and above the 7% average.   How can we avoid being drawn into the low return eras?   Another long-term characteristic of equity markets is that Price to Earnings (P/E) ratios expand and contract.  That is for $1 in earnings, sometimes people pay $25 in price (a 25 P/E ratio) and other times less than $10.

For those well versed in market history, we know that the exemplary 20 year annualized returns seen in the late 1990’s, saw their birth in the low Price to Earnings era of the early 1980’s.  There are many studies showing how long term returns are borne from low P/E multiples.   Given that currently we are only beginning to enter the 20-years-later period after the dot.com bubble, we only have the first 20-year cycle from 1995, which gave us 7.3% annualized price growth.  Given that the late 1990’s saw large price appreciation, this acts as a headwind to the 20yr annualized returns in the next few years.  The S&P 500 started 1997 at 766 and if we end at 2200 in 2016 that will give us only 5.4% 20yr returns.  The S&P500 started 1998 at 963, and to maintain the 5.4% 20yr returns, the S&P500 would need to end 2017 at 2765, a gain of more than 25%!    The propensity is for the 20 year annualized returns to continue the downward slope that began in 2002 and likely repeat the bottoms like 1980, 1949 and four other periods where long term (20yr+) returns were very low.  The chart below is from Barry Ritholtz.

rolling-20-yr-returns-ritholzSource: http://ritholtz.com/2011/12/dow-jones-industial-average/

The results since this chart was created in 2010 are indeed following the red dashed line down.  Knowing that the market in 2000 was amongst the most expensive ever (highest P/E ratio) it should be considered that the 20 years ending in 2020 may see results that are amongst the worst in the past 100 years.  To have 0% return from 2000 to 2020, the S&P 500 would only need to decline by 31%, about the average for a bear market.   To have 2.5% annualized return from January 2000 to January 2020, the S&P500 would end 2019 at 2335, a change of about 6%, or only 2% annually.    The moral of the story is outlook for equity returns over the next 2-3 years is low and likely volatile, not a good risk to return prospect.

What Should One Do?

While 20yr annualized returns are slow moving data points, it’s clear that the long-term average is in decline.  Paying a high price (high P/E multiple) leads to poor long term returns is a slow lesson investors simply don’t have the time to learn from experience, and that many Baby Boomers can ill afford to learn now.

Knowing, or rather, expecting returns from stocks to be low going forward will enable an investor to seek returns from other asset classes.   Few Investment Advisors currently work with models outside of the traditional stock/bond portfolio mix.   An Advisor who recognizes that there are indeed 7 asset classes with which to pursue returns has an advantage.  Being successful at putting that understanding to work, is, indeed, the work of portfolio management.

Investors who want to earn returns in the medium term should look to other asset classes for returns, ideally ones that meet the ‘low’ metric for their markets.   True diversification is the call today, not simply bonds and stocks, but also commodities like oil and agriculture, precious metals and even cash.

If you would like more information on my Volatility Based Dynamic Asset Allocation process that seeks positive gains regardless of how equity or bond markets perform, contact me via email at awaszkowski@namcoa.com.

Adam Waszkowski, CFA

This commentary is not intended as investment advice or an investment recommendation. Past performance is not a guarantee of future results. Price and yield are subject to daily change and as of the specified date. Information provided is solely the opinion or our investment managers at the time of writing. Nothing in the commentary should be construed as a solicitation to buy or sell securities. Information provided has been prepared from sources deemed to be reliable, but is not guaranteed by NAMCO and may not be a complete summary or statement of all available data necessary for making an investment decision.  Liquid securities, such as those held within managed portfolios, can fall in value. Naples Asset Management Company, LLC is an SEC Registered Investment Adviser. For more information, please contact us at awaszkowski@namcoa.com.