2015 Q2 Market Commentary

“More money has been lost reaching for yield than at the point of a gun.”–Raymond DeVoe, Jr.

 

“The Stock Market is designed to transfer money from the Active to the Patient.”–Warren Buffett

 

Two issues, strength in the U.S. dollar and interest rates, seem to be making headlines on a regular basis. The U.S. dollar continues to strengthen against the rest of the world’s currencies. This strengthening impacts markets both close to home and abroad. The strength of the dollar is partially a result of the recovering U.S. economy. This leads to a discussion of interest rates. As the economy recovers the Federal Reserve will have to increase interest rates to avoid excessive inflation.

The U.S. Dollar and Markets

The rise in the dollar has been driven by two factors: the continued strength in the U.S. recovery in comparison to other advanced economies, and by concerns about reduced growth forecasts for China and some other emerging markets. As a result, we’ve seen a “flight to safety” to the dollar by global investors as central banks in the rest of the world keep rates at record lows in an attempt to fuel economic growth, while the Federal Reserve continues to send indications of raising U.S. short-term interest rates later this year. The strength of the dollar and resulting weakness in other currencies impacts markets around the world.

Overseas markets produced positive results in the first quarter. Strong leadership by the European Central Bank improved the outlook for Europe’s economies. There was a general sense that accommodation would be reached with the anti-austerity government elected in Greece without the disruption that would follow a “Grexit” from the European Economic Union. Furthermore, European multinationals have seen their competitiveness increase due to the fall in value of the euro (in relation to the dollar). Consumers also have benefited from the drop in oil prices since the middle of 2014, resulting in the prospect of stronger consumer spending pushing markets higher.

Meanwhile, forecasts for gains in the U.S. stock market in the remainder of 2015 have been adjusted downwards since late last year. Most analysts take the view that with valuations well above historical averages, this means growth in U.S. stock prices will be driven by earnings growth rather than expansion of the multiple that the market is willing to pay for profits. With regard to earnings growth, a recent article from CNBC[1] highlights increasing talk of a “profit recession” in which 2015 will see little or no growth in profits. Reuters highlights two big headwinds for the bottom line among U.S. companies[2]: The energy sector, which makes up almost 10% of the U.S. stock market, has been hit hard by the sharp decline in oil prices since last June, and the sector’s earnings are estimated to drop by over 50% in 2015. And second, the steep rise in the U.S. dollar (up 20% against a basket of global currencies from last June to the end of March) means that multinationals are seeing a drop in the value of their offshore profits when converted to dollars. This has a big impact given that approximately half of the revenue of companies in the S&P 500 comes from outside of the United States.

None of this is to say that stocks can’t continue to advance. We’ve written in the past how no measure has proven accurate in forecasting one-year equity returns – but it does suggest we may see some headwinds. Much of the above has been driven by an improving U.S. economy, which then leads to a discussion of interest rates.

Ben Bernanke: “Why are interest rates so low?”

In normal times, when the prospect for stocks is uncertain, investors look to increase their exposure to bonds. But given low interest rates and the concern about capital losses when rates rise, many investors don’t find bonds an attractive option. In fact, some clients have asked about reducing their bond allocations below the lowest point in their target allocation.

Recently former U.S. Federal Reserve Board Chairman Ben Bernanke wrote an article in response to the question, “Why are interest rates so low?[3] In this article, Bernanke talks about the challenge for central bankers in finding what economists call the equilibrium interest rate; that is, interest rates which are not so low as to overheat the economy, resulting in inflation, but low enough to encourage economic growth by making it attractive for companies and consumers to invest and to spend. Given the slow economic recovery, the equilibrium interest rate has been unusually low around the world. Here’s how Bernanke wrapped up his analysis:

“The state of the economy, not the Fed, is the ultimate determinant of the sustainable level of real returns. This helps explain why real interest rates are low throughout the industrialized world, not just in the United States.”

Low interest rates throughout the industrialized world, and the prospects of a near term U.S rate hike, cause world investors to purchase the dollar. These purchases cause the increases discussed in our previous section. For us, if we expect rates to increase, the next question should be “what about bond prices?”

Clients have asked us questions in response to talk about a “bubble” in bond prices that could lead to a crash in bond values as interest rates rise, which could then spill over to stocks and to the housing market. Yale economist Robert Shiller, who warned about both the tech bubble in 2000 and the housing bubble in 2005, spoke to this in a recent article titled “How scary is the bond market?[4]

Shiller applied his research on bond prices as a student 40 years ago to today’s situation. Here is an excerpt from his article:

The explanation that we developed so long ago still fits well enough to encourage the belief that we will not see a crash in the bond market unless central banks tighten monetary policy very sharply (by hiking short-term interest rates) or there is a major spike in inflation… It is true that extraordinarily low long-term bond yields put us outside the range of historical experience. But so would a scenario in which a sudden bond-market crash drags down prices of stocks and housing. When an event has never occurred, it cannot be predicted with any semblance of confidence.

The years since 2008 have seen many periods of uncertainty, and today is no exception. With stocks at above average valuations, U.S. corporate profits flat or even in decline and interest rates stuck at record low levels, what’s an investor to do? To help navigate through times like these, we’d like to reiterate our core principles of Focus on Quality, Diversify, Maintain Balance, and Manage Risk. We’ve written about these before, but they are so thoroughly embedded in our approach that they are worth repeating:

Focus on Quality

When interest rates are low, investors are sometimes tempted to increase cash flow by looking at lower quality issuers that pay a higher rate of interest. Similarly, it can be tempting to look at stocks that are paying dividends of 5% or more. There is an old expression in the investment industry: “More money is lost reaching for yield than at the point of a gun.” Significantly increasing portfolio risk by moving to lower quality stocks and bonds is seldom a prudent strategy.

Diversify

In the past we’ve pointed out the response to expensive markets is to look outside the United States. In late August, Princeton’s Burton Malkiel wrote a Wall Street Journal article titled “Are Stock Prices Headed for a Fall?[5] In that article, he suggested that investors consider adding emerging-markets stocks to their portfolios. Based on 10-year earnings valuation, those stocks are priced more than 40% below that of the U.S. market. Still another strategy is to look selectively at stocks in Europe and Japan that trade at lower levels than comparable U.S. companies.

Maintain Balance

A key trait of successful investors is ensuring that their portfolios stay balanced. There was a strong performance by stocks over the past number of years. Because of this, unless action was taken to reallocate funds along the way, it’s likely that portfolios that had the right balance three years ago are out of balance today with an overweighting to equities. That overweight can lead to greater downside risk than was built into the original portfolio.

Manage Risk

We design portfolios with the view of providing clients with the best possible returns on a risk-adjusted basis when looking across a full market cycle. To do that, we look at the broadest possible range of alternatives, both within the United States and around the world.

Ultimately, every client’s needs are unique, and we work hard to develop the portfolio that is right for your personal risk tolerance and situation. If we haven’t talked recently, we would welcome the opportunity to sit down to update your circumstances, to ensure that your portfolio is designed to provide the returns to achieve your long term goals with no more risk than is necessary.

The views and opinions expressed are of White Horse Advisors, LLC. This commentary is provided for educational purposes only and should not be construed as investment advice. White Horse Advisors is an investment advisor firm located in Atlanta, GA. 

[1] http://www.cnbc.com/id/102531050

[2] http://www.reuters.com/article/2015/03/13/us-usa-results-companies-idUSKBN0M915R20150313

[3] http://www.brookings.edu/blogs/ben-bernanke/posts/2015/03/30-why-interest-rates-so-low

[4] http://www.project-syndicate.org/commentary/bond-market-crash-contagion-by-robert-j–shiller-2015-03

[5] http://www.wsj.com/articles/burton-g-malkiel-are-stock-prices-headed-for-a-fall-1409178881