Market Analysis January 2016

DIS and DAT - Market Analysis, January 2016

The ultimate authority must always rest with the individual's own reason and critical analysis.
Dalai Lama

 Performance review by the numbers

We begin by reviewing past performance of broad areas, which is not indicative of future results.

SP 500                                   7.04%                     1.38%                  12.57%

SP 500 Value                         6.05%                   (3.13)%                 10.96%

SP 500 Growth                      7.86%                    5.52%                  14.06%

Russell 2000 Growth             4.32%                  (1.38)%                 10.67%

Russell 2000 Value                 2.88%                  (7.47)%                  7.67%

Aggregate Bond                   (0.57)%                     0.55%                  3.25%

MSCI EAFE                           4.71%                   (0.81)%                3.60%

Gold                                      (4.85)%                 (11.61)%             (5.49)%

XOM                                      5.82%                   (12.57)%              4.25%

Commodities                      (16.63)%                  (32.86)%            (10.66)%

SOURCE: Yahoo Finance, Morningstar.com – As of 12/31/2015

 

Fundamental review

Turning to a review of the general investment fundamentals we find that, according to the Bureau of Labor Statistics (www.bls.gov) the core (ex food and energy) inflation rate increased 2.0% and the headline increased 0.5% for 12 months ending November. The increase is the largest 12 month increase since May 2014 and December 2014, respectively. The five year average inflation rate is 1.45%.  For purposes of analysis, we will use 2.0% inflation as that still seems reasonable. From Value line selection and opinion (www.valueline.com), we find 90 day T-bill yields moved up drastically to 0.20% versus 0.01% a year ago, as the Federal Reserve raised the Federal Funds rate for the first time in 7 years.  “A” rated industrial corporate bond yields increased 40 basis points from a year ago, to 4.35%. The 10 year minus 2 year treasury yields spread ended at 1.21%, the smallest spread since 2007. Historically, the flattening of the yield curve has signaled some economic weakness. In terms of calculating equity investments, we would want an 8% return on equity to show fair valuation if the equity price were at book value. The JP Morgan guide to the markets, reports that the SP500 index of stocks had a return on equity of 16.1%, and a price to book value of 2.6.  Currently, SP500 has an earnings yield of 6.2% and the 10 year treasury yields 2.27%.

 

Thoughts and comments on asset classes

With the SP 500 squeaking out a paltry 1.38% gain, it may look like a quiet 2015, yet it was anything but. After a slow grind higher through the first 7 months, August and September experienced volatility not seen in years. Major Indexes had their first 10% correction in 4 years, only to rally back to new highs by October, with volatility continuing through the end of the year. Small Caps, particularly Small Cap Growth, along with International lead the way the first half of 2015, only to lag in the back half.

               Volatility wasn’t immune to Fixed Income either. From the speculation leading up to the eventual first Fed rate hike since 2008, the bond market was on edge in 2015. The 10 year treasury yield ranged from a low of 1.64% at the end of January shooting up to 2.5% in June. The air came out of High Yield bonds, as the oil crash prompted a surge in default rates for that sector.

                The commodity markets continued to be hit hard after the little relief rally in the first half of the year. Commodities ended 2015 down nearly 33%, led by energy. The strong dollar and over supply continue to haunt this asset class.

               Taking a longer term, contrarian view of broad asset classes, it is of our opinion that international developed equities and Bonds would be the area we would look for bargains with new money. After a 6 year bull market, International continues to lag U.S Equities by a large margin. While bonds don’t necessarily look very attractive with higher rates possible in the future, it is a place to hold while waiting for the next opportunity to present itself. While it’s not there yet, Large Cap Value may just be that next opportunity.  When wanting to rebalance or needing cash, we believe Large Cap Growth would be an area to sell.  

 

Corporate Updates

                This section highlights a few updates from the companies we have been watching this quarter.

Microsoft – As the C.E.O. , Satya Nadella,  continues to make changes the company once again made the cover of Barron’s magazine.  They also increased their quarterly dividend by 16%.

G.E. – The Company completed its spin-off of Synchrony Financial.

Hewlett Packard – The company split into two separate companies Hewlett Packard Enterprises (HPE) and Hewlett Packard Incorporated (HPQ).

Weight Watchers – Oprah Winfrey purchased a 10% stake with rights to buy another 5% of the company.

 

Tax Corner

            From time to time we may have interesting investment related tax updates.  We will continue with the tax corner and other communications for more in depth information.

           

            Congress in one of its budget compromises of 2015 passed important social security reform, and in another tax reform.  One can only assume this qualifies as broad passed tax legislation!  All kidding aside we may have to put up with tax changes being passed in these ways for a while.

                Effective October 30, 2015, Congress made sweeping changes to the rules of Social Security.   “The measure includes a provision that ends two popular Social Security claiming strategies: file-and-suspend and filing for a restricted claim of spousal benefits.”

            The Protecting Americans from Tax Hikes Act of 2015 (PATH Act) was signed into law on Dec. 18, 2015, as part of the Consolidated Appropriations Act, 2016.  Changes effected REITs, S corporations and Depreciation among others.

 

Concepts for Investing

               Studies by Dalbar demonstrate that the average investor’s results far well below index returns and the returns of tools in which investors use to invest. Our desire is to improve our client’s results and we realize key concepts are not natural to human thinking.  We believe this means investors must constantly remind themselves of investing concepts, or else their portfolios tend to drift away from those concepts.  Here is our creation of ten key concepts for investing. 

1. Low turnover
2. Diversification of risk drivers
3. Contrary mindset
4. Business analyst mindset
5. Separate investment versus non-investment funds
6. Process over performance
7. Investing is personal
8. Exhibition not a competition
9. Development mindset
10. Comprehensive review

DIS Commentary

We believe it’s important to enlarge the outlook beyond what just occurred in the last quarter for a moment. Studies have shown that humans have a tendency in their thinking to give more weight to current events.  Two investment philosophies which have worked in years past are trend continuance and regression to the mean.  Value and contrarian type strategies rely on the regression to the mean concept and trend following and growth rely on the trend continuance concept.  As a whole investors have shown a tendency to rotate back and forth between the concepts (usually at the worst times) depending on popularity.  We believe that investors will fare better over the long-term by choosing one and remaining faithful through the bad periods.  If they do so, then they can avoid changing at exactly the wrong time.  The last 18 months are one of those painful periods for us and other value oriented investors. It is said that you learn the most from the tough times, so we are embracing the opportunity to add to our experience.

                Throughout 2015, the constant chatter on the soap box was new U.S. stock index highs, yet there were a lot of underlying stories that were playing out beneath the surface. While the SP500 ended slightly positive for the year, 282 of the stocks were negative in 2015. Yet if it weren’t for Wall Street’s new beloved acronym, FANG (Facebook, Amazon, Netflix and Google), the SP 500 would have been down 4.8% at years end. This brings back memories of some of Wall Street’s old favorites like BRICs and dot-coms.  In 1999, Exxon stock price rose 10.17% while Cisco’s jumped 130.84%. Over 2013, 2014, 2015, ExxonMobil stock price returns were 19.77%,-5.98%, and -15.68% respectively.  This compares to Facebook stock returns of +105.30%, 42.76%, and 34.15% over the same time frame according to 1stock1.com.  Other momentum periods that were similar were the Nifty Fifties of the 70’s.

               The next interesting story was played out in High Yield bonds, or as they used to be called, junk bonds, and MLPs. As low interest rates caused investors to reach for yields, investors found out the hard way that High Yield bonds do actually default. As years of being able to refinance their debt and oil prices near $100 came to an end, investors ran for the door as default rates rose, spreads widened, and oil fell below $40/barrel. This was only the second negative year for High Yield bonds and MLPs in 10 years, with the other being 2008.

                We do not know or pretend to know what 2016 will bring.  We do know that trees don’t grow to the sky and that this too shall pass.

We appreciate your time and will talk to you again soon,

Reggie McFadden, CFA 

 

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Performance Disclosures

All indexes are unmanaged and an individual cannot invest directly in an index. Index returns do not include fees or expenses. (JPM: Guide to the Markets)

The S&P 500 Index is widely regarded as the best single gauge of the U.S. equities market. This world-renowned index includes a representative sample of 500 leading companies in leading industries of the U.S. economy. Although the S&P 500 Index focuses on the large-cap segment of the market, with approximately 75% coverage of U.S. equities, it is also an ideal proxy for the total market. An investor cannot invest directly in an index (JPM: Guide to the Markets)

The Russell 2000 Growth Index® measures the performance of those Russell 2000 companies with higher price-to-book ratios and higher forecasted growth values. (JPM: Guide to the Markets)

The Russell 2000 Value Index® measures the performance of those Russell 2000 companies with lower price-to-book ratios and lower forecasted growth values. (JPM: Guide to the Markets)

The MSCI®EAFE (Europe, Australia, Far East) Net Index is recognized as the pre-eminent benchmark in the United States to measure international equity performance. It comprises 21 MSCI country indexes, representing the developed markets outside of North America. (JPM: Guide to the Markets)

The Barclays Capital U.S. Aggregate Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. These major sectors are subdivided into more specific indexes that are calculated and reported on a regular basis. (JPM: Guide to the Markets)

The Dow Jones-UBS Commodity Index is composed of futures contracts on physical commodities and represents 22 separate commodities traded on U.S. exchanges, with the exception of aluminum, nickel, and zinc. (JPM: Guide to the Markets)

The spot price for gold bullion is determined by market forces in the 24-hour global over-the-counter (OTC) market for gold. The OTC market accounts for most global gold trading, and prices quoted reflect the information available to the market at any given time. (Ishares) 

XOM is the common stock symbol of ExxonMobil Corporation that trades on the exchange