Asset Class Summary / Market Volatility: Fourth Quarter 2015
Given the stock market’s higher volatility during the last few months of 2015 and the start of 2016, let’s look at the volatility itself, the major causes, and how it has affected our asset class allocation decisions for 2016.
The Volatility Index (VIX) is the standard measure of volatility in the market. Since its inception 25 years ago it has averaged about 20. It has spent about a third of its time in the 20 to 30 range. However, the VIX has been remarkably calm the last few years. For example, in 2013 it spent just 1% of its time in that range and in 2014 only 5% of the time. The VIX closed at 27 on consecutive days, 60% higher than a year ago. See the chart below for an illustration of VIX over the past couple of decades.
So, what are the likely causes of the higher volatility we’ve been seeing in the market lately? And how have we adjusted portfolios accordingly? One of the causes, of course, is The Fed. For years the Fed embarked on asset purchases (Quantitative Easing) and kept interest rates at rock bottom. Asset purchases are no longer in place and beginning in August, just as investors became convinced the Fed would raise interest rates, volatility began to increase.
Another reason is the slowdown in China and that government’s clumsy attempts to intervene which instilled less confidence in market participants. A third factor explaining the rising VIX is rapidly falling oil prices. In the past, falling oil has been a bad thing due to its association with economic slowdowns and recessions. It has usually been a demand slowdown issue. Finally, corporate earnings growth is slowing down and in fact, will likely turn negative.
The above concerns are all understandable, but we believe should not cause investors to panic and abandon stocks. Here are the counterpoints. The Fed will not embark upon a series of rapid rate hikes as it has done in the past when in tightening mode. In fact, we believe it will probably proceed even slower than it has already indicated (4 one-quarter point hikes over each of the next two years) if it senses doing so will negatively affect the fragile global economy. China’s economy and stock market has been very volatile for decades. Too much is being made of the current downturn and this will become evident. Also, we view plummeting oil prices as more of a good thing than a bad thing because it is an oversupply issue (not demand) this time around. Lower oil prices keep more money in the pockets of American consumers and help the corporate profits of non-energy related companies.
Finally, although corporate profit margins are beginning to come off all-time highs (see the chart below) and earnings will start to roll over in 2016, the hit to corporate earnings will be relatively mild and nowhere near the magnitude of the last downturn we saw during the financial crisis.
Here is the bottom line as to what all this means in terms of our asset class allocations:
We believe that the recent sell off in U.S. stocks has been overdone. Both the reported GAAP Earnings levels and the forward looking P/E rates are in line with the long-term average, if not a little cheaper. In addition, interest rates are still extremely low, which increases the value of expected future earnings by a significant amount versus historical interest rate levels. Also, the other traditional choices an investor has for their investments – cash and bonds – remain unattractive. Money market rates are still negligible and good quality bond yields are only in the 2% range. In addition, from these low levels, rising interest rates will likely hurt bond returns more than they would if rates were already higher and rising.
Although we continue to like U.S. stocks as an asset class, we expect the volatility of the stock market to be noticeably higher in 2016, and that has certainly already been the case.
The main logs fueling the fires of high volatility are the Fed Funds rate increase, the slowdown in China, a slowdown in earning growth rates and concerns over the freefall in oil prices. These issues won’t be going away overnight, and they are overblown concerns in our opinion regarding the prospects for stocks in 2016.
Some of the positives offsetting these concerns include corporate earnings near all-time highs (see the chart below), interest rates still near all-time lows, a relatively robust economy versus most other areas of the world, high corporate profit margins and corporate buyback programs that are still in place. When corporations perceive their shares as cheap and purchase them in the open market, this lowers shares outstanding and increases reported earnings per share.
Technology and healthcare were two of the strongest performing sectors of the S&P 500 in 2015. It’s also worth noting that we are staying relatively conservative in our stock exposure, staying away from direct investment in mid-cap and smaller-cap issues which underperformed during the year.
Developed International Stocks (EAFE Index) once again underperformed the performance of U.S stocks in 2015, but only by 1%. By several measures including the P/E ratio, international stocks remain cheaper than U.S. stocks. For this reason and because of the diversification benefits, we are maintaining our exposure to international stocks. Clients generally have close to one-third of their equity holdings dedicated to international markets. Both Japan and Europe have undertaken U.S. style Quantitative Easing measures, and we believe these actions will result in better performance in 2016. In addition, we doubt the dollar will again appreciate double digits against other major currencies like it has in the past two years. This will help the overall performance of international returns for U.S. investors.
Our returns in the international markets were in line with the EAFE benchmark return.
Emerging markets are smaller, more volatile international markets and they were down about 15% in 2016. Not only did we have a small 3% allocation to begin with, but we stayed on the sidelines and did not purchase more when they began to fall.
Bonds remain expensive in our opinion and provide little to no return in 2015. Available yields are very low. In addition, the Fed is officially on a campaign to raise rates. The current Fed Funds rate is in a range between 0.25% and 0.5%. The Fed committee expects this to rise to a range of 1.25% to 1.5% by the end of 2016 and 2.25% to 2.5% by the end of 2017.
Generally, the price of existing bonds falls when interest rates rise. Thus, we believe there is a decent chance that bonds have flat to down performance in 2016 just as they did in 2013 and 2015. We remain defensively positioned in our bond holdings, favoring high quality issues and short durations.
We hold alternative investments for their diversification benefits, specifically for their low correlation to stock and bond returns.
During the fourth quarter of 2015 we became convinced that we would continue to see volatility levels (as measured by the VIX) increase. As a result, we began to search specifically for Alternative mutual funds that performed relatively well in a sideways moving, more volatile markets. We have done just that and added them to client portfolios – replacing a couple of other Alternative strategies which had not held up as well as we would have liked during periods of downturn. We look forward to talking to you further about these new investments in the near future.
All references in this publication referring to our average allocation or “typical portfolios” reflect those of the fully discretionary accounts of clients with moderate risk profiles. Actual client portfolios are tailored to individual client circumstances and asset allocations may vary. Any reference to returns reflect the performance of asset classes, are for illustration purposes only, and do not reflect the returns of any specific investment of Smith & Howard Wealth Management. No representation is made that any investment decisions discussed herein have been profitable in the past or will be in the future. Past performance is no guarantee of future results. A list of all recommended investments is available upon request.