Market Perspective for December 3, 2016
Market Perspective
November was a very good month for U.S. stocks, but not much else. Even among U.S. stocks there was a very high dispersion between the best and worst performing stocks and industries. For example, financial services stocks rose 13.94% in November, according to S&P Dow Jones, while utilities declined –5.40% over the same time period.[1] A high dividend-oriented fund might have had the bulk of its assets in the top three yield sectors, utilities, consumer staples, and real estate and if so, it would have declined close to -4% in November. This would have badly trailed the S&P 500’s 3.7% advance.[2] On the other hand, a portfolio equally weighted to the industrials, energy, and materials industries (the three most economically sensitive sectors) would have gained 8%.[3] There has been a real opportunity (finally) to outperform the S&P 500 by owning stocks and industries that do not depend on a friendly Federal Reserve and unusually low interest rates. The catch is that you have to be willing to bet on a significant acceleration in corporate profits and major corporate tax reform. That was not priced into the market on November 9th, so there was the potential for strong gains if one was over-weighted in the right industries at that point. Three weeks later, I believe that scenario is fully priced in.
As nice as the month was for U.S. stocks, however, it has been brutal for bonds and international stocks. Rising interest rates and a soaring dollar have put tremendous pressure on those asset classes. In fact, a globally diversified investor probably made a slight profit in November but is still down for the quarter. If you figure that a 60/40 portfolio is probably 45% U.S. stock, 15% foreign stock, 30% U.S. bond, 5% foreign bond and 5% cash, then 45% of your portfolio rose about 3.7% and 50% of your portfolio lost -2.7% in November, leaving you with a gain of less than half a percent. Quarter to date, 45% of your portfolio has gained 1.8% and 50% of your portfolio is down 3.1%, so you are off three quarters of one percent. [4] That might be tough for clients to understand when they hear that the stock indexes have hit all-time highs.
The most important thing is to be earning at least the market equivalent in in US stocks and to be losing less than the market equivalent in U.S. bonds. Stock investors should think about shifting towards companies offering cyclical earnings growth, because that growth promises to be more dynamic than secular growth industries like health care and technology (which trade at significant premiums when they are the only growth assets available, as is no longer the case). Low growth, high dividend industries will be the most out-of- favor until interest rates rise enough to threaten the expansion (whereupon their high dividends will provide the most cushion in the ensuing recession).
Bond investors should consider reducing interest rate sensitivity. Bonds have enjoyed a phenomenal three decade run. Let’s hope the great bond bull market has ended such that we can gradually get to a level that rewards savers. If a 3% 10-year bond is enough to kill the economy, then we have almost no chance of growing the economy at a fast enough rate to pay down our national debt.
Keep in the back of your mind that rising rates are a headwind for stocks. Every dollar earned in the future has to be discounted at a higher rate. During the long bond bull market, P/E multiples rose from less than 10 times earnings to well over 20 times. This multiple expansion carried along all but the worst run companies and the most economically sensitive sub-industries (think things like base metal miners, steel companies, and shipbuilders). Earnings multiple contraction is going to hurt all companies that can’t grow their earnings fast enough. If we do successfully get the economy to 3-4% real growth (6-7% nominal growth) once again, Main Street will do better than Wall Street. Why? Because we could not have a 30% profit increase (about what is currently projected) without that growth leading to at least 2 interest rates increases, which probably causes a 2-3 point drop in P/E’s. That reduces your 30% earnings gain to a stock price gain of around 12%. We are not at the threshold of a new bull market no matter how fast the economy grows next year.
The short term – stocks are overbought and bonds are oversold. The trend has clearly changed but investors have moved prices too far too fast. Look for a period of sideways action as the stock gains and bond losses are consolidated. The end of December traditionally brings portfolio stuffing (buying the year’s winners so one’s annual report looks better), so financial and materials stocks might finish strong.
Thoughts on Italy
On Sunday, Italy votes on a referendum that would give Italian Prime Minister Matteo Renzi the ability to affect certain constitutional reforms which would make it easier for him to govern. More specifically, it would limit the power of the Italian Senate to block his reform proposals. The significance of the vote is that the fairly popular Renzi has said he would resign if the referendum failed. Renzi has been working to shore up struggling Italian banks. The Italian banking system would become more fragile in the case of a “No” vote, and that fragility would not likely be limited to Italy as major European banks would be exposed to losses by Italian banks. The polls have the No side modestly ahead. The markets are very nervous, as one can see from the spectacular underperformance of Europe versus the United States over the last month (obviously, it is not the only reason).
It should be noted that global macro funds are said to be quite short Italian securities, so a Yes vote has the potential to produce as much or more of a “relief” rally than a No vote would produce a loss. These binary events certainly make investing more challenging.
[1] S&P Dow Jones Index Dashboard, November 30th, 2016
[2] S&P Dow Jones Index Dashboard, November 30th, 2016
[3] S&P Dow Jones Index Dashboard, November 30th, 2016 & Trademark Financial Management
[4] S&P Dow Jones Global Index Dashboard, November 30th, 2016 & Trademark Financial Management