Tuesday, April 5, 2016

What Lies Ahead—and What It May Mean For Your Portfolio

As the stock market has recovered from its February 11 low (and posted a modest gain for the year), many of us wonder what lies ahead.  Given the Federal Reserve’s recent decision not to hike interest rates now, low-risk investors are looking elsewhere for return, and many are questioning whether the stock market is their only option.

At a recent economic forecast presentation hosted by Denver-based AMG National Trust Bank, insights were offered that could be a guideline.  Themed, “growth with a speed bump”, the speakers were careful to point out both the positives and negatives that may be in store.  On the plus side, consumer spending, which accounts for around 67% of our country’s Gross Domestic Product (GDP), looks to be running in the range of 3%.  Add to that figures for rising home prices, low energy costs, an improved labor market, and expectations for GDP growth ranging from 1.5% to 3.2%.  (Although that figure may be a tad optimistic:  Other analysts put it at 2%-2.5%).

On the other side of the ledger is declining business investment, particularly capital spending in the energy industry, which has seen sharp declines.  A few other risks could cloud the picture:  high domestic inventories, an increase in foreign imports, and weakening credit standards.  High inventories mean that businesses won’t produce goods while they are drawing down inventories.  Increased foreign imports mean we are buying more from other countries than from our own US manufacturing base. Deteriorating credit standards are reflected in troubled real estate and construction loans, which may compress banks’ interest income and margins.  These things combined make for a somewhat murky outlook.

The credit picture is further complicated by high-yield debt, currently yielding around 7%.  Although improved from the higher rates seen in December and January (primarily because of a better outlook for oil prices that caused those bonds to rally), the spread between these rates and the risk-free rate of the US 10-Year Treasury remains fairly wide compared to a couple of years ago.

So what does this mean for investors?  First, valuations for stocks are high:  A current price/earnings ratio of 17 (versus the long-term average of 15) for our stock market suggests that it may be tough for the market to have a significant rise.  According to another analyst, Vinny Catalano, President of Blue Marble Research, either interest rates need to drop or earnings have to accelerate for stocks to rise much more.  Interest rates can’t drop much (they are already low: just .50%), and first quarter earnings for 2016 are expected to decline by more than -7% over last year, and fall another -2% for the second quarter versus a year ago, before turning positive for the third and fourth quarters.  These forecasts amount to a projected overall increase of a mere 1.49% for the year.  Not exactly a rosy scenario. 

But the outlook for European stocks may be better, given their lower market valuations.  The European Central Bank (ECB) also recently expanded (and extended) its quantitative easing program, by which it will purchase more bonds, thereby putting more money in circulation.  The ECB also introduced negative interest rates (that encourage savers to spend), and the Eurozone is enjoying a strengthening currency.

The outlook for oil is not clear.  Although its price peaked at $41 per barrel before retreating slightly to around $36, it still represents around a substantial increase from the $26-per-barrel low reached in February.  As a commodity, oil prices are determined by supply and demand, and several factors have affected both sides of the equation.  Demand from emerging markets (China, among others), has contracted, and at the same time, we have more supply from US oil producers.  As low prices prompted domestic producers to cut back production, Saudi Arabia and other global producers continued to pump to preserve their market share.  In addition, now that we have an agreement with them to remove sanctions in return for their adopting a more acceptable nuclear policy, Iran is now a factor, and is expected to add sizable production to the supply.  Given these facts, oil may trade between $40 and $60 per barrel—higher than the rock-bottom low we saw earlier this year, but still a far cry from the $82-per- barrel-price of 2014.

For the time being, talk of recession seems muted, given the improving economic data and how well the stock market is performing.  But economists do draw some interesting parallels.  According to their findings, recessions that occurred during a bear market (defined as a drop of 20% or more), typically lasted 500 days. Contrast that scenario with historical trends for recessions that occur outside a bear market lasting around 136 days. 

So how can we use this data to our advantage?  Most professional investors view market timing to be a fool’s game, because it demands making two correct decisions:  when to sell out, and when to buy back in.  A more prudent stance is to have a well-diversified portfolio that is in line with your comfort level with risk.  In the short term, it is tough to get meaningful return in bonds, as the US 10-Year Treasury yields under 2%, and once interest rates begin to rise, capital will be risk (as bonds with higher rates are more attractive to an investor).  That reality has spawned much ink in the financial press about how standard equity/fixed income asset allocations for conservative investors and retirees may be passé.  It also has pushed many investors to invest in the stock market without adequately understanding, much less being comfortable with, the added risk. 

Risk has many connotations, among which are the degree to which you can “sleep at night”; the likelihood that your portfolio will lose value; and the possibility that you may need to make withdrawals to cover retirement living expenses at a time when the market is in decline. Depending on the severity of the decline, you may have insufficient time for your portfolio to recover, meaning your assets could be substantially depleted while you still need income. That degree of equity exposure may be uncharted territory for you, and you should understand the risk. One study showed disastrous results for a portfolio that was invested entirely in stocks for the 15-year period 2000-2015.

Building a portfolio with a mix of different types of equities, including those in international developed countries, along with some exposure to bonds for stability, may be a more acceptable strategy.  Stocks with dividends are one option, as typically—but not always—dividend-paying stocks do not suffer as much during a market selloff.  Another option is to select a balanced fund with a mix of both equities and bonds.  Although investors generally purchase bonds for their income characteristics, fixed income investments also stabilize a portfolio, as the underlying capital is a loan to the corporate issuer.  An issuer with solid credit is unlikely to default on the obligation.  Having bonds in your portfolio will help preserve your capital should the market suffer a decline.

You also should realize that in an election year, fiscal policy and market behavior can have an impact on how your portfolio performs.  When election campaign rhetoric is leading the charge, the outcome may be beyond your control.  But you can control how you react, and having a properly diversified portfolio is one way to counter the chaos.