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.
