We have to confess, we would feel better about last week’s decline in the global equity markets if 2015 had been a bit more positive. Unfortunately our negative outlook for stocks at the beginning of 2015 is finally proving prescient. Slightly more than a week ago the stock market closed the books on a lackluster 2015 with a 0.7% loss in for the S&P 500, 2.2% loss for the DOW Industrials Average and a more positive 5.7% gain for the Nasdaq Composite.
Though the equity market performance for 2015 was poor, 2016 has started off in terrible fashion with declining valuations around the globe. Spurred by concerns for China’s weakening economy, currency devaluations against the dollar, and poor U.S. corporate earnings driven by lackluster sales growth, every significant stock market in the world declined for the first week of the New Year. Through the close Friday the S&P 500 is down 6%, the Dow down 6.2% and the Nasdaq ended the week off 7.3%. These declines are in-line with the performance of markets around the globe with European and Asian markets off 6-7%.
As we have discussed in our last several quarterly newsletters, we have been anticipating a correction in the equity markets for some time simply because we believed that the outlook for GDP growth and corporate earnings were too optimistic. We argued that the headwinds of reduced stimulus from the U.S. Federal Reserve, the rising value of the dollar relative to global currencies and maxed profit margins would yield little in earnings growth for the U.S. companies in the near-term. The brief market correction in August 2015 was not a surprise in our view. What was surprising was the brevity of the correction. This bull market expansion has been long-lived relative to historical expansions and the more than six years of improving valuations has rewarded investors that buy on the dips and punish those that sell on weakness.
We remain concerned regarding the economic fundamentals and of U.S. corporate earnings in particular. Equity valuations still appear high in our view. Reading the financial press, China is to blame for the global sell-off, but this is far too simplistic. China is likely the latest factor to push investors to accept a more realistic outlook after several years of unrequited optimism. China is problematic and it appears that there is real risk for the world’s second largest economy. Unfortunately, China is a black box. There is no way to fully understand what is happening within the carefully managed economy. What is apparent is that the managers have lost some level of control and in the worst case, it appears that the insiders may no longer be able to control the machinations of their own economy.
The combination of weak U.S. earnings, rising dollar, less fiscal stimulus, uncertainty in China and increasing geopolitical risk (Saudi Arabia, Iran, North Korea) have pushed investors to reconsider the overly optimistic forecast of 18% earnings growth in 2016 as shown in the table below. We are willing to bet our Powerball tickets that 2016 earnings will come in well below this forecast.
|S&P 500 EPS||$96.82||$107.30||$113.01||$106.38||$125.56|
|EPS y/y growth||0%||11%||5%||-6%||18%|
|S&P 500 Index||1426.19||1848.36||2058.9||2043.94||1922.03|
|Index y/y return||13%||30%||11%||-1%||-6%|
|* 2016 based on full year 2016 EPS estimates and index price 1/7/2016|
We reduced our exposure to equities last summer and continue to hold significant assets in cash and fixed income in anticipation of further weakness in the equity markets. At the end of December, firm wide cash totaled 21% of assets while both equities and bonds were each 37% of assets under management. The remaining 5% of assets were held in real-estate vehicles at the close of 2015. We added a few select defensive stocks in December, but remain very conservatively positioned.
Our analysis since the market correction in August 2015 is largely unchanged. If earnings really do fail to grow, a case can be made that the S&P 500 could fall as much as another 15% more before appearing attractive. With no earnings growth, the S&P could trade closer to the 15 times trailing earnings as the market did in 2012. At $112 or so in earnings, 15 times results in 1,680 on the S&P 500 index, or 13% below Friday’s close. The bullish case would be that earnings will accelerate as forecast and that the $125.56 estimate for 2016 is realistic. If earnings growth accelerates then a 17 times forward multiple is expensive but possible resulting in 2,134 for the S&P 500, or 11% higher than Friday’s close. The most likely scenario between now and year end will be something in between these parameters, but our cautious bias is that earnings projections will continue to be revised downward. With unknown factors including China, a potentially messy political election, and geopolitical risks, we think it is very possible that 2016 will end with the major stock indices in negative territory.
Our investment philosophy is to try to protect assets first and maximize returns second. The bond market is up 0.6% through Friday despite the specter of rising interest rates and we will continue to collect coupon yield in the months to come. The cash that has been raised we will deploy as opportunities present themselves in both stocks and bonds. If the correction continues we will look for suitable entry points to redeploy capital when valuations appear attractive. In the mean time we may reduce equities further to protect against losses if conditions warrant.
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