For the last five months, stock prices have more or less surprised investors, continuing to edge higher amid a flow of unsettling news. On top of that, we experienced two points this year that had many reaching for the emergency brake. First was the harrowing start to the year, which saw stock prices fall 10.27% after only 28 trading days. Second was the remarkable post Brexit snap that saw stock prices lose 5.4% over two days in late June. In spite of this, stock prices have soldiered on, with little regard for the often event-driven mentality, and closed out July with the S&P 500 at 2,173, 7.6% above where they started the year.
This year is unusual because all the asset classes we utilize are putting up solid returns. Stock prices are on the rise because investors expect improved earnings reports. Fixed income (US corporate and municipal bonds) has done well largely due to a recovery in credit, particularly energy and a tailwind from falling interest rates. Another reason bonds have rallied is the flight to safety trade – investors have continued to buy bonds hoping to stay out of harm’s way. REITs are having a strong year due to a stable financial backdrop and their high yields. And finally, the pipeline MLPs are putting up attractive returns as the price of oil has stabilized and quarterly distributions look to be secure.
Stock prices have been struggling through an “earnings recession.” Q2 2016 is expected to be the fifth consecutive quarter of year over year declines in earnings. From 2012-2014 earnings growth was north of 5%. Then, in 2015 earnings fell 0.8% and are expected to fall another 0.3% in 2016. The decline was largely a byproduct of the drop in oil prices. Starting in mid-2014, a barrel of oil dropped in price from over $111 to below $40. This had an immense impact on a vast array of businesses with both direct and indirect exposure to the energy patch. While motorists saw heaven at the pump, stock investors cringed as returns from stocks, across most sectors, began a protracted sideways move.
Today, with the possibility for improved earnings on the horizon, stocks are priced at a P/E of 17x expected earnings. Analysts currently forecast bottoms up S&P 500 earnings of 134.4 for 2017. A valuation in this range is not unreasonable in light of the extremely low interest rates and inflation. In my opinion, there is an avenue for stocks to return 6-10% over the next 12 months. Of course, things will need to go well. The market is expecting an earnings recovery, and stock prices are being bid up in anticipation of this outcome. Currently, the dividend yield on the S&P 500 is 2.3% – #paidtowait.
Something we are watching closely is the shift in the type of stocks generating returns this year. Growth stocks have outperformed value stocks for years. Then, late last year, the market began rewarding value stocks, and this shift has been in effect all year. When earnings growth is scarce, dividends become more attractive. The push into value stocks has driven their prices up, currently trading over 115% of their historical P/E. Although we have tweaked our models to take advantage of this shift, we prefer not to chase expensive stocks. I expect the market to turn its attention back toward growth with improved S&P 500 earnings later this year and into 2017.
Our advisory approach rests on three principal tenets: utilize quality assets where we are confident in a reliable information flow, insure our investors have a high level of transparency and communication, and all assets must be readily salable. We have adhered to these guideposts for over 20 years. During times like these, with an absurd political narrative, and heightened incidents of terror, our principals are more important than ever. When fear rises, it is generally difficult to rein in. We will watch closely as events unfold, trimming overpriced assets, and remain prepared to raise cash if need be.
I hope you are enjoying the long days and have had a chance to slow things down. If you would like, please feel free to check in. It’s a good time to take a few minutes to review your portfolio. There is a lot of noisy commentary which makes investment decisions more complex. We are happy to work with you to make sure you are enjoying your summer time to the fullest.
Bruce Hotaling, CFA
The views and opinions stated herein are those of Bruce Hotaling, are as of this date, and are subject to change without notice. Information contained in this report was received from sources believed to be reliable, but accuracy is not guaranteed. Investments are subject to market risk, including the possibility of loss of principal. Past performance does not guarantee future results. The S&P 500 is an unmanaged index of 500 widely held stocks. Investors cannot invest directly in an index. The PE ratio (price/earnings) is a common measure of relative stock valuation. This note contains forward-looking statements, predictions and forecasts (“forward-looking statements”) concerning our beliefs and opinions in respect of the future. Forward-looking statements necessarily involve risks and uncertainties, and undue reliance should not be placed on them. There can be no assurance that forward-looking statements will prove to be accurate, and actual results and future events could differ materially from those anticipated in such statements.