Faltering Market — January 2016
January 27, 2016
Dow Jones Average: 16,167
S&P 500 Index: 1,904
The U.S. stock market limped to the finish line in the final quarter of the year. The Standard and Poor’s Index closed the year at 2044, about one percent lower than where it started the year. Even though the market fell slightly on a price basis, it was actually up 1.4% percent when cash dividends from a theoretical, fully invested portfolio of all 500 S&P companies are included. It was a year much like 2011, when price action was flat to negative, and dividends comprised all of a minimal gain. The aftermath to the weak years in 2011 and 2015 has been quite different. Whereas the market moved higher in early January 2012 and continued up throughout that month, January 2016 started out as the worst beginning to a new year in market history. The drop so far this month has wiped out the market’s meager gain from last year, and much of the progress made in 2014 as well. In retrospect, making money in stocks over the past twenty-four months has been a grinding affair for most investors.
Stock prices are often viewed as a barometer of the future, more than a verdict on the present. For much of the past seven years investors believed that the global economy would improve, profit margins would remain at record levels, and short-term interest rates would remain at zero. In other words, investors thought that the perfect environment for stocks would continue. This optimistic outlook started to weaken in 2014, as the troubles in emerging market economies challenged the notion of steady global growth. Investors also began to doubt the sustainability of record high profit margins, as companies such as Walmart, IBM, American Express, Union Pacific, and many others reported lackluster results. Too many competitors and a glut of product have hampered many industries. And for the first time in seven years, the Fed actually increased interest rates in December 2015, albeit by only 1/4 of one percent. The weak action in stocks during the last two years has reflected growing concerns that these clouds may threaten the perfect environment for investors.
It is easier to relay what has happened in the markets than to predict what is coming next. It remains to be seen whether modest strength in the U.S. economy and historically low interest rates can offset the problems emanating from China and the impact of competition on corporate profit margins. Continued improvement in the U.S. economy is absolutely critical for a world awash in both political and economic turmoil. While Federal Reserve policy has been hugely supportive of the economy and financial markets over the past seven years, the impact of Fed actions appears to be diminishing. The Fed has done about all it can do to put the economy on a firm, upward track. The economy is in better shape, jobs are more plentiful, and surveys show a marked improvement in consumer confidence. It is now up to U.S. consumers, buoyed by increased confidence in their financial circumstances, to carry the torch. If something were to damage the psychology of consumers and their willingness to spend, the impact on the economy and financial markets could be severe. We will be carefully monitoring events, both financial and political, to gauge their potential impact on the mood of the U.S. consumer.
The U.S. stock market was led in 2015 by an extremely narrow group of companies. As investors pulled away from energy, industrial, retail, and many consumer companies, they put more and more of their investment dollars into a small group of tech companies. Market commentators assigned the acronym FANG (short for Facebook, Amazon, Netflix, and Google) to this small group of winning stocks. The major market averages eked out a gain on the year only because of these four stocks. When so much investment capital ends up hanging on a few branches, the result is usually bad. While outsized gains in a few stocks can disguise general market weakness for some time, the market cannot be supported for long by a handful of companies. The sharp drop in stocks at the start of 2016 was presaged by the narrow market breadth in 2015.
The diversified portfolio we have built for most clients struggled to make forward progress in 2015. A few positions produced good gains on the year, but many others faded as the year wound to a close. While we consider the overall market to be at a relatively high level, our allocation to stocks is slightly higher than was the case in previous high markets. We have built a larger core of financially strong and dominant companies, which in many cases pay substantial dividends to shareholders. While the share prices of these companies will fluctuate with the overall stock market, we are not concerned about the viability of the businesses or the dividends. In a financial climate where yields on shorter-term paper are still about 1/2 of one percent, we feel that maintaining a somewhat larger base of core holdings makes sense.
We were quite active on the fixed income side of the portfolio in the second half of 2015, as interest rates finally moved up modestly. Our purchases of municipal, corporate, and treasury securities all look good in retrospect. Interest rates are very sensitive to economic data and swings in financial markets. The recent plunge in stock prices has put downward pressure on interest rates again, and may put further interest rate increases by the Fed on hold.
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