Last quarter, we talked about how markets made lots of noise in 2015 but ended at virtually the same place they started. Interestingly, the first quarter of 2016 was a microcosm of 2015. Lots of volatility, but very little net price movement. Our quality bias helped us materially in navigating the market’s up and down moves in 2015 as the biggest losers were those most fragile to energy’s volatility. However, this bias has hurt us during the first quarter. As we previously discussed, oil’s 70% drop in 2015 hurt the weakest Energy, Materials and Industrial stocks as many were priced as non-going concerns. Understandably, as oil bounced +40% from February 11, 2016, those securities which were previously priced-for-near-bankruptcy – due to the leveraged nature of their cash flows – have rallied the hardest as their probability of surviving has increased. Unfortunately, the quality bias of our investment process has not allowed us to participate in the full extent of the advance in the second half of the quarter.
Just a few months following initiation of a new monetary regime to normalize interest rates from their overly accommodative policy, the Fed reversed course from their clearly diagramed four increase “dot plot.” Janet Yellen & Co. attributed the abrupt policy adjustment to signs of economic slowing here and abroad, the strength of the dollar, the weakness in commodity prices, and the policies of other central bankers. While Yellen has sworn off negative interest rates here, the more dovish stance helped U.S. equities recover from the their early first quarter correction with the riskiest stocks performing the best in March. The equity market low on February 11th, coincided with extreme levels of investor bearishness as the AAII sentiment measure of bullishness fell to just 19.2% on February 10th. While Fed rate raises are no longer an imminent threat, improving employment and inflation trends should inspire the Fed to raise rates once more this year. If wage gains continue to take hold and CPI begins to approach the Fed’s inflation goal of 2%, we expect the current level of nearly full employment will guide Fed officials to lift the Fed funds rate higher.
Rainbows and Unicorns
We have to be realistic. As U.S. large cap equities rest near bull market highs on the heels of improvements in investor bullishness, I think we have to realistically assess the probability that we are entering a new multi-year bull market. With a current S&P 500 price-to-earnings ratio at 18.5, interest rates near secular lows and year-over-year earnings falling for the fourth consecutive quarter, it’s hard to imagine double digit five-year returns from this level. However, there is no alternative. In early April, the 10-year U.S. Treasury yields are just 1.70% and many high-quality intermediate-term municipal notes yield only 2.50%. Taken together many fixed income securities yield no more than the S&P 500’s dividend of 2.17%. Capital protection without opportunity for capital growth. With little signs of economic recession on the near-term horizon and equities near their historic term price-to-value ratios, I still believe five-year returns for a diversified portfolio of high quality stocks will outperform a comparable fixed income portfolio.
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