Week in Review
After an extended upturn, markets gave investors a bumpy ride last week. The S&P 500 fell 1.1%. Small-cap stocks sank 1.8%. International markets increased 0.3%. Bonds rose 0.4%, and commodities rallied 1.4%. Given the strong rally since February 11, this is a relatively small step back.
This week starts the first quarter earnings season. Earnings for S&P 500 companies are expected to drop into the high single digits. Energy companies account for a large chunk of the decline, but other sectors are seeing declines too. The earnings fall is attributable to the dollar’s rally in recent years and declines in energy investment. Analysts have already cut estimates aggressively, which should mitigate the angst over declining earnings. Analysts also suggest the decline is temporary and earnings growth should resume in coming quarters.
Anatomy of a Rebound
In the first quarter of 2016, we witnessed a tremendous rally in the stock market. For instance, the S&P 500 rose nearly 13% from its lows for the quarter. It wasn’t as noticeable on quarterly statements because it followed a sharp downturn in the market that pushed most major stock markets down more than 10%. Expect volatility to make regular appearances in coming quarters.
When asset prices shoot rapidly higher, which asset classes do best? What does this tell us about how investors are looking at the market? The following analysis examines how various market indexes performed from the market bottom in mid-February through the end of the quarter.
Improved Attitude Toward Risk
The returns suggest investors became more positive about the prospects of risky assets, rather than rewarding particular segments for improved fundamentals. The rally produced tightly clustered sector returns in the recovery phase, which suggests low levels of discrimination by investors. Six of the 10 sectors rallied between 14.3% and 16.6% from the market lows. Those six sectors are classified as more aggressive and would be expected to do better in rallies. The defensive sectors – consumer staples, healthcare, telecommunications, and utilities – all posted returns of below 10% from market lows. For the quarter, telecommunications and utility stocks posted the best results because they rose in the early part of the quarter.
The major asset classes performed roughly in line with risk-based expectations. Investors welcomed the Federal Reserve (Fed) announcing lowered expectations for rate hikes, which flowed through to stocks and bonds. Small-caps did best, rising 17% and beating their risk-modified target return. International stocks beat domestic markets by a narrow margin. Even with the strong rally, bonds still generated a positive return.
Aggressive Interest Rate Sensitivity Performed Well
Most investors understand that bonds are particularly sensitive to changes in interest rates. And, some understand interest rates also affect the value of higher-dividend-paying sectors. During the decline stage, bonds and high-dividend sectors (telecommunications and utilities) held up better.
There are other sectors that benefit when rates are falling and the appetite for risk increases. Real Estate Investment Trusts (REITs) often pay high dividends but are viewed as sensitive to economic growth. During the rally stage, REITs rose more than 18%.
Emerging market currencies also fall into this camp. Investors believe emerging market currencies benefit from reduced expectations for interest rate hikes in the U.S. Lower rates in the U.S. provide less competition for investors looking to generate income. Emerging markets also issue bonds denominated in U.S. dollars. When the dollar falls, it makes it easier to make payments and refinance the loans.
While emerging market stocks lagged the U.S. in their home currencies, U.S. investors benefited from strong results when measured in its own currency. Emerging market stocks rallied 17.7% in U.S. dollars from the February lows.
This Pace Isn’t Sustainable
A key message for investors is not to expect the rally to continue at its current pace. While we expect future returns to be positive, markets will likely experience continued spikes lower and higher. Risk Budgeting is designed to help investors stay invested and benefit from long-term opportunities.
International Markets in the First Quarter
For the quarter, international markets fell and then rallied, just like the U.S. While the U.S. finished barely positive, international markets fell just short of neutral, falling 0.4%. Unlike the broad asset class returns, international markets experienced wide differentials between markets. Within the Asian, European, and resource (Americas, Middle East, Africa, and Russia) regions, excellent returns were tightly concentrated in a small number of generally smaller markets.
Wide dispersion created an opportunity for very strong returns in some international portfolios, while some international portfolios lagged behind. The graphic below shows how concentrated high returns were.
In Asia, Thailand, Indonesia, and Malaysia, markets all rose double digits, while the large markets of India, China, and Japan fell. In Europe, the top three performing markets – Turkey, Hungary, and Poland – all rallied by double digits. The Czech market, which performed fourth best, only rose 5%. Israel, Italy, and Greece were all down more than 10%. Major markets, like the United Kingdom and Germany (not pictured), fell just more than 2%.
The broadly defined resource region includes some big winners benefiting from the improved price of oil. Brazil, Colombia, and Peru all rose more than 20%. Russia rose more than 15%. Some of this increase can be attributed to political news. In Brazil, efforts to impeach the president contributed powerfully to the rally. Peru and Colombia benefited from healthy economies and renewed interest in Latin America.
One caveat: The rallies in these markets represent a bounce back from a period of underperformance. Only Hungary has posted a return above the average regional performance over the last three years. Fundamentals represent a challenge for some of these markets even as small international markets offer the potential for continued gains.
Six-Putts, Statistics, and Investing
On Thursday, Ernie Els, an accomplished golfer, six-putted the first green of the Masters Golf tournament in Augusta, Georgia. Of his six putts, five were within three feet of the hole. A Bloomberg article examined Els’ history-making putting performance and determined it should only happen once in 10,000,000 occurrences. When you see statistics like this one, you should be on your guard. Probabilities, whether applied to sports or investment performance, are fraught with the perils of improper assumptions that can lead to the wrong conclusions.
The author listed a number of events more probable than Els missing so many puts from close range, including:
While being humorous, this analysis leads to the wrong conclusion that this event is highly improbable because it ignores key differences between the putting challenge and random statistical events. Specifically, it ignores the physical, non-random, and psychological conditions:
As investment fiduciaries, CLS structures its investment team to minimize these challenges. We evaluate the investment environment from multiple perspectives. We use an approach to risk management that encourages discipline and reduces emotion. We use a team approach so we can help each other reach better conclusions. These steps are designed to avoid a six-putt in your portfolio.
The S&P 500® Index is an unmanaged composite of 500-large capitalization companies. This index is widely used by professional investors as a performance benchmark for large cap stocks. The Russell 3000 Index is an unmanaged index considered representative of the U.S. stock market. The index is composed of the 3,000 largest U.S. stocks. The Russell 2000® is an index comprised of the 2,000 smallest companies on the Russell 3000 list and offers investors access to small-cap companies. It is a widely recognized indicator of small capitalization company performance. The MSCI EAFE International Index is a composite index which tracks performance of international equity securities in 21 developed countries in Europe, Australia, Asia, and the Far East. The MSCI All-Countries World Index, excluding U.S. (ACWI ex US) is an index considered representative of stock markets of developed and emerging markets, excluding those of the US. The Barclay’s Capital U.S. Aggregate Bond® Index measures the performance of the total United States investment-grade bond market. The Barclay’s Capital 1-3 Month U.S. Treasury Bill® Index includes all publicly issued zero-coupon U.S. Treasury Bills that have a remaining maturity of less than 3 months and more than 1 month, are rated investment grade, and have $250 million or more of outstanding face value. The Equity Baseline (EBP) is a blended index comprised of 60% domestic equity (represented by the Russell 3000 Index) and 40% international equity (represented by the MSCI ACWI ex US Index), rebalanced daily. An index is an unmanaged group of stocks considered to be representative of different segments of the stock market in general. You cannot invest directly in an index.
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