What a year 2015 turned out to be! Market behavior attracted quite a bit of attention in the latter part of the year (as it often does near important inflexion points), with a particularly headline from Bloomberg stating that 2015 was “The Year Nothing Worked”. But first, let's highlight two medical milestones that made Bill Gates’ list of great things that happened in 2015. According to the Center of Disease Control (CDC), Rubella (the “R” in the MMR vaccination) was eliminated in the Americas. We also passed the entirety of 2015 without a single case of Polio being found in Africa. Thinking of the millions that have been affected by these terrible diseases, this progress is truly awesome news! Isn’t it amazing how good news is so often taken for granted, and sometimes overlooked or ignored altogether?
Speculating on the upcoming year is always a popular activity at this time of year. We’ll take a look at some of the most widely held expectations heading into 2016, and then point out some specific areas of opportunity that we see related to each of these. The consensus outlook for the next year can be broken down into the following five main themes:
• Energy and other commodity prices remain subdued
• US economic activity remains relatively strong (Gross Domestic Production or GDP above 2.5%) when compared to generally feeble overall global growth.
• Limited rise in interest rates with few market consequences
• Continued strengthening in the dollar against other currencies
• Historically average stock market returns
While often ridiculed, the consensus market outlook is usually simply an extrapolation of recent market trends. Usually reasonable when markets continue trending in the same direction they’ve taken for some time, consensus opinion can be wildly wrong at and around inflection points. With recent trends and relative valuations currently stretched, we think it is reasonable to consider how markets could plausibly stray from the consensus in 2016 and to position our portfolios with these possibilities in mind. We plan to remain diversified so that a near-consensus outcome would still work out just fine, but we also plan to continue to bias our portfolios toward what we see as likely long term outcomes.
Energy & Commodities
After years with oil in the $100 per barrel range and natural gas fluctuating between $3 and $5, energy investors have had a rude awakening in 2015 as hopes for a rapid snap-back in prices have given way to hopes for $50 per barrel. In the past couple months, even these hopes have been dashed as prices fell below $40 to under $35 and natural gas prices fell below $2 per MMBTU. Amazingly, oil is now cheaper than bottled water!
There is a silver-lining to low prices. Ultimately low prices are the best cure for low prices as supply is reduced, and future plans to extract resources are placed back on the shelf. With energy companies widely struggling to attract capital in the markets at reasonable prices, the only way to raise funds is asset sales. While it’s possible that we see more liquidation in upcoming months and quarters, energy sentiment may be facing a final “give-up” stage at the same time fundamentals turn positive with supply rapidly declining due to stalled capital spending and demand ramping up due to cheap prices.
Substantial declines in commodity prices have not been confined to the energy markets. The Commodities Research Bureau’s (CRB) Index of commodity prices reached levels not seen even in the depths of the 2008-2009 market panic! With prices of almost all commodities from aluminum, copper, iron ore to wheat, corn, soybeans, uranium, and gold having declined substantially for several years now, supply has been rapidly curtailed. This plants the seeds for the next price rally. In addition, with market sentiment being so bad in commodities, producers are now trading at historically low levels which are attractive to the long-term investor.
Interest Rates & Bonds
As big as the recent moves in energy prices can seem, it is the bond markets that are the most historically stretched from their long term averages. Interest rates continue to linger around three-hundred year lows by some measures! In December, the US Federal Reserve raised rates for the first time since June 2006. While it is certainly their communicated intention to raise rates only a bit, and that at a slow pace, it is conceivable that this could end up happening much faster than the market now expects. A surprise in the other direction is also possible should the US economy falter, or markets react negatively to the tightening monetary policy. To mitigate these risks while remaining diversified with bonds, we have reduced duration (the length of time to maturity of the bonds) and increased quality (by focusing on investment quality bonds and cash equivalents).
The relative value of the US dollar has a profound effect on the perception of gains and losses of a domestic (US-based) international investor (buying foreign stocks and bonds). This is especially so during periods similar to recent months where the dollar strengthened rapidly against other currencies reducing the returns of assets not demonstrated in dollars. Some of the currency moves have reached points which historically marked turning points. By way of example, you could get 7.7 Mexican pesos for your dollar in 1995 during the Tequila Crisis and 15.3 pesos for your dollar in 2009 at the peak of the financial crisis. Today a US dollar buys more than 16.9 Mexican pesos. Similarly, a dollar today buys more Malaysian ringgits that it would have during the Asian financial crisis in 1998, in 2005 when the peg to the dollar was removed, or during the 2009 crisis. We don’t plan to stuff pesos or ringgits under our mattresses anytime soon, but these examples are useful to keep in mind as we look around the world for investment values.
International stock markets are also relatively undervalued when compared to the US stock market. While many international developed markets trade below their multi-decade average valuations, some emerging markets trade at only a half of that. While valuation is a very poor timing tool, over the long run the price you pay for any investment matters quite a bit and when the expectation bar is set so low, a minor positive surprise here and there can have a dramatically positive effect on asset prices.
US Economy and Stock Market
The United States economy has continued to improve steadily and for years has outperformed many foreign economies. The domestic stock market has similarly outpaced international markets recently with these differences exaggerated by the aforementioned currency gains. In spite of this (or perhaps because of this) the current expectation is that the US market will continue to outperform its international peers despite some increasing risk factors.
One risk factor is valuation. Looking at four different measures of potential upside in the US stock market, (price earnings multiples, comparative 10-year treasury rates, labor unemployment rate, and profit margins), we see a similar picture in each. The US market has advanced so strongly since early 2009 that future gains look smaller and less likely than at other more attractive buying points.
Another concerning aspect is the positive performance of only a smaller and smaller number of stocks relative to the broader averages such as the S&P 500. Some of the most noteworthy of these have even acquired a widely used acronym, FANG (Facebook, Amazon, Netflix, Google) and trade at very high multiples of earnings and sales.