It’s been an amazing start to the year. First the market cratered on slowing China economic concerns, domestic recessionary fears, deteriorating oil prices, and negative interest rates abroad. In response to all these worries (and others), stocks dove more than -11% (S&P 500 Index) in January, before settling down. Subsequently, the market has made a screaming recovery, in part due to dovish monetary policy comments (i.e., reduction in forecasted interest rate hikes) and diminished anxiety over a potential global collapse. Month-to-date stocks are up an impressive +5.4%, and year-to-date equities are flattish, or down less than -1%.
With an endless amount of information flowing across our smart phones and computers, it becomes quite easy and tempting to chase news headlines, just like a hyper dog chasing a car. But even once an investor catches up (or reacts) to a headline, there’s confusion around how to profit from the fleeting information. First of all, every plugged-in hedge fund and institutional investor has likely already traded on the stale information you received. Second of all, rarely is the data relevant to the long-term cash generating capabilities of the company or economy. And lastly, the news is more often than not, instantly factored into the stock price. Chasing news headlines only eaves individual investors holding the bag of performance-shattering transactions costs, taxes, and worn-out pricing.
The heightened volatility in late 2015 and early 2016 hasn’t however prevented investors and so-called pundits from attempting to time the market. Any battle-tested investment veteran knows it’s virtually impossible to consistently time the market (see also Market Timing Treadmill), but this fact hasn’t prevented speculators from attempting the feat nonetheless. Famed investment guru, Peter Lynch, who earned an average +29% annual return from 1977-1990, summed it up well when he stated the following:
“Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.”
The Important Factors
As I’ve written many times in the past, the keys to long-term stock performance are not knee-jerk reactions to headlines, but rather these following crucial factors (see also Don’t Be a Fool, Follow the Stool):
- Profits
- Interest Rates
- Sentiment
- Valuations
On the profit growth front, corporate income has been pressured by numerous headwinds over the last few years, including an export-shattering increase in the value of the U.S. dollar and a profit-squeezing collapse in energy sector earnings. As you can see from the chart below, the value of the U.S. dollar increased by about 25% from mid-2014 to early-2015, in part because of diverging global central bank policies (more hawkish U.S. Fed vs. more dovish ECB/international central banks). Since that spike, the dollar has settled into a broad range (95 – 100), and the former forceful headwind have now turned into modest tailwinds. This trend is important because an estimated 35-40% of corporate profits are derived from international operations.
Adding insult to injury, the roughly greater than -70% decline in forward energy earnings over the last 18 months has caused a significant hit to overall S&P 500 profits. The tide appears to be finally turning (or at least stabilizing) however, as we’ve seen oil prices rebound by about +30% this year from the lows in January. If these aforementioned trends persist, profit pressures in 2016 are likely to abate significantly, and may actually become additive to growth.
Source: Barchart.com
Profits are important, but so are interest rates. While incessant talk about the path of future Fed policy continues to blanket the airwaves (see also Fed Fatigue), absent a rapid increase in interest rates (say 300-400 basis points), interest rates remain unambiguously positive for equity markets, providing a floor for the oft-repeated volatility in financial markets. As long as stocks are providing higher yields than many bonds, and depositors are earning 0% (or negative rates) on their checking accounts, stocks may remain unloved, but not forgotten.
And speaking of unloved, the sentiment for stocks remains sour. One need look no further than the quarter-billion dollars in hemorrhaging outflows out of U.S. equity funds (see ICI Long-Term Mutual Fund Flows) since 2014. This deep underlying skepticism serves as a positive contrarian indicator for future equity prices. Right now, very few individual investors are swimming in the pool – the time to get out of the stock market pool is when everyone is jumping in.
And lastly, valuations remain very much in line with historical averages (approximatqely 17x 2016 projected earnings), especially considering the generational low in interest rates. Bears continue to point to the elevated CAPE ratio, which has been a disastrous indicator the last seven years (and longer), as a reason to remain cautious. The ironic part is that valuations are virtually guaranteed to improve a few years from now as we roll off the artificially depressed years of 2008-2010.
When you add it all up, zero (or negative) interest rates, combined with the other key factors of profits, sentiment, and valuations, equities remain an important and attractive part of a diversified long-term portfolio. Your objectives, time horizon, and risk tolerance will always drive the proportion of your equity allocation. Nevertheless, some bond exposure is essential to smooth out volatility. Regardless of your investment strategy, chasing headlines, like a dog chasing a car, serves no purpose other than leaving you with a tired, unproductive investment portfolio.
