One Burning Question
by Victor K. Lai, CFA
Off with a bang
2015 was a dull year for US stock and bond markets. The S&P 500 delivered 1.40% total return, and the Barclay’s Aggregate delivered 0.98%. But 2016 has already started off with a bang. As of January 31, the S&P 500 is down by more than 7% -- one of the worst calendar year starts in history. And from its high of 2,134, the S&P was down more than 15% at one point, officially placing it in correction territory. Investors everywhere are wondering “is the US stock market headed for the next big crash?” It’s an understandable concern – we’ve seen two big crashes in fifteen years and all the blinking red lights can’t help but trigger deja-vu. In this letter we’ll take a closer look at this burning question and consider the implications for investors.
This time is different
Reinhart & Rogoff would argue that things usually turn out the same, but I still think 2016 will be different from 2000 or 2007. Despite the fear-mongering in the financial media, I don’t think US markets are headed into the next big crash. While this is just a personal opinion, it seems rational based on the data. For example, one factor that is highly correlated with market crashes is valuation. The tech bubble and the financial crisis were two of the most extreme crashes in modern history. Not surprisingly both of those extreme sell-offs were preceded by equally extreme market valuations. During the dot-come bubble, the trailing P/E multiple (ttm) on the S&P 500 got close to 50x, and during the financial crisis it rose above 70x. At present the trailing P/E on the S&P 500 is close to 20x, shown in Figure 1.
With a long-term average P/E of 16x, 20x on the S&P isn’t low by historical standards. But the point is current US stock market valuation isn’t as extended as some may think, and certainly not as extreme as it was in 2000 or 2007. To be clear, I’m not implying we won’t see another bear market. The fact is bear markets were not historically uncommon when the multiple was above 20x. But what I’m pointing out is current valuation is not a convincing reason for a 2000 or 2007 type of market crash.
Another factor highly correlated with major stock market crashes is the business cycle. As with 2000, 2007, and practically every other major US stock market crash, the economy was either in or on the cusp of recession. But right now US economic conditions don’t appear recessionary. They’re not fantastic --but the entire recovery since 2009 has been characterized by sluggish expansion, and the same appears likely for 2016. Though there will be external pressure from weak global demand, domestic consumption should help the US grind forward. In the US, consumption accounts for roughly 70% of GDP, shown in Figure 2.
The US consumer should receive support from multiple themes in the year ahead. First, employment continues to improve and real personal income is on the rise. The unemployment rate has actually fallen below its long-term average, now at about 5%. Some may argue that the unemployment rate is understated and that workforce participation is low. That may be true. But the fact is that since 2009 the US has created more jobs than were lost during the financial crisis. At the same time the unemployment rate (however you measure it) is now well below its double-digit highs of 2010. So it’s simply hard to argue that the employment picture has not improved. Figure 3 shows the unemployment rate and real personal income from 1948 to 2015.
Consumers in aggregate are also experiencing improvements in household net worth. This is being driven mainly by a continued rebound in housing prices and reduction in debt, shown in Figure 4. As with employment and income, net worth is another important factor behind consumer spending.
Difficult situation, simple solution
Though I don’t believe a stock market crash is imminent in 2016, that doesn’t mean I’m particularly bullish on the US equity market. As noted above, the US stock market is slightly above fair value at best. And though many will argue stocks don’t look as overvalued as a 2% handle on the 10 Year Treasury – US equities are simply not bargain-priced at present. This places investors in between a rock and a hard place – paltry bond yields and overpriced stocks. Being forced to choose between two bad choices can be difficult and frustrating. But for prudent, long-term investors, the solution can be quite simple.
Don’t choose between the two, instead own some of both. Maintaining a balanced allocation between stocks and bonds will mitigate the risk of your portfolio getting “blown-up” by either asset class. If the drop in stock prices accelerates, high-quality US bonds (like Treasuries and Investment Grade Credit) are likely to be among the few things that generate positive returns. This is true regardless of how low current yields are – remember that German Bunds were priced to negative nominal yields in 2015.
On the other hand, if normalization of interest rates takes hold and bond prices suffer as a result, that would imply improving economic conditions and continued earnings growth. In that case, a corresponding rebound in stock prices would more than offset the decline in bonds. Either way, maintaining balance eliminates the risk of getting stuck in the worst case scenario – being fully invested in the wrong the asset class at the wrong time.
Perhaps surprising, a balanced allocation can also improve risk-adjusted returns. Figure 5 compares the historical performance of the S&P 500 (in red, labeled “100% Stocks”) with the performance of a hypothetical portfolio that is 50% S&P 500 and 50% Barclay’s Aggregate Bond (in blue, labeled 50% / 50%). The chart on the upper right plots return (geometrical mean) over risk (standard deviation). Note that the 50% / 50% portfolio delivered returns (Y axis) that were similar to the S&P 500, but did so with much less volatility (X axis).
Said another way, the 50% / 50% portfolio delivered nearly the same overall return as the stock market, but did so without the large drawdowns that the stock market experienced in between – shown in the bottom right of Figure 5 (see (2002 and 2008). The result was significantly improved risk-adjusted returns for the 50% / 50% portfolio (i.e. more return earned per unit of risk exposure).
This doesn’t mean a 50% / 50% portfolio is infallible or that it will always outperform. The truth is in a raging bull market, it will certainly underperform. But maintaining a balanced allocation has been a reliable strategy for helping reduce large drawdowns, improve risk-adjusted returns, and ultimately helping investors stay the course through intermittent periods of market volatility. For prudent, long-term investors who are perplexed by market conditions and asset class valuations, a balanced approach should be a more appealing alternative to guessing whether it’s better (or worse) to be in stocks or bonds right now.
For risk-seeking investors, I see a couple of opportunities from a valuation perspective. They’re mostly carried over from last year, and in some cases are even more attractive now. No surprise they are all somewhat related -- namely emerging market stocks and commodities.
Emerging market equities in aggregate appear attractively valued relative to US and foreign developed markets. This should be expected given the problems in key emerging markets like Brazil, Russia, and China. China stole much of the spotlight again with a volatile stock market that saw swings of 40% within the year. The MSCI China index ended down 7.6% in 2015. But despite some big moves, Chinese stocks still don’t look especially attractive valuation wise – thanks to a huge run-up heading into 2015.
Within emerging markets, and actually all around the world, the Russian equity market still looks to be one of the most undervalued. I pointed out what looked like extremely low Russian equity market valuations in my 2015 letter – and with trailing P/E multiples currently in the 5x to 6x range, that continues to be the case in 2016. The Russian equity market is still down over 65% from its highs, but was the second best performing major equity market in 2015 (second to Japan). The MSCI Russia index returned 5% in 2015. However, hedged for currency exposure, Russian stocks were actually the best performing by far, returning close to 23% in local currency terms.
Despite that, pessimism for anything related to Russia remains pervasive and expectations are in the gutter. Though the timing of a rebound is always uncertain, Russian stocks are likely an outstanding long-term bargain at current prices. Potential catalysts for unlocking upside in Russian equities include a lifting of sanctions, recovery from recession, and of course a rebound in oil prices (a major Russian export). The risks are obvious. Emerging markets are riddled with extreme bouts of economic and market volatility, only further complicated by geopolitical and currency risks. Point being, a position in Russian stocks should be taken with patience, perseverance, and nerves of steel. Figure 6 shows the relative performance of the S&P 500 versus the Russian Stock market since 2008.
Closely tied to emerging markets are commodities. And like emerging markets, commodities had another tough year, with the broad Bloomberg Commodity Index falling close to 25% in 2015. Driving that was a plunge in crude oil prices which fell another 50% in 2015. Crude prices are now down almost 80% from their highs. This still looks like a supply and demand issue. Supply is simply outpacing demand, and overflowing due to a surge in US production. But the reality is at $30 per barrel, many US oil producers simply cannot operate profitably and will be forced to stop producing. That’s precisely why OPEC nations have been so reluctant to cut production – to protect market share and force others out of production.
The point is, if this really is a supply and demand imbalance, then it’s only a matter of time before the market sorts out the excess and prices adjust. Like I wrote last year, the one scenario in which oil prices remain perpetually depressed is if oil becomes permanently less valuable of a resource than it has been historically. Again, I doubt that will be the case near-term, and my bet is on the more likely outcome that oil prices will bounce eventually – emphasis on eventually. Trying to time a bottom is like trying to catch a falling knife (it’s dangerous), so I don’t suggest trying that. Instead, simply recognize that prices are already low and will eventually look like a bargain regardless if oil prices have bottomed or not.
Another part of the commodity market in my sights is precious metals. Spot gold prices fell by almost 11% in 2015, marking a third year of negative returns. Less noticed is the continued and larger fall in silver. Spot silver prices are now down more than 70% from their highs. Annual returns from 2013 to 2015 were -36%, -20%, and -12%, respectively. Compared to gold, silver looks relatively undervalued. Throughout the 20th century, the ratio of gold to silver prices has averaged 47x. At current prices, the ratio is at 77x. While not the highest (which was 97x in 1940) the current level is the 4th highest in the past one hundred years, shown in Figure 8. Some degree of mean reversion from here seems reasonable. And whether that happens via gold prices falling or silver prices rising, the relative outlook for silver seems favorable.
One relevant risk for all precious metals is interest rates. All else equal, higher interest rates are negative for precious metals in general. This is because precious metals don’t generate cash flows like earnings or dividends. At the same time they actually have a cost of carry – as physical metals must be transported and stored. Interest rates affect both of these factors. As yields on other assets rise, they become relatively favorable to precious metals. Rising rates can also affect the cost of carry by increasing the financing and opportunity costs of physically trading the metals. There is a turning point, however. When high rates eventually correspond with high inflation, slowing growth, and deteriorating corporate profits, precious metals tend to benefit from flight to safety trades. The point is, though silver values look attractive, they may very well experience more short-term price pressure from rising interest rates. But from a long-term perspective, it seems unlikely that silver will remain at current levels through the duration of a full rate cycle.
The bottom line
This year has already gotten off to a volatile start. With oil prices continuing their dive, US markets suddenly selling-off, the Federal Reserve raising rates, Chinese growth deteriorating, and geo-political tensions tightening around the world, we really shouldn’t be surprised by continued market volatility. Yet as investors climb the proverbial wall of worry, it’s always too easy to peek down and get scared into a fear-induced decision to turn back. At times like these, it’s important to look ahead and keep our eyes on the big picture. In the US, neither market valuations nor economic conditions indicate that we are headed into the next big crash – at least not yet.
For prudent, long-term investors, the implications are clear. With no extreme circumstances on the horizon, it doesn’t make sense for extreme portfolio changes. Maintaining a balanced and broadly diversified allocation to both stocks and bonds (along with a healthy side of cash) continues to be the most sensible course of action for the time being. For those investors looking to be more opportunistic, both commodities and emerging market stocks appear to offer good long-term values at current prices or better.
In closing, I’d like to take a minute to thank all of the new clients that joined BCM in 2015 -- and of course all of our existing clients as well. We know it is no simple decision to choose a partner to help grow and protect your hard-earned, life-long savings. We are honored and grateful that you chose BCM to be that partner, and your vote of confidence is what keeps us constantly growing and improving. Thank you for always keeping us in mind whether for yourself, your family, or friends. From the BCM team, we wish you the very best in 2016.
Victor K. Lai
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