THE FAI 2Q INVESTMENT OUTLOOK

Transcription

1 INVESTMENT OUTLOOK 2015 THE FIRST THREE MONTHS THE FAI 2Q INVESTMENT OUTLOOK Start to finish, U.S. stocks went nowhere in this year s opening three months; but prices were as fidgety as an eight year old who just wolfed down two ice cream cones with sprinkles! In the month of March alone, the Dow Jones Industrial Average rose or fell by triple digits on 16 of the 22 trading days! The S&P 500 was just as antsy Source: CNN Money Both indices set all-time highs in February, but retreated in March. The S&P finished the 1 st quarter with a total return (excl. dividends) of just +0.4%. The Dow Jones lost -0.3%. The background news flow has had a steady negative bias: Middle-East wars produced terrifying headlines, analysts kept trimming U.S. corporate earnings estimates, and the Federal Reserve Bank had bond traders biting their nails over when it might finally raise the overnight interest rate which has been hugging 0% for over six years. We re now looking at corporate profit declines for the 1st AND the 2nd quarters of the year. Valuations remain high, though economic indicators are wilting (ex., March new jobs were the lowest in 15 months.) So, we recently trimmed stock positions a bit below the mid-point of each client s allocation range. Portfolios are a tad defensive as we head into the second quarter. We have a fully-vetted list of stocks we d love to accumulate if the market weakens. 1

2 What s ahead for bonds? The value of all the publicly-traded bonds in the world is greater than the value of all stocks! Governments are the biggest issuers. Today, the worldwide government bond market is a poster-child for the Wall Street adage, Anything that can t go on forever won t! Here are a few samples from today s bizarre fixed-income smorgasbord. The 10-year U.S. Treasury Bond trades at a 1.87% yield-to-maturity. The Dallas Fed s latest monthly inflation indicator (which is very volatile) shows an inflation rate of 2%. This suggests that if you buy the 10-year T-bond today, you might expect to lose money in inflation-adjusted terms for the next ten years! Do you know anyone who would sock away their savings in a 10-year bond expecting to lose buying power? I d put today s negative real interest rates in the can t go on forever category. Translation: real interest rates will eventually increase, depressing bond prices. Think that s bizarre? Check out the 10-year German Bund. Its yield is 0.16%; no, that s not a typo! Stranger still, all German government bonds up through the 7-year maturity actually carry a negative yield to maturity! That s right; the bond buyer is guaranteed to get back less than he or she invested. You pay the government to let them use your money! At 1.7%, the 10-year rate for Portugal, that industrial dynamo with 14% unemployment and running 4% and 5% government deficits, pays an investor less than Uncle Sam s 10- yr bond! And Spain s 10-year government bond yields a whopping 1.2%! Yes, that s right; Spain with its 23.7% unemployment rate is able to sell bonds at a much lower interest rate than the U.S. Go figure! OK, so it s certifiably crazy out there in bond land. How did this happen? Short answer: Central Banks everywhere are manipulating their financial markets in the hopes of firing up their exports with cheap currencies and raising spending with cheap loans. They re literally printing money with which to buy their own government bonds in the open market driving up the price of bonds and, de facto, driving down the yields. Taking a lesson from America s Fed, the European Central Bank (ECB) is actually scheduled to buy more government bonds than the participating governments expect to issue over the next year! Do you think those governments may take the hint and start running even bigger deficits? Hmmm? Summary Q. Who in the world would buy bonds guaranteed to lose money? A. The government using Monopoly money, and any investor who thinks the government will drive bond prices even higher (and rates even lower!) 2

3 A year ago virtually every forecaster predicted rising interest rates, if only because they couldn t imagine a world of actually negative interest rates. As it turned out, interest rates didn t rise in the latest 12 months they fell! Some went negative! What now? We think the central bank s primary policy objective is to avoid deflation and stabilize inflation in the neighborhood of 2%. With economic signals weakening, they worry that raising rates may discourage borrowing and depress economic activity. We think the likelihood is they will raise short-term rates very reluctantly and very, very slowly. Outlook for Stocks Simplistically, two metrics tend to determine the price of a company s stock: its earnings pershare (EPS) and the multiple of earnings (P/E ratio) that investors are willing to pay to own it. Typically, (and of course, there is no typical ) the two main drivers of the P/E multiple for a stock are 1) the company s future earnings outlook and 2) the current and prospective interest rate environment (because, when bond yields are lower, stock investors seem to be more accepting of higher P/E s). Behind the scenes, of course, a million other things can motivate investors and traders to buy, sell, or ignore a stock. Some examples: how does company X s business outlook compare with its competitors? Might the company be acquired by another business at a fat premium? Or go bankrupt?! Stocks dividends are also a factor, especially in these times of miniscule bond yields. And, just to make it trickier, more and more of the daily volume in stocks is initiated by traders and hedge funds with very short time horizons and idiosyncratic decision processes! Earnings and earnings prospects are closely followed by thousands of professional analysts across the fruited plain; changes in collective earnings forecasts have a great influence on the market value of stocks. For example, in 2014, SP 500 earnings rose just +4.9%, yet stock prices gained % for the year! Of that gain, 11.7% happened in the last 10 weeks of the year when analysts began posting more optimistic 2015 earnings forecasts. We ve seen that after a lot of churning in Q1 2015, stock prices failed to rise. The main culprit: analysts estimates of 1Q profits for the S&P index companies were reduced by almost -9%! Now, with earnings already beginning to disappoint, the latest full-year 2015 estimate is a mere +2.4% gain. With that large a shrinkage in the 2015 outlook, and given the reality that stock prices have not yet corrected, our instinct is that there is a sort of valuation air pocket beneath the index that could produce a significant correction in U.S. equities overall. 3

4 See the following chart Corrections are healthy. But with economic indicators fraying, a correction could turn into a stern reprimand. We believe there is a fair chance that even the reduced profit forecasts will yet prove too optimistic the average 2016 forecast for SP500 EPS is +12.4% on a 6% revenue increase. We haven t seen that kind of revenue gain since 2011, and this economic cycle is getting a bit long in the tooth. With P/E s historically elevated, we think wisdom urges caution. There is one potential source of growing investor demand that could elevate the P/E on U.S. stocks and further depress the interest rate on US bonds: it is the strength of the U.S. dollar relative to most foreign currencies. Europe has just begun what purports to be a year-long Central Bank stimulus similar to what the U.S. has had for the last six years. European investors know the dollar has appreciated 20% against the Euro in nine months. This has accelerated capital flows to the U.S. from Europe (and elsewhere). The consensus anticipates more of the same. Strong foreign inflows could boost U.S. stock prices more than business conditions suggest. That s why our defensive adjustment in equity exposure is only modest. Be assured we are keeping a keen eye on all these global developments. Feel free to call your FAI advisor any time for updates as we go along. For the Investment Team, J. Michael Martin April 2, 2015 SP 500: year Treasury: 1.87% 4

5 This memo contains the current opinions of the author, J. Michael Martin and Financial Advantage Inc. These opinions are subject to change without notice. Any views expressed are provided for informational purposes only and should not be construed in any way as an offer, endorsement, or inducement to invest. This material should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. Past performance is not indicative of future performance. There is no guarantee that these investment strategies will work under all market conditions and each investor should evaluate their ability to invest for a long-term especially during periods of market decline. Investors should discuss any investment with their personal investment counsel. No part of this material may be reproduced in any form, or referred to in any other publication, without attribution. 5