Hello and happy new year! As we close the books on 2015, we leave behind a year of stagnant equity returns, a rout in energy prices, and the first rise in short term interest rates in over eight years.
Today investors find themselves in a precarious situation, with stock markets hovering near all-time highs and interest rates poised to rise. From my perspective there are three main themes investors should address as we head into 2016: valuation “dissonance” between domestic and international stocks, weakness in oil prices, and vulnerability in the high yield bond market.
As always, Investment Insights will attempt to filter through these issues and provide actionable, data driven analysis and guidance.
Domestic vs. International Stocks
Large cap equities in the U.S. remained mostly calm in 2015. The S&P 500 index fell 0.73%, and other than a spout of volatility in August and September large cap stocks were contained to tight trading bands. Meanwhile, the Russell 2000 index, which represents smaller companies, lost 5.71% on the year.
A common refrain among investors is that stocks are too expensive to buy right now and the market is poised for a correction. The S&P 500 closed the year at 2043.94 - 96% of its 2130.82 record high is set in May. The Russell 2000 sits at 1135.89, or 88% of its all-time high set in June. But rather than avoid equities in anticipation of a market correction, this analysis will advocate for a steady, long term, and globally diversified portfolio strategy.
To start, the price to earnings multiple is one of the most commonly used metrics to gauge how expensive an equity investment is. By dividing the market price of one share of stock by the annual earnings produced by that share, the P/E ratio is an excellent relative valuation measure used by investors and analysts worldwide.
The same concept can be applied to entire indices, which helps determine whether given markets are cheap or expensive. By comparing an index’s current P/E multiple to its long term average, we can make an adequate comparison. This analysis is helpful when making investment decisions, since P/E multiples tend to be mean reverting over time.
Professionals and academics argue about the S&P 500’s long term average P/E ratio, but most agree that it lies somewhere between 14 and 17. So, any P/E multiple above 17 would imply that the 500 stocks in the S&P 500 are collectively more expensive than average. P/E ratios under 14 would imply that the group is less expensive than average.
Currently the S&P 500 trades at a P/E ratio of 22.95 times last year’s reported earnings. This simple comparison implies that the S&P 500 is valued “richly”. While the multiple may not be sitting at an all-time high, it is towards the top. After ranking the P/E multiples from the S&P 500 on January 1st of each year since 1871, 22.95 falls in the 93rd percentile.
We must also acknowledge that the P/E ratio has its limitations. The denominator, corporate earnings, tend to be somewhat volatile from year to year. This causes the ratio to bounce around unpredictably, making it difficult to use as a barometer for future market returns. To combat this limitation, economists John Campbell and Robert Shiller published research in 1988 exploring the use of average earnings over time. Rather than divide market price by one year’s worth of corporate earnings (either last year’s or next year’s expectation), the “Shiller P/E Ratio” uses a 10 year, inflation adjusted moving average as its denominator. By doing so, the metric improves on the traditional P/E ratio by smoothing out cyclical earnings fluctuations.
Empirical data since 1988 shows that the Shiller P/E ratio is a far superior predictor of equity market returns. While I won’t recap his entire Wikipedia page, Shiller went on to win a Nobel Prize in 2013 for his work on asset prices – stemming from the P/E ratio research in 1988.
Today, the same analysis tells us that U.S. stock markets are indeed richly valued. Large cap U.S. stocks have a Schiller P/E ratio of 25, which is well above the median of 16. Small cap U.S. stocks also fall above the asset class’s median ratio at 47, and are not far off from their all-time high of 52.
International stocks paint a starkly different picture. Among economically developed markets, stocks have a Shiller P/E ratio of 14 compared to a median of 22 and all-time low of 11. Among stocks in countries of emerging markets, the Shiller P/E is currently at its all-time low of 11. This compares to a median of 19 and max of 35.
As you can see, international and emerging market equities appear to be trading at bargain levels compared to U.S. shares. But while knowing whether a stock market is over or undervalued is convenient, we are most concerned with how that market will perform in the future.
Using various fundamental research, indicators, and other analysis, many economists create projections of how various asset classes will perform in the future. An accurate projection is very useful when building portfolios and making asset allocation decisions. One of the more successful and accurate research teams in recent years has been Research Affiliates, out of Newport Beach, CA. The team of PhD economists creates rolling ten year performance projections for various asset classes and regions. And unsurprisingly, the Shiller P/E ratio is a key factor in the group’s projections for equities. Also unsurprisingly, the group predicts emerging market and international equities to outperform U.S. equities over the next ten years.
For investors, the real question is how to use this information to improve investment decision making. While it may be easy to conclude that emerging markets and other international stocks provide the most value, it’s important to remember that any international equity includes risks that U.S. stocks don’t.
Mainly, currency risk should always be taken into consideration when investing internationally. Foreign shares typically transact in their native currencies, making the stocks susceptible to appreciation or depreciation against the U.S. dollar. Also, many emerging market companies borrow money in U.S. dollars to fund their operations. When the dollar appreciates, debt repayments become more expensive and depress earnings.
In 2016, many foreign governments continue to aggressively devalue their currencies. The European Central Bank and Bank of Japan are still employing quantitative easing measures, devaluing their respective currencies against the U.S. dollar. China intentionally devalued its currency last August, and may well do so again in 2016. Along the with the country’s slowing economy, Chinese shares represent a fair amount of risk to emerging markets investors as Chinese shares represent 25% of the MSCI Emerging Markets Index.
Beyond the relative investment merits and discussion of domestic versus international equities, it is impossible to predict stock market corrections. Scores of academic studies have shown that investors timing the market are more likely to miss out on potential gains than avoid losses by correctly identify an upcoming correction. Additionally those who make correct calls appear to be lucky rather than prescient, since few (if any) make consistently correct predictions. In other words, investors are better off employing long term, consistent investment strategies.
In balancing this philosophy with today’s investment themes, investors are best served by creating a customized, long term investment strategy. Rather than “abandoning ship” because they believe a correction might be on the horizon, investors should consider smaller tactical shifts into undervalued asset classes.
Be sure to appreciate the risks and historical volatility associated with international investing, but don’t ignore the value and opportunity either. There are three “take aways” here: focus on the long term, stay invested, and consider a calculated risk by moderately increasing exposure to foreign shares.
Our second theme dominated headlines throughout 2015: oil prices. Brent crude ended 2015 at $37.58 per barrel, a 40% drop from $62.16 12 months earlier. A consistent stream of supply for new and existing producers is the chief culprit, which is likely to continue in the short term.
To start, oil is being drilled around the world at a tremendous rate, thanks in part to OPEC refusing to adapt to lower prices by cutting production. Under normal circumstances, OPEC countries would cut back on drilling activities in order to reduce global supply and support prices. These are not normal circumstances though. New technologies like fracking have introduced new suppliers to the world’s oil markets. Rather than cede market share, OPEC is attempting to drive out its competition. By maintaining their large production numbers, OPEC can suppress oil prices.
Beyond OPEC, there will be two new oil suppliers coming online in 2016: the U.S. and Iran. The U.S. now produces more oil than it consumes thanks to a 90% increase in production over the last six years. With somewhat consistent consumption over that time frame, we now operate at a surplus. Accordingly, congress recently passed legislation that allows exportation of this surplus for the first time in 40 years.
Additionally, some of Iran’s economic sanctions will soon be lifted in exchange for a wind down of the country’s nuclear program. This will free Iran to sell oil on the open market. This is no small amount, as Iran has the fourth largest oil reserves in the world behind Venezuela, Saudi Arabia, and Canada according to British Petroleum. In fact, OPEC believes that oil prices could fall another 5-10% in the short term if they do not cut production once Iran is open for business.
These factors point to additional downward pressure on prices in the near term. However, looking out a bit farther a rebound seems imminent. Saudi Arabia is the elephant in the room at OPEC, as well as its chief decision maker. The country relies on oil as its main source of revenue, and low prices are contributing to a current fiscal budget deficit of 20%. While the country is comfortable exerting pressure on competition now, it cannot do so forever.
Saudi Arabia’s budget deficit is being funded by the country’s foreign exchange reserves. At the current pace, these reserves will be exhausted in five years. While the country is beginning to respond with spending cuts, they will be forced to change tact and raise oil prices to bring in more revenue. This must occur at some point in the next several years, if for nothing more than self-preservation.
Iran is also in dire economic straights – even more so than Saudi Arabia. Keep in mind that while the country may be allowed to participate in the oil market, some of the sanctions being lifted have been in place since 1979. Iran has been isolated economically for years, and has a desperate need for higher prices. The question is whether Iran and Saudi Arabia will be comfortable working together in this regard given their recent feuds.
Ultimately, it’s likely that oil will fall further once the U.S. and Iran enter the market. This is a short to medium term issue though. Saudi Arabia, Russia, and Iran all have economies dependent on oil prices, and all three see more pressure each day to raise prices.
For investors the implications boil down to time horizon, as short term pain can become long term gain. Be prepared for consistently low oil prices for the next 12-18 months. Those with time horizons of under three years should seriously consider cutting exposure to oil producers. On the other hand, it’s difficult to see oil so low over the longer term. Those who can afford to wait out the economic woes in the Middle East may have a great buying opportunity.
High Yield Bonds
Also known as “junk bonds”, the high yield sector provides debt financing to less credit worthy companies. Since these companies are more likely to default, lenders require a higher interest rate in return for their money.
Often, a correction in high yield bonds is a precursor to more troubles in the economy and markets. Many in the media have noted that the high yield market has lost 6.5% in the last six months and remains particularly vulnerable. Thus, the high yield sector is our third investing theme for 2016.
The high yield sector is thought to be vulnerable for three main reasons: interest rates, liquidity, and credit risk. With interest rates on an upward trend in the U.S., financing costs will increase for borrowers across the country. Higher interest expenses hurt the income statement of any business, but high yield businesses are by definition the least equipped to handle them. More frequent defaults often follow interest rate hikes.
Liquidity is also a concern. Historically, banks and brokerage firms have held a large number of bonds in their inventories. The firm would then act as a “market maker” when another firm or an investor wished to buy or sell that particular bond. This activity added a bit of revenue, but also provided a great deal of liquidity. Firms with bond inventory were ready to buy when investors wanted to sell, and ready to sell when investors wanted to buy.
Since the financial crisis in 2008, banking regulations have changed. Banks and brokers are now required to hold far more capital on their balance sheets, which creates a buffer against bankruptcy in times of financial stress. While this is a great safety net for the public, the industry’s response has brought unintended consequences.
Market making sucks up precious capital on balance sheets, and is less profitable than other lines of business. Thus, market making was the first business on the chopping block as banks and brokers raised capital levels to meet the new standards. Fewer market makers equates to fewer buyers, fewer sellers, and less liquidity.
As a result, the market for high yield bonds may not be deep enough to support supply and demand mismatches. If too many investors attempt to sell bonds at the wrong time, it could spark a serious correction since there are far fewer market makers prepared to step in and buy.
Finally, the composition of the high yield bond sector has changed over the last ten years, making it vulnerable. Today energy companies represent 16% of the asset class, compared to 7% ten years ago. Not only will these companies start to see pressure from higher interest costs, their revenues are already suffering from low oil prices. Energy companies are being squeezed from both sides of the income statement, increasing the likelihood that more will default.
Investors should be sure to account for these issues when allocating bond portfolios. Again, we absolutely do not advocate for abandoning a long term investment strategy because of short term vulnerability. Rather, be wary of concentrating too much capital in energy related high yield debts. It may be wise to employ active management in this area, as many mutual fund managers are aware of these issues and have built a cash buffer into their funds. Look for funds with such a margin of safety, and a track record of strong performance during times of stress.