The fourth quarter marked an overall positive period in the stock market. As equities stabilized in September after an August fall, October brought the best month for U.S. stocks in four years. During November, markets came around to the realization that an interest rate rise would be forthcoming. And stocks moved in tandem with oil as it touched multi-year lows after Saudi Arabia reinforced its determination to continue its current level of production, dragging OPEC along for the ride.
For the year, equities were basically flat, not performing as anticipated. Market leadership was incredibly narrow, exemplified by the fact that the largest ten companies accounted for almost all of the positive return last year, concentrated in the Consumer Discretionary and Technology sectors. Several events stood in the way of better gains, some of which only impact the US economy to a limited degree. First, China’s deceleration was the biggest concern in 2015 and has impacted commodity and equity prices worldwide. However, their growth rate is only slowing, not collapsing. China is in the midst of shifting their economy from one driven principally by industry and manufacturing to one driven primarily by consumption. During such a massive transition, their economic potential will be scrutinized following each and every economic release.
Second, the dollar strengthened against virtually every currency. While a positive reflection of strength, it negatively impacts our export activity as it makes our products more expensive in the global marketplace. We expect this pressure to abate as we get towards mid-year. Third, a global oversupply in oil that continues to outpace demand growth sent oil down 30% for the year, which led to the Energy sec- tor turning in the worst performance. Uncertainty over cash flows, possible dividend cuts or even bank- ruptcies drove much of the concern. Oil may not have hit its low, but it does appear to be in the process of finding a bottom.
Despite these trials, the U.S. economy continued to expand, growing by 2.0%, about the same as 2014. Progression is steady, if slow, and economic activity is reflected in the data. In 2015, 5.5 million existing homes changed ownership, 500,000 new homes were sold, auto sales reached 17.5m units and 2.5 million jobs were created, more than enough to absorb labor force growth and pull more unemployed off the sidelines. These numbers are supportive of a modest, if unspectacular expansion.
Following are our expectations for the sectors next year.
| Sector | 2015 Return | 2016 MCM Expectation |
|---|---|---|
| Consumer Discretionary | 10.1% | Positive – solid US economy and lower energy prices |
| Consumer Staples | 6.6% | Neutral – seen as safe haven amid market volatility |
| Energy | -21.1% | Negative – not as bad as 2015 but supply remains a problem |
| Financials | -1.5% | Positive – US interest rate increase should help net margins |
| Healthcare | 6.9% | Neutral – solid growth offset by political rhetoric |
| Industrials | -2.0% | Negative – currency and international economies struggle |
| Technology | 5.9% | Positive – innovation in new products and cost reduction |
| Materials | -8.4% | Negative – not as bad as 2015 but supply remains a problem |
| Telecom Services | 3.4% | Negative – interest rate hikes hurt dividend stocks |
| Utilities | -4.9% | Negative – interest rate hikes hurt dividend stocks |
With so much event-driven behavior in the news, we find ourselves returning to our core investment philosophy for insight. Our equity portfolio is built with growing companies who use little or no debt. Our collective investing decisions are driven not by headlines that may or may not materialize, but rather by fundamentals that support operational success. We try to stay rational when the market can sometimes appear quite the opposite.
Headlines come and go, but earnings growth remains the primary stock market fuel. Last year the S&P 500 barely grew earnings by an estimated 0.3%, drug down by energy names, which explains returns to a large degree. Comparatively, our portfolio grew earnings by an estimated 15.7%, a reminder that events can over- take fundamentals periodically, and the equity market recognizes and rewards earnings growth in the time and manner of its own choosing.
At 15x 2016 earnings, we view the market as neither cheap nor expensive. We are currently expecting 14.0% earnings growth from the companies in our portfolio in 2016, but given the expectations above we an- ticipate making changes in the portfolio to push that towards 15-20%. Consumer discretionary stocks will be added as our research uncovers new ideas and opportunities. The industrial and healthcare exposure will be reduced as the strong dollar will hurt both groups. And healthcare may struggle due to political rhetoric on drug pricing and changes to the Affordable Care Act overcoming the lure of new drug introductions and above average earnings growth. Assuming no change in multiples, such earnings growth suggests that a high single digit increase in portfolio value is a reasonable expectation for 2016.
In December, the FOMC raised rates for the first time since 2006, finally moving by a quarter of a per- centage point. It did so in an environment of uncertainty and doubt. The FOMC is operating under a new pro- gram to raise the overnight rate, but not everybody is on board. Now that the FOMC has taken the first step, the more important question is how far and fast they will move. Their own median projections show four moves, and the markets are projecting two moves. The distinction is understandable. Given the FOMC’s own reluctance to move earlier in the year, markets are skeptical the FOMC has the will to pursue their program.
The Federal Reserve is charged with a dual mandate: full employment and price stability. With unem- ployment declining from 10% in October, 2009 to 5%, the full employment charge has been met. Meeting the price stability mandate has been problematic and is the primary source of delay in raising rates. Core inflation is running comfortably at 1.0% to 2.0%, while headline inflation is well below 1.0% due to low energy prices and low import prices. The FOMC wants inflation at 2%. The FOMC has repeatedly said it sees these factors as ‘transitory’ and is projecting an increase in 2016, supporting its decision to raise rates in December. We think the FOMC will have the coming economic data to follow through on their plan.
Even before the FOMC acted last month, interest rates were already on an upward trajectory. Having hit the low in January at 1.64%, the 10yr US Treasury Note closed the year at 2.27%. The 30yr US Treasury also hit its low in January at 2.22% and closed at 3.01%. Accordingly, many fixed income assets are showing negative returns since the low points in January, while our fixed income portfolio returned positive results. For investors who sought greater yield through longer-dated securities, this is what interest rate risk looks like, and should be kept in mind as we transition to 2016. The same search for yield also drove investors to mini- mize credit and liquidity concerns, but both of these risks resurfaced this year as well.
In high yield assets, or junk bonds, more and more investors are questioning the ability of lower quality issuers to service their debt. The renewed concern with credit risk has produced negative returns for junk bond indexes and energy driven partnerships as investors start casting a more critical eye. The apprehension began in the energy sector in late 2014, which represented a substantial portion of new junk bond issuance over the last several years, but has extended to other sectors and asset classes too. Such a notable shift in sentiment from the days when massive junk bond issues were placed with little question is not unusual, we simply have not seen it happen for a while. And longer-term problems will arise as these companies look to refinance that debt after interest rates have risen further.
Liquidity risk, or the inability to convert a security to cash as expected, is also making itself known more frequently, the most recent example surrounding the European Central Bank decision in early December. Markets were disappointed with the degree of easing announced, which prompted a rush of trading activity to get on the right side of the action. There were simply too many parties on one side of the trade for the market to clear without prices moving significantly. As with the sudden equity drop in August, 2015, the US Treasury flash crash in October 2014, recent mutual fund lock-ups, and others, we expect to see more of these types of instances due to the extreme concentration in various asset classes, certain strategies utilized and the crowding therein.
Interest rate, credit and liquidity risks are major hazards that we manage. We invest in fixed income assets the way it was meant to be done. We build portfolios to behave with the stability and safety that are ex- pected in a core fixed income allocation. We conduct credit analysis on every security we hold. We assess the trade-off between additional yield and the risks involved. Most importantly, we are not afraid to look different to protect our investor’s capital.
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