As investors, being patient with the markets is sometimes the hardest part of our job. Since the beginning of the year, we noted the increase in volatility in the U.S. stock market. Earlier in the year we began to raise cash in your portfolios as a hedge against a possible market correction. The good news and the bad news is our concerns were warranted and a market correction did occur. Typically, during a market correction you will get a bit of a zig-zag pattern where the market will hit a low, rebound, and hit the low again. If the low holds, that low becomes a base from which to move forward. So far during this market cycle, we have had a successful re-test of the summer market low. So far that low has held. While we are starting to see a few signals turn positive, our indicators are still flashing yellow so we remain in the holding pattern—not quite ready to fully re-invest.
The purpose of a correction is just what you would expect—to correct the imbalances of the market. We have discussed in previous newsletters our concern that the U.S. stock market had high valuations. These high valuations combined with slow economic growth, the continuing crisis in Europe, a slowing Chinese economy, and increased volatility in the bond markets are what led to the increase in volatility in the equity market. The summer correction did reduce valuation, but, perhaps, not as much as we had hoped. A fairly valued S&P 500 is around 16 times earnings. Before the correction, the S&P 500 was about 22 times earnings and today it stands at about 20. Further, the macro-economic themes of slower growth remain in place. On a short-term basis, if the market is basing, it should set us up for a nice year-end rally. On a longer-term basis, we remain cautious.
U.S. Equity Market
Volatility was high this summer with the S&P dropping to a low of –11.23% in August and ending the quarter down -6.75% for the year. The table below illustrates Year-to-Date Returns for each of the Ten S&P 500 Sectors.
S&P 500 SECTOR CONTRIBUTION — YTD THROUGH Q3 2015
|Sector||Weight in S&P 500
As of 12/31/2014
|YTD Through Q3 2015
|Source: S &P Dow Jones Indices. Price only.|
|Ned Davis Research Group|
remaining positive for the year. We believe the equity markets are in a bottoming process. Over the last two months, we have seen a marked increase in market volatility as the stock market sold off sharply in August and then retested its lows at the end of September. If those lows continue to hold and the breadth of the market improves, we believe this could be setting up a good buying opportunity. As you know, we increased our cash reserves before the selloff in August and are now in position to take advantage of this market.
The Consumer Discretionary, Consumer Staples, Health Care, and Information Technology Sectors all held up relatively well during this correction process. It is in these four sectors that we are most likely to find leadership as we begin the next leg up in the market. If the market is bottoming, as we suspect, you will likely see us start to build positions in these four key areas. This should set up for a strong year-end.
U.S. Fixed Income Markets
We started this year with the belief that the U.S. Fixed Income markets would be stuck between slowing economies around the Globe and the Federal Reserve’s desire to move to a more normal interest rate structure. With the current round of disappointing employment numbers, we would now add concerns over U.S. economic growth. This puts the Federal Reserve in a bind.
Any move to a more normal interest rate environment will now be much slower and take much longer unless we see a significant improvement in the employment picture and acceleration in economic growth.
We would continue to stay with high quality corporate and municipal bonds avoiding high yield and international bonds at this time. Bonds remain expensive with little to no appreciation potential while providing historically low yields. We remain conservative in our approach to the fixed income markets.
Longer Term Concerns
While we are cautiously optimistic for a strong finish to 2015, longer term our view is less sanguine. Global GDP is clearly slowing down. From China to Europe to commodity-driven economies like Australia, Canada and Brazil, we have seen a marked reduction in Global growth over the past several months. While here in the U.S., the last two jobs growth numbers can only be described as dismal. Private payroll increased by just 118,000 while the U.S. Government added 24,000 for a total of 142,000 jobs created in September. The average jobs growth number for the last three months has now fallen to 167,000 compared to the average of the prior six months of more than 260,000 jobs.
According to David Rosenberg:
Adding insult to injury and revealing an even softer underbelly to this report was the contraction in the workweek to 34.5 hours from 34.6 hours in August, which is effectively equivalent to an added 348,000 job losses.
So take the headline number, tack on the downward revisions and the loss of labor input from the decline in the workweek, and the “real” payroll number was – 265,000. You read that right.
On top of the disappointing jobs reports, we have seen sales and earnings growth stall. The consensus for earnings per share for the S&P 500 is around -3% this quarter after declining more than -11% last quarter. The two factors that seem to get the most blame for the weakness in sales and earnings are: 1) the strong dollar; and 2) the decline in oil prices.
As we discussed in our January 2015 Riggs’ Report:
Unfortunately, with the price of oil down to about $50 a barrel and with U.S. shale production costs estimated to run between $40 to $70 a barrel, many current and future shale projects will be delayed or canceled. This will have a ripple effect throughout the manufacturing and services …Further, the energy industry has been one of the few industries creating and supporting higher wage jobs over the past six years. According to Rigzone’s Salary Survey, in 2014 the average salary for a person working in the oil and gas industry was $90,000. That figure is well above the median household income of roughly $52,000. So, while declining oil prices will benefit many consumers, a slowdown in the U.S. energy sector will affect the number of high paying jobs and have a ripple effect on jobs in related and supporting industries.
For the last six years, the major driver of capital expenditures (i.e., new plant and equipment) came from the oil and gas industries. Currently this industry is reeling from low commodity pricing and high debt levels and it will not be a driver of economic growth for some time.
A further roadblock to economic growth is the strength of the U.S. Dollar. The strong U.S. Dollar issue is really less about the strength of the U.S. economy driving up the Dollar and more about the weakness in the economies of our major trading partners in Europe and in Asia. And yes, on top of this those trading partners are also actively working to devalue their currencies to enhance the pricing of their exports.
While much of the evidence of a slowdown is anecdotal and housing and auto sales remain strong, there are enough negative data points that we are becoming concerned with the outlook for U.S. economic growth. For the last six years, U.S. economic growth has averaged roughly 2% a year. If we continue to see signs that even this modest growth is waning, we could once again hear cries for additional stimulus from the Federal Reserve.
Given that the last round of Quantitative Easing was largely ineffective (according to a recent study conducted by the Federal Reserve), it is unclear what tools are available for the Federal Reserve to use to stimulate the U.S. economy. Would they want to introduce another round of Quantitative Easing? Perhaps. Would they consider negative short-term interest rates? Unlikely. The Federal Reserve is trapped in a cage of their own making—not really having any good levers to pull should the economy weaken and yet, unable to move away from its current policy.
As a result, for the first time in several decades the economy and the investment markets are entering an environment where the Federal Reserve’s ability to step in and provide a backstop will be limited. We believe that interest rates will likely stay lower longer and for the most part remain supportive of the economy and markets. However, we also believe volatility will remain elevated in both the bond market and the stock market for some time to come.
The economic backdrop remains muddling, as the US economy simply is not firing on all cylinders. The Federal Reserve is trapped with limited options should the U.S. economy weaken. With a 2016 Presidential Election year, the discord in Washington is likely to get worse and the chances of any meaningful improvement on the fiscal side unlikely.
While the pullback in August and September has done little to relieve our valuation concerns, recent market action looks to be improving. We executed against our plan as volatility increased raising cash as a hedge and to preserve the asset base against a possible market correction. Now that the market appears to be bottoming, we will look to redeploy that cash into those sectors that performed well during the correction—Consumer Discretionary, Consumer Staples, Health Care and Technology. Those areas dominate our buy list. We remain focused on our signals with cash at the ready looking to re-invest once we get the green light.
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