Wednesday, January 13, 2016

Irrational Pessimism Pop Quiz - How many times over the last 13 years has the S&P 500 reported positive results?

From the Desk of Joe Rollins

I thought I would start the blog for the year ended 2015 with a question for you to ponder. I will get to the answer to this question later in this posting (teaser alert), but I want you to think about it as I report on the numbers for the just finished lackluster 2015 investment year.

2015 could be characterized as the investment year in which almost nothing happened. There has hardly been a financial year when so many crises hit the market all in one year. I remember back to the summer when Greece was all anyone talked about. And then we had the financial and personal crisis of the Middle East along with terrorism, followed by the perceived implosion of economics in China.

While none of these events really affected the United States directly, the U.S. market sold off for reasons not totally clear to me. I have many great subjects to cover in this posting, including why I believe the market will rebound quickly and returns will normalize in 2016, but the results for 2015 must be addressed first.

For the year 2015, the Standard & Poor’s index of 500 stocks had a total return of +1.4%. The Dow Jones industrial average returned +0.3%, NASDAQ composite +7%, the Russell 2000 small-cap index -4.4% and the Barclays aggregate bond index +0.4%. Basically, all of these indexes were essentially flat for the year. However, if you look at it on a more long-term basis, you will see the constant earning power of these indexes.

The S&P 500 returned 1.4% for the year, but over five years has returned 12.6% and over 10 years 7.3%, annually. The NASDAQ composite returned 7% for one year, 14.9% for five years and 9.7% over 10 years. The Dow Jones industrial average returned 0.3% for one year, 11.3% for five years and 7.8% for 10 years. The Barclays aggregate bond index returned 0.4% for one year, 3.1% for five years and 4.1% annually for the last 10 years. As you can see, stocks of every size basically had a return of 2 to 1 to the aggregate bond index.

While certainly a 1.4% return for 2015 does not seem all that significant, it is interesting to see how the different asset classes’ results compared to that 1.4%. If you look at broad classifications, you can see that the return for the S&P 500 was higher than virtually any of the indexes. As an example, large-cap core returned -0.56% for the year. Mid-cap core returned -4.31%. Multi-cap core returned -2.17%. Small-cap core returned a -5.14%. Equity income returned -3.69%. Alternative long/short equity returned -1.7%. Also, major losses for the year were gold at -9.8%, oil at -50%, silver at -14%, and virtually all commodities. I found it funny that the more conservative funds lost more money than the growth funds. The only consistent, positive return for the entire year related to municipal bonds, which due to scarcity and low return of tax-free income had a moderately positive year in 2015. Therefore, to answer my question, “What outperformed the S&P 500 stock index for the year 2015?” Virtually nothing!

Particularly interesting for 2015 was that the S&P index earnings report for the year declined -5.9%. It has been a long time coming for this index to decline so much in only one year. You would basically have to look back to 2008 to see such a decline in earnings from one year to the next. However, the interesting part of this calculation is that if you excluded energy stocks from the 500 index for the year, earnings actually increased +5.6%. It is very important that you understand this concept.

The price of oil has been very volatile over the last two years and has greatly impacted the earnings of companies related to oil and oil exploration. During May 2015, oil topped out at roughly $64 a barrel, but most recently traded at $30 a barrel. Therefore, the price of oil was cut in half during 2015 and is down almost 65% from the level it traded at in 2014.

I do not think it is realistic to assume that the price of oil will drop dramatically in 2016 since it is already trading at below the cost of production. As marginal producers reduce exploration and reduce their costs by cutting out oil projects, the price of oil will stabilize and either move flat or marginally up in 2016. It is highly unlikely that the significant effect on S&P earnings that occurred in 2015 will reoccur in 2016.

Now to answer my own question in the title about how many years the Standard & Poor’s index has been up over the last 13 years, please examine the following chart.

As you will note, the S&P 500 has had a positive return in 12 of the last 13 years. Therefore, your win ratio is essentially 92%. If I gave you the opportunity in Las Vegas to win 92% of the time, I am guessing that almost everyone reading this post would take those odds. If you started January 1, 2003 with $10,000, by the end of 2015 you would have $30,292.67, which would be an increase on your original investment of well over 200%. Also, please note that this time frame included 2008, when the index lost 37%.

Almost every day, I ask prospective clients, “How many years of positive returns have we have enjoyed over the last 13 years?” I have gotten answers of 8 loss years out of 13, but no one has indicated 12 positive years. With such high historic likelihood of making a profit in the S&P 500 index, it is amazing that so few people understand or comprehend the true potential for gain.

It is also interesting to note how high the dividend yield is on this index. If you compare current estimates for the dividend index for next 12 months, it is roughly 2.3%. It is very rare indeed when the dividend index on the S&P 500 exceeds the current dividend on a 10-year treasury bond, which is currently 2.17%. Once again, with all things being equal, your return on the investment of the S&P 500 is higher than the return you would get on a 10-year treasury bond, which has virtually no chance of market appreciation due to its already low level.

I am sure you are interested in why my fearless forecast for 2015 was inaccurate. Basically, I had projected that the S&P 500 index would have a closing level of 2,250 by the end of 2015. The actual closing level was 2,044. Basically, my projections are always based upon three major economic calculations. The most important of which is earnings, but you also must take into consideration interest rates and basic economic conditions. While I got two of the three correct as being positive, I seriously missed on earnings.

I calculated based upon the Standard & Poor’s website that the earnings for 2015 would be $136 per share. In fact, earnings ended up being at the lowly level of $106 per share. This miss in earnings was critical to my calculation, since basically the calculation was based on outstanding earnings, when in fact earnings came in at a net negative. There are two major reasons why earnings were so low during 2015, which neither me nor essentially anyone else got correct.

As previously mentioned, the following price of oil dramatically reduced the earnings from an increase of 5.6% to an actual decline of 5.9%. Additionally, due to the rising dollar it is estimated by Standard & Poor’s that earnings during 2015 declined close to $94 billion, based on the earnings effect of the rising dollar against foreign currencies. Neither of these major market movers could have reasonably been forecasted, and in fact were not forecasted, by major market participants before 2015.

There is an enormous market speculation at the current time regarding basic economic forecasting. One, of course, is the dramatic affect that China will have on corporate America and earnings. Just like we suffered during July and August 2015 due to the unknowns of China, we are now going through that exact same volatility.

Even though we export less than 7% of our total exports to China, there seem to be many who believe that the decline in the Chinese economy would somehow affect the U.S. economy. Interestingly, China itself is forecasting a GDP growth above 6% in 2016, down from above 7% in prior years. As for the cynics, many believe that these numbers cannot be relied upon, but those are the only numbers we have to compare. In my opinion, nothing has changed in China that requires adjustment.

Looking forward to spring!

Robby, Danielle, Caroline and Reid - Christmas 2015

Also, I am totally blown away by how well the current economic statistics relate to future stock market performance. I have quoted some of these in the past, but I think I will bore you with a few again. Some of the positive events are as follows:

• The personal savings rate in the United States is up 28% over last year from 4.3% to 5.5%. It is unlikely that savings rates would be going up at such accelerated levels, if personal earnings were not going up in tandem with savings.
• Personal income is up 4.6% over the last year. When personal income is up, there is more discretionary spending, and therefore more available money to produce GDP.
• It was announced on Friday that 292,000 new jobs were created during the month of December. There are well in excess of 2 million more people working in the United States this year over last year. The unemployment report indicates that unemployment is 5%, which is deemed to be full employment by economists. Yes, I understand that the cynics would point out that the participation rate is at an all-time low, but nevertheless there are 149 million Americans employed today for those wanting to work, which is a high level.
• During 2015, car sales exceeded an all-time U.S. high. Never in the history of the United States has car sales been greater than in 2015. There is no better indicator of the positive effects on personal finances than car sales. Since car sales are almost universally a discretionary purchase, people would not be buying new cars if they did not have confidence in their financial future.
• As I have pointed out in the past, virtually everything about the housing sector is higher this year than last. New home permits of 19.4%, new housing starts up 16.48%, non-residential spending of 13.66%, public spending up 6%, residential spending up 11.9% and the home price index up 5.08%. You do not need to be an economist to see all the construction cranes that I can view outside my window. Virtually every day, huge projects are announced all over Atlanta, office rents are sky rocketing, price of homes are accelerating and by any definition, residential housing is strong and getting stronger.
• Consumer confidence continues to be strong even with all the volatility in the market at 96.5%, up 3.65% over the prior year. Interestingly, the index of leading indicators is now at 125.6%, up 3.4% over the last 12 months.
• Even though it is cited as being truly negative for the U.S. economy, the price of gasoline has dropped dramatically, therefore creating a huge economic gain to the vast majority of Americans. While a negative for those in the oil industry, it is a positive for virtually every American and every business that uses energy.

Therefore, using my three most important components of future positive stock market performance, I have to once again evaluate earnings for 2016, interest rates and the general economy. We all know interest rates are going up in 2016 since the Federal Reserve has basically told us they will. Therefore, it is highly likely that interest rates of all characterizations will be higher, creating a situation for bond investors where returns will either be marginal or negative. It does not make sense to me to invest in an asset class where the best circumstances would only return a marginal investment return.

As illustrated above, the economy is strong. While certainly not as strong as it could be, a 2%-3% GDP growth is actually positive for earnings growth. If GDP were higher, almost assuredly the Federal Reserve would increase interest rates more aggressively, creating a negative headwind for all investment projects. This brings us to, by far, the most important component of all - earnings.
As I illustrated above, two major headwinds of the economy and earnings in 2015 were a dramatic decline in oil prices which effected earnings of oil related companies, in addition to the $94 billion effect on earnings to the S&P 500 during 2015 due to currency fluctuations. I believe this is not likely to occur again in 2016, as I don’t think the U.S. dollar will accelerate at such high levels without some extra geopolitical event that cannot be forecasted. If earnings in 2015 are not impacted by a gigantic fall in the price of oil and also a double whammy gigantic increase in the value of the dollar, might there be optimism for a rate of earnings much greater than anticipated at the current time?

My guess is that neither of the components mentioned here will have a dramatic effect on earnings in 2016, except moving in a positive direction. I think there is a high likelihood that the dollar will stabilize in 2016 and not necessarily go down but almost assuredly not accelerate at that level. No one can forecast the price of oil, but I am betting that there is no chance that it continues to fall at these levels. While flat would not have a positive effect on S&P earnings, it certainly would not have a negative one.

Therefore, my projection for 2016 is based on the current earnings as forecasted by the Standard & Poor’s company for 2016. They are currently forecasting earnings of $125.54 for 2016. If you just add a normal market multiple of 17, which is not particularly high, that would indicate a level of 2,134 at the end of 2016. If you compare current levels of 2,043, you would see that would increase the index 91 points for all of 2016 for a total return of 4.5%. If you then added the current projected dividends of the S&P 500 index for 2016 (2.3%), a projected return for this year would be 6.8%.

The calculations on this return of 6.8% are based on projected earnings as of January 11, 2016. As I look back over 2015, I realize there were so many geopolitical events that affected the markets as to distort virtually all calculations. As mentioned, I think there is almost no chance that the price of oil will decline as much in 2016 as in 2015. I am almost positive that the effect on earnings of overseas market valuations based on currencies will not occur in 2016.

Even though I project a 6.8% return on the S&P 500 index for 2016 I fully recognize it could be significantly higher if earnings came in at better than expected. It would not surprise me if total return for the S&P 500 index is double digits in this upcoming year.

I also recognize that volatility is on everyone’s mind. I highly recommend that you refrain from watching the market day to day, week to week. The momentum traders move the market at their discretion based upon the billions they maintain in buying power. Their goal is to scare you out of your positions so they can benefit from your flight.

I am often asked if we ever just go to cash. Unless there is a change in the three major components of valuing stock we would never do so. There would have to be a significant change in corporate earnings, interest rates or the general economy for us to take a major position in an investment that earns nothing. In all likelihood, we will always find some alternative investment better than zero. I forecast that for 2016, unless economic events are significantly different than I currently project, we should enjoy a very satisfying investment year at the end of 2016. Stay tuned – more later.

As always, the foregoing includes my opinions, assumptions and forecasts. It is perfectly possible that I am wrong.

Best Regards,
Joe Rollins

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