A Look Back and Look Ahead…and why I’m optimistic

January 19, 2016

It’s appropriate for our first newsletter of the year to summarize what we experienced in 2015, put some perspective on the negative news we’ve been hearing and consider the period ahead.  If you are at all concerned with markets today, I encourage you to read all of this letter.

These days, most newspaper headlines paint a dim view of the future. Without dismissing the very real issues that we are facing around the world, I want to share why we should be optimistic about the future.

But first, here’s an overview of how last year’s markets performed.

2015 stock market performance

Four macroeconomic factors cast a big shadow over markets in 2015 – uncertainty about the timing of the interest rate increase by the US Federal Reserve Board that finally materialized in December, the impact on corporate profits from oil prices that fell by over 30%, a rising U.S. dollar and questions about growth in China.

Stock prices were more volatile in 2015. After a relatively quiet first half, concerns about Chinese growth led to a sharp decline in stock prices in the third quarter – although the fourth quarter saw a recovery sufficient to leave our stock market positive for the year as a whole

2015 Canadian Stock Market Performance – S&P TSX Total Return

Q1                   Q2                   Q3                   Q4                   Total for Year

+1.85%           -2.34%            -8.56%            -2.23%            -11.09%

2015 US Stock Market Performance

Q1                   Q2                   Q3                   Q4                   Total for Year

+1.4%             +0.3%             -6.7%              +6.8%             +1.3% USD $

CND $

Total return including dividends; Source: MSCI

Rise of the FANGs

After double-digit gains in each of the previous three years, a pause in growth in prices was inevitable at some point. A key driver of sideways stock prices was flat corporate profits after an 8% increase in 2014. The backdrop to flat profits is outlined in a Wall Street Journal article, Falling Corporate Profits Blur U.S. Growth Outlook.

With a sharp decline in the price of oil, the energy sector saw a sharp drop in profits and share prices for this sector fell by 26%. Other sectors whose stock prices declined were materials, down 10% as demand for minerals and other commodities declined and utilities, which dropped by 8% in anticipation of an increase in interest rates.

The stronger dollar hurt profits in two ways: Companies relying on exports were challenged as the cost of their goods increased in foreign markets. And second, for multinationals the rise in the dollar led to a decline in the value of profits in their overseas subsidiaries.

Offsetting the weakness in energy was strength in companies that focused on the domestic consumer. Particular strength was shown by the four technology companies known as the FANGs – Facebook (+36%), Amazon (+122%), Netflix (at +131% the top performing U.S. large company stock last year) and Google (+49%).

Even with a flat 2015 and the big decline in 2008, for patient investors who stayed the course, over the past 10 years the compound annual return on the U.S. stock market still exceeded 7%.

Annual change in Canadian Stock Market

2006      2007       2008      2009      2010       2011       2012      2013       2014       2015

14.5%     7.2%      -35%     30.6%     14.5%    -11.1%     4%        9.6%       7.4%     -11. 1%     (CDN$)

Annual change in U.S Stock Market

2006      2007       2008       2009       2010     2011       2012      2013        2014       2015

+16.0%  -9.8%     -23.1%    +9.3%     +8.8%  +4.41%   +13.4%  +41.9%   +24.2%   +20.8%    (CDN$)

Total return including dividends

*compound annual return

Source: MSCI

Stocks around the world

Even with a flat return in 2015, U.S. markets continued to outperform the rest of the world, with emerging markets continuing their weak performance over the past five years. These returns are in local currency – if translated to U.S. dollars, the rise in the U.S. dollar would have made the gap between U.S. stock market performance and the rest of the world over the past five years even more pronounced.

Period Canada US Europe Emerging Mkts World
2015 -11.1% +1.3% +5.4% -5.5% +1.8%
3 yrs +4.6% +15.1% +10.7 +1.5% +12.2%
5 yrs +2.3% 12.5% +7.6% +1.4% +9.1%
10 yrs +4.4% 7.4% +4.6% +5.9% +5.5%

 

Total annual compound returns including dividends to December 31, 2015 in local currencies.

Source: MSCI

Concerns about the Future

Looking backward is only helpful to the extent that it helps provide perspective on the future. And today there is no shortage of worries about the period ahead.

This was crystallized in the first week of January, when bad news about the Chinese economy and a drop in the value of the Chinese currency led to a 10% decline in stock prices in that country. This led to declines in stock markets around the world, with the U.S. market down by 6%, its worst start on record. And with indications that demand for oil will continue to soften, its price, after a sharp drop in 2015, was off by another 10%.

But it’s not just weakness in the Chinese economy that is causing concerns. Scan the headlines and here are some of the things you’ll read about:

  • Stalled global economic growth almost everywhere outside the United States, with continued woes in Europe and countries like Brazil;
  • Continued uncertainty about whether the European Union can remain intact, with a vote this year in Great Britain about a “Brexit” from the EU;
  • Political turmoil, with Russia flexing its muscles and unrest in the Middle East and Africa, leading to record numbers of migrants and refugees;
  • The rise of religious zealotry and terrorism with Western institutions coming under attack; and
  • Rising deficits and debt levels in many economies around the world, at the same time as aging demographics and pensions in developed countries will put pressure on spending.Why I’m optimistic Here are some reasons to be optimistic in the near term:
  • In the face of this, there are three reasons why I am optimistic about the future: Some short-term good news, some mid-term positives and the fact that we’ve overcome tough challenges in the past.
  • Add to these concerns about the impact of global warming and questions about the leadership in Washington and its no wonder that in many corners pessimism reigns.
  • The U.S. economy is strong: The increase in interest rates in December reflected a U.S. economy that is showing real strength. A report released at the beginning of the year showed that almost 3 million new jobs were created in 2015 and unemployment dropped to 5%, half the level that we saw as recently as 2009. For 2016, the International Monetary Fund forecasts growth in the U.S. economy of 2.8%, first among the major developed economies.
  • Oil prices boost consumer spending: While declining oil prices hurt oil producers, they provide consumers with a big lift. Lower oil prices will help fuel consumer spending around the world and will be especially positive in countries in Europe, Asia and South America that are oil importers.
  • A recovery in corporate profits: The impact of a stronger dollar and low oil prices is already reflected in 2015 profits. Provided that we don’t see more declines in oil or more strength in the dollar, the negative impact on profits is behind us. Current forecasts are for profit increases by U.S. companies this year of over 7%.
  • Retirees are happy: This Wall Street Journal article explains why most Americans in retirement are happy with their situation.
  • There are also reasons to be optimistic looking out beyond this year:
  • Better leadership in key developing countries: The difficulties in Brazil and China obscure positive developments when it comes to new leadership in countries like India, Argentina, Nigeria and Tanzania that will unleash the potential of young populations. The 2014 election of Narendra Modi as Prime Minister of India is particularly promising, as an economy that has been a chronic underperformer is starting to turn around. In the next 10 years, India will surpass China as the world’s most populous country – what happens in India matters to the rest of the world.
  • A big drop in global poverty: According to a World Bank report the percent of the world’s population living in extreme poverty has declined to 10%, down from over 35% in 1990. That’s a huge increase in the number of people that can afford to send kids to school and that offer the promise of entry into the middle class. This video shows the remarkable strides that have been made in reducing malnutrition, in providing access to electricity and in aspiration to educate children and in particular to send girls to school.
  • A reduction in violence: Contrary to popular view, violence has actually declined over the recent past. In The World is Not Falling Apart Harvard’s Steven Pinker illustrates how today compares to the past.
  • Elimination of diseases: In this article, Bill Gates shares the top six good news stories of 2015, including the elimination of rubella (German measles) in the Americas and a 12-month period in which there were no new cases of polio in Africa.
  • Other reasons for optimism relate to the impact of technology. Peter Diamindis is an entrepreneur with degrees in engineering from MIT and from Harvard Medical School. Here’s an excerpt from the New York Times review of his book which I’ve read and recommended previously, “Abundance: Why the Future is Better than You Think” on four reasons to be positive:
  • The first idea is that our technologies in computing, energy, medicine and a host of other areas are improving at such an exponential rate that they will soon enable breakthroughs we now barely think possible.
  • Second, these technologies have empowered do-it-yourself innovators to achieve startling advances – in vehicle engineering, medical care and even synthetic biology – with scant resources and little manpower, so we can stop depending on big corporations or national laboratories.
  • Third, technology has created a generation of techno-philanthropists (think Bill Gates) who are pouring their billions into solving seemingly intractable problems like hunger and disease.
  • And finally, we have what Diamandis calls “the rising billion.” These are the world’s poor, who are now (thanks again to technology) able to lessen their burdens in profound ways. “For the first time ever,” Diamandis says, “the rising billion will have the remarkable power to identify, solve and implement their own abundance solutions.”
  • My final reason for optimism is that we’ve successfully overcome tough challenges in the past. In the 1970s we saw runaway inflation and double-digit interest rates. In January of 1990, Saddam Hussain had seized Kuwait and we were waiting for the West to formulate a response; meanwhile we were dealing with sharp increases in oil prices at a time when the U.S. was dependent on imported oil and the collapse of the savings and loans industry in which almost a third of those institutions would ultimately close. Finally, in the depths of the great financial crisis, in early 2009 there was a broad view that there was a 20% chance of a global depression.
  • None of this is to dismiss the real issues that we are facing today. But there are solid reasons to adopt a positive outlook and to believe that we will work our way through the current challenges, just as we’ve worked through serious challenges in the past.

What this means for your portfolio

  • Having outlined the reasons that I’m positive for the mid-term, I recognize that 2016 seems like a particularly uncertain time. To help navigate through that, here are, once again, the three core principles that we employ in constructing portfolios: Diversification, maintaining balance and risk management:

Diversification

  • In my client letter a year ago, I provided data from Nobel Laureate Robert Shiller, suggesting that U.S. stocks were expensive by historical standards. Shiller compares stock prices to average earnings for the past 10 years adjusted for inflation. By that standard, even after the drop in equities in early January 2016, the price to earnings ratio is 24-times, 50% more expensive than the historical average of 16-times earnings.
  • This doesn’t mean that equity prices will collapse, especially if earnings growth recovers, but it does call for caution. We have already diversified portfolio’s outside North America to take advantage of lower valuations in Europe, Japan and Emerging markets
  • Diversification doesn’t just means holding equity and bond funds; it also entails ensuring that there is broad exposure across industry sectors. Investors who were overexposed to the energy sector saw the drop in oil prices hit their portfolios particularly hard. And on the topic of global diversification, note that the reduction in oil prices, if sustained for the period ahead, is particular positive news for large oil importers in Europe and Asia.

Maintaining balance

  • A key lesson from successful investors is the importance of not just starting with a diversified portfolio but maintaining that diversification as markets rise and fall. As a result of the strong performance by U.S. stocks over the past three years, chances are that unless there has been action taken to reallocate funds along the way, portfolios that had the right balance three years ago are out of balance today.  That also applies to countries, industry sectors and individual stocks – We review and rebalance portfolio’s regularly with the objective of not being too over weight or underweight in any one sector, geography or asset class.

Controlling risk

  • We design portfolios with the view of providing clients with the best possible returns on a risk-adjusted basis when looking across a full-market cycle. To do that, we look at the broadest possible range of alternatives, both within the United States and around the world.
  • Ultimately, every client’s needs are unique, and we work hard to develop the portfolio that is right for your personal financial plan. If we haven’t talked recently, we would welcome the opportunity to sit down to update your circumstances, to ensure that your portfolio is designed to provide the returns to achieve your long term goals.

I hope that you have found this review helpful. And as always, thank you for the opportunity to serve as your financial advisor.

Richard Yasinski CFP

The Affect of Praise on Mindsets

With a background in engineering, I always appreciate when someone provides actual proof of their theories.  When proof is provided, it’s not a theory anymore but fact.  If you ever wondered how your praise affects your children, colleagues, or staff watch this short video by Carol Dweck:

Video – Carol Dweck

Bear Market Truths

We are now experiencing a typical bear market.  Bear markets are not fun, but a necessary part of being an investor.   We know after every bear market a bull follows and there a few other interesting truths of bear markets:

Bear Market Truths