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At a time when many are trying to stick to their New Year’s resolutions for 2016, we’re going to offer some of our own based on our observations of investor and financial pundit behavior from 2015. There is a lot we could have thrown in here, but we have restrained ourselves to only the really key mistakes we saw folks making—and we highlight these for you now because the media is still largely banging the same drum. We’re hoping you can avoid these errors by learning from others.
Energy stock bargain-hunting was popular in 2015. Some thought Energy valuations were attractive, while others simply believed what goes down must necessarily go back up. Fund flows show retail investors piled in, as natural resource ETFs issued far more shares than they redeemed. But as investors attempted to snap up bargains in the Energy bin, a continued global supply glut pressured oil prices and hence Energy stocks throughout the year, as Energy firms’ earnings are oil price-sensitive. While the S&P 500 was mostly flat, Energy stocks are down 21.4%i. Those who thought they were getting bargains in the spring, when oil prices recovered briefly, were sorely disappointed over the rest of the year.
When a sector gets hammered as hard as Energy was, the time to buy is either when fundamentals turn and/or investors become far too pessimistic. In Energy’s case, this would be when no one wants to own Energy stocks and the supply glut shows signs of easing, laying the foundation for oil prices to rise. But Energy bargain-hunting remains extraordinarily popular. And oil production hasn’t turned down yet, suggesting ultra-low prices will stick around for the foreseeable future.
2015 was the year Japan’s weak yen was supposed to finally boost its economy by driving demand for cheaper Japanese goods abroad. And the year a strong US dollar would dent US exports, corporate profits and stocks as revenues earned abroad in weaker currencies are diminished when converted back into stronger dollars.
But this also didn’t play out as many expected. Many Japanese firms didn’t pass those lower costs to foreign consumers—they pocketed the profit from currency translation instead. Export values rose, but not volumes, so production ebbed. In the US, the strong dollar didn’t have much earnings impact at all. Supply chains for many finished goods are pretty darned globalized. Many firms have foreign-sourced input costs—labor, raw materials, components and transportation—which are cheaper for US firms when the dollar is strong. That cancels out much of the dollar’s impact on overseas revenues. Yes, overall S&P 500 earnings were a bit sad this year. But this is largely due to plunging Energy earnings. Excluding Energy, S&P 500 earnings per share rose 8.5% y/y in Q1, 5.9% y/y in Q2 and 5.6% y/y in Q3ii.
As for stocks, while it might be tempting to blame the dollar for the S&P 500’s muted full-year returns, that’s correlation without causation. Exchange rates don’t predict stock returns. The dollar strengthened throughout the back half of the 1990s, one on the strongest periods in history for US stocks. But stocks also fared just fine during the 2003-2007 period when the dollar weakened.
Fed forecasting once again proved futile in 2015. As the year began, many thought the Fed would begin raising rates by June. Then it was September. Then December, when the Fed finally hiked. Across the pond, expectations for the Bank of England’s first rate hike continued shifting all over the map as officials continued issuing conflicting guidance. None of this surprises. To forecast central bank moves, investors would need to know not only future economic data, but how each central banker will interpret that data and what policy decisions they will think appropriate in response (usually influenced by their many opinions and biases). Nailing this down for one person is impossible, never mind a diverse group that must reach consensus.
But that’s ok, because initial rate hikes don’t have a set impact on market returns. There is no need to forecast them, because there is no need to navigate them. After the six initial Fed rate hikes in each full bull market since 1970, bull markets have endured for 3.3 more years on average, with the S&P 500 averaging over 80% through the eventual bull market peakiii. Nor is there a set short-term impact. On December 16, the day the Fed hiked, the S&P 500 rose 1.5%iv. It has been flattish (albeit choppy) since then. There was nothing to navigate. (Not that short-term moves are ever navigable—they aren’t. Rate hikes usually don’t become headwinds until they invert the yield curve, which over a century of data shows is negative. And even then, you likely don’t need to forecast the move or act right away, as inverted yield curves don’t end bull markets or expansions immediately. They’re warning signs, not triggers. And today, with 10-year Treasury yields at 2.3% and the effective fed-funds rate at 0.36%, the yield curve is steep enough to withstand a few rate hikes.
2015 was the year that people worried about bond market liquidity. Some worried regulations would prevent dealers from buying when there is a rush to sell, causing a crash. Others worried bond funds wouldn’t be able to sell assets to meet redemption requests, creating a vicious circle of falling prices, redemptions and firesales. Many thought that scenario finally came true in early December, when a high-yield bond fund called Third Avenue Focused Credit Fund announced it was halting redemptions and would slowly liquidate assets and pay out the proceeds. High-yield markets plunged on the news, and everyone feared the worst.
What investors feared—low liquidity causing a bottleneck of investors who couldn’t all get out of a fund quickly as they wanted to—actually happened! But the widespread contagion many envisioned would follow, never did. Markets realized the fund in question was a distressed debt fund, containing the junkiest of junk bonds, which are already widely known to be illiquidv. “Normal” high-yield bonds, by contrast, stabilized quickly and continued to be traded regularly. Markets functioned fine, and investors were able to buy and sell broad high-yield ETFs without incident. No panic, no firesales. When people wanted to sell, plenty stepped in to buy, even with banks restricted by the Volcker rule—it was always a myth that dealers are the ones who buy when there is blood in the streets. That role has always been played by steely nerved value investors. The Hetty Greens of the world.
When big fears like bond market liquidity are discussed globally pretty much daily (and we mean daily—Bloomberg’s Matt Levine kept an excellent roundup in his daily linkwrap, under the convenient header “People Are Worried About Bond Market Liquidity”), there is no surprise power. It might sound dismissive to say they are priced in, but it is generally true. Markets have considered the risk, and it’s reflected in prices—and market participants adapt and find solutions. Remember this the next time you see sweeping fears about market structure.
i Source: FactSet, as of 12/31/2015. S&P 500 Energy total return index, 12/31/2014 – 12/30/2015.
ii Source: FactSet, as of 12/31/2015. S&P 500 earnings growth for Q1, Q2 and Q3 2015.
iii Source: FactSet, as of 12/31/2015. S&P 500 Price Index returns.
iv Source: FactSet, as of 12/31/2015. S&P 500 total return index percent change on 12/16/2015.
v A hedge fund with similar issues also shuttered, though its problems had been brewing for months.