Download April 2016 - Paragon East Advisors

At a Crossroads?
The first third of 2016 certainly had its fair share of financial market excitement. The themes
that drove markets over the last 8 months (China, Global economic growth, oil and interest rate
policies) haven’t changed – what did was their direction or perception of direction. In this
month’s newsletter we’ll look at the current state of these factors along with two familiar ones:
valuation and volatility. These will likely play major roles in asset price direction in the months
ahead and require further understanding.
After falling roughly 10% from late November through February 11th, the S&P 500 Index quickly
retraced those losses and is up nearly 2% year to date. Why the dramatic turnaround? As the
following graph of the S&P 500 Index (blue line) and NYMEX Crude oil (red line) illustrates, the
two have been fairly positively correlated. (As a side note, we recently wrote a blog post on
correlation. You can see it, and other topics, by clicking here. We’ve also published several
white papers on financial education – budgeting, college savings strategies and reverse
mortgages. These can be viewed by clicking here)
Signs of rising gasoline demand, falling oil drilling rig counts, and rumors of an OPEC production
freeze (or cuts) buttressed crude oil prices. This helped assuage concerns of a crude oil driven
financial “crisis” in the banking sector or that a global economic slowdown was continuing
and/or worsening.
Only during late March/early April did the S&P/Oil price positive correlation deviate. What
happened to temporarily break this relationship? The Market’s eyes shifted to US monetary
policy. On March 16th, The Fed kept rates unchanged and adopted a more accommodative
posture. Even in the face of tightening labor markets, the Fed’s concerns over the condition of
the overall economy warranted, in their opinion, a reduction in their 2016 interest rate increase
expectations by 50 basis points (from 1.4% to .9%). In a speech just two weeks later, Fed Chief
Janet Yellen confirmed that global economic risks were a major determining factor in the Fed’s
decision. Both stock and treasury market participants cheered this news. Crude oil price related
“fears” were effectively put on the back burner.
As March ended, another one of the “culprits” for the stock market’s mid-August, 2015 swoon
– the health of China’s economy – also began showing some signs of stabilization. On March
31st, two indicators that measure March Chinese manufacturing activity showed significant
improvement. Coupled with positive Chinese General Services data released on April 5th, it
became easier to explain how the S&P 500 Index was reaching 2016 highs. The reversal in
crude, the removal of near term interest rate increases and the apparent stabilization of the
Chinese economy combined to rally stock and fixed income security prices. The question then
became, “Were both of these sharp moves higher justified?”
Generally speaking, equity bear markets (defined as a decline of 20%+ over at least a 2 month
period) have coincided with US recessions. The focus of the graph below is on the S&P 500
Index (green line) and the 10 year US Treasury yield (blue line). One of the reasons the 10 year
yield is so closely monitored is that it’s the basis behind most residential mortgages. It is
commonly referred to when discussing the US government bond market in general.
Economic data is quickly assimilated into bond prices so when “bad” economic news is
released, demand for bonds increases as investors anticipate Fed policy to be “looser” or
“easier”. What’s unique about our current situation is that since the Federal Funds rate (the
interest rate that banks charge each other for loans) went to 0% in ’09 (red line); the trend of
the 10 year yield has continued lower (black lines). As the chart shows, 2000 and 2007 were
market tops. The question becomes, “Is our current situation mirroring those periods and is the
decline in 10 year yields signaling a repeat performance?”
As we mentioned earlier, the factors that induced the Market’s late ’15 decline have reversed
to a certain degree. And lower interest rates have, historically, justified higher stock prices. This
is through its direct impact on valuation. One way to value a company today is based on the
present value of its future, expected cash flows. The lower the interest rate (discount rate in
this example) used in these calculations, the higher the present value of those future cash
receipts.
Another correlation between low interest rates and higher equity demand is through expected
rates of return. Simply put, if one were to buy a 10 year US government bond today, they would
be receiving a current yield of roughly 1.90%. And, the price of that bond is only going to
increase is if interest rate expectations go down. In low interest rate environments, investors
look for the higher yields and expected returns that equities can provide.
Is the US government bond market telling us that investors expect interest rates to continue to
decline? Are expectations of future economic slowing rising? There may be a dichotomy
brewing between rising stock and bond prices.
The current environment (relatively high stock prices with declining earnings) has led to higher
PE ratios (stock’s price divided by its earnings per share). The graph below illustrates this point.
The red, upward sloping line is a regression (a historical statistical measurement) of the S&P
500 Index. P/E 10 (blue line) measures the monthly averages of the S&P 500 Index’s daily close
divided by 10 year average of real (inflation adjusted) earnings. It is also depicted with its
regression (lower red line). While the graph is probably (and understandably) somewhat
confusing, what is critical to understand is that both the S&P 500 Index and the PE 10 ratio are
at historical premiums to their regression. The farther away it gets from the regression, the
larger the price move that is required for it to return. While past performance is no guarantee
of future results, this bears noting.
Another factor driving the rebound in US stock prices was the state of global interest rates.
Both Europe and Japan effectively adopted negative interest rate policies (again, please see a
recent blog post for clarification/more information). One motivation behind this monetary
policy is to encourage asset price inflation. The transition mechanism is as follows - lower
interest rates encourages bank lending, and, subsequently, spending. This “demand” increases
prices. This tends to be the case with securities as well – namely stocks and bonds. The fact is
many global investors (European, Chinese and Japanese in particular) currently consider US
stocks (by virtue of our relatively healthier domestic economy) to be the premier equity asset
class. The US stock market has become the “best investment in town”.
As the US Market rebounded from its February lows and risks faded, fears ebbed. Nowhere was
this more evident than in the dramatic decline in the Volatility (VIX) Index. While there is also a
blog post on the VIX, in a nutshell the VIX represents one measure of the Market’s expected
volatility over the upcoming 30 day period. The graph below shows the historical relationship
between S&P 500 Index and the VIX.
What you can see from this depiction is that periods of Market stress (red arrows) correspond
to high levels of expected volatility, and vice versa. This is an example of a contra-indicator and
may seem a bit counter intuitive. To elaborate, when there is a lot of fear and expected future
volatility (high VIX), it, historically, has been an indicator of a potentially good time to invest –
and vice versa.
We are currently near the lower end of the VIX’s range. It should be noted that the VIX can
remain at low levels for fairly long periods of time and there is no guarantee that it will
necessarily move higher (and correspond with a Market move lower). This development just
bears watching.
Contrastingly, another contra indicator provides some support for the Market. As many of us
know, sentiment can be very influential. For the most part, many investors and analysts are
skeptical of the Market’s recent rebound. As an example, individual investor sentiment, as
measured by the American Association of Individual Investors, is at a relative low. Results from
last week’s poll showed that roughly 47% are bullish – up from 43% at the Market lows of
February but well below 54% recorded in late ‘14/early ’15. At that time, the S&P 500 Index was
approximately where we sit today. The fact that bullish sentiment is relatively low could mean
that there may be cash on the sidelines waiting for a better entry point to invest.
There is a good reason for holding some cash. Everyone should have an emergency fund.
Ideally, one should have at least 6 months worth of expenses saved in order to deal with any
unforeseen event(s). Outside of the emergency fund, however, better opportunities exist for
cash. In this low interest rate environment we currently live in, many don’t realize that cash and
many US government bonds generate a negative real rate of return – approximately 2% for
cash given the current rate of inflation.
To conclude, fears of another financial crisis have eased. Whether this is temporary or more
permanent, no one can be sure. What is important is being aware of how certain factors
influence markets. Being mindful of various states of “expectations” can help provide some
guidance as to where markets may head in the future. Markets can be volatile. The good thing
about volatility is that it can remind one to address their risk tolerance. Assuming that this has
been thoroughly vetted, excess volatility shouldn’t alter one’s course of action. If anything,
those times can provide opportunities – either to discuss new objectives, ask questions,
examine options or reconfirm your disciplined approach to your investment strategy. We’re all
ears if you’d like to have that conversation.
* The material (charts, graphs and statistics) used in this newsletter is based on public
information. While we consider it to be reliable, we don’t represent that it’s accurate or
complete. The content is not an offer to sell or the solicitation of an offer to buy any security in
any jurisdiction where such an offer would be illegal. It should not be construed as a personal
recommendation as it doesn’t take into consideration one’s investment objectives and
circumstances. One should note whether or not any particular statement made or conclusion
drawn is suitable to their needs. Past performance is not a guide to future performance. Every
investment strategy has the potential for loss. This material is presented for informational
purposes only.