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In what has become an annual tradition, one of Oxford Financial Group Ltd.'s long-time clients, Mr. J. Doe, recently met with me to review his investment portfolio and discuss the outlook for 2016. A retired corporate executive, Mr. Doe arrived at our office with a Starbucks Venti in one hand and a binder of notes in the other. I knew from past experience with him that our conversation would be wide-ranging, stimulating and likely to hit on a number of timely investment topics. No doubt the recent equity market declines would be weighing heavily on his mind, and certainly he would want to hear our views on interest rates, China and commodities prices. With new "cracks" forming in the investment landscape daily, it was anyone's guess as to where our conversation might lead. Hmmm, no wonder he went for the Venti.
Mr. Doe: As you know, Bob, I'm a close follower of markets and my portfolio. I have to say I'm feeling pretty spooked at this point and I don't sense that things will get better anytime soon. Oxford has been warning me for some time to prepare for a period of lower returns but this looks like something worse - this looks increasingly like a bear market!
Schaefer: It looks and feels a lot like a bear market to us too. Even before the big sell-off here in January we were referring to 2015 as a "stealth" bear market. The S&P 500 Index managed to breakeven during 2015 and finished the year not far off its all-time highs, but those numbers really masked underlying weakness. Beyond a handful of large momentum-growth stocks that propped up the index, everything else finished the year in negative territory. In fact, as of December 31, 36% of the stocks comprising the S&P 500 were down at least 20% from their 2015 highs. That number was over 50% for small cap stocks. I find those stats pretty amazing when you consider the S&P 500 itself was positive.
Mr. Doe: I guess that underlying weaknesses would explain why active managers continue to have such a hard time beating the indices?
Schaefer: Yes, that's certainly part of the answer. Most active managers have a valuation discipline when selecting stocks, even many growth managers. But last year you really just wanted to pile into the handful of momentum stocks that were moving up the fastest, regardless of how expensive they had become. It felt a little like 1999 in that regard.
As you know, we have studied the active versus passive (i.e., indexing) issue closely. In highly "efficient" markets like large cap US stocks, we think there is definitely a place for low-cost, tax-friendly indexing. But even within efficient markets like domestic equities, there is a clear cyclicality between active and passive performance. We often see the indexes do better during bull markets, while the active managers show their value on the downside. The current trend favoring indexing will eventually subside. We think there is a place for both in a portfolio.
Mr. Doe: Well, at this point my beef really isn't with US equities. The recent weakness comes after a long period of strong results. I can live with that. On the other hand, many of the areas we have diversified into, such as international stocks, continue to lag behind.
Schaefer: Agreed. It has been a frustrating period for diversified investors. Hindsight being what it is, we should have just put everything in the S&P 500 after the Financial Crisis and let it run. Of course, we would never do that - and I know you would never have allowed us to do that. Any such move would have been pure speculation and exposed you to extreme risk. Spreading risks by diversifying broadly across regions and strategies continues to make a ton of sense.
Mr. Doe: Yes, I know you're right, but it seems to me the long-term outlook has changed for some of the asset classes we use to diversify. China's slowdown, for instance, appears to be a longer-term trend that's impacting the entire emerging markets space, and don't even get me started on our allocation to natural resources!
Schaefer: I think you raise some important issues. Let's take China first. China basically spent its way out of the 2008 crisis by pouring money into new highways and other infrastructure projects they mostly didn't need. They can't do that again. Mounting debt and an aging population have become headwinds during a time when China's leadership is transitioning the economy from manufacturing and exports to services and internal consumption. It's a complex job and there will be mistakes made along the way.
We would agree that the extreme growth phase of China's economic maturation is largely over. We don't think China is ready to head off a cliff but we think it will continue to gradually slow. We can't totally dismiss the chance of a "hard landing" – something that could pull the entire globe into recession – but we see that as still unlikely. Nonetheless, even a gradual slowing will continue to have adverse implications for other emerging markets that count on China as a buyer of their goods and natural resources.
Mr. Doe: So you agree, the game has changed for emerging markets?
Schaefer: For now, yes, the game has changed. Growth is slowing, external capital flows are reversing, and corporate profitability and currencies are both under pressure. You'll recall that we reduced your emerging markets exposure early in 2015 and then we subsequently reduced it again during the third quarter. The result is very little EM exposure today. However, this is not a permanent change in our thinking. Emerging market stocks are down nearly 40% from their 2014 highs. At some point, they become too cheap to ignore. And just to be clear, not all emerging market countries have seen their long-term prospects decline. India, for instance, has an extremely young and growing workforce; it could eventually help plug the growth hole left by China.
Mr. Doe: And what about natural resources? With Chinese demand for commodities slowing and OPEC seemingly pumping as much as they can, I'm not sure our allocation to natural resources still makes sense.
Schaefer: I'm not going to sugarcoat it, it's been a bloodbath for natural resource stocks. It's amazing how quickly the outlook has changed, particularly for oil, which has declined from over $100 a barrel to under $30 in approximately 18 months. At $30 none of the shale fields in North America make economic sense. There will be no new drilling and the list of bankruptcies will grow. But $30 oil doesn't work for OPEC either. Saudi Arabia is running a budget deficit equal to 20% of GDP! Something has to give.
Many commodities - not just oil - are trading well below their marginal cost of new supply. This can't go on forever or we will get massive supply shortages resulting from producers halting new projects. Supply and demand must find a new equilibrium price; we just don’t know how quickly that will come. To take advantage, you want to be invested in natural resource companies with staying power, those that target low cost producers with solid balance sheets.
Mr. Doe: It all seems pretty scary to me. Where does one invest these days for safety? I know Oxford has consistently told me that rising rates won't doom my fixed income portfolio, but I'm wondering if the Fed's December move changes your view?
Schaefer: Not really. We think the Fed will have difficulty raising rates more than a couple times this year. The economy is too weak and the inflation outlook too tame. The strength of the US dollar and the recent rise in corporate bond yields are also conspiring to pressure corporate profitability. The Fed will almost certainly dial back the interest rate forecast that it has been telegraphing to the markets.
Mr. Doe: Careful now, that sounds a little like a prediction...I know you guys shy away from consulting the old crystal ball. What if the Fed's resolve is stronger than you think?
Schaefer: Well, in truth, it just doesn’t matter that much. Fixed income investors' fear of rising rates is largely misplaced. If you're a long-term fixed income investor you actually want rates to rise, as this will mean receiving a higher yield going forward. When it comes to bond investing, a little short-term pain means greater long-term gains. If your primary concern is safety, managing your equity risk is far more important than worrying about the risk of rising rates on your bonds. As one of my colleagues likes to say, a bad year in the bond market is like a bad day in the stock market. When the equity seas get rough, bonds often benefit from the resulting flight to safety. We continue to like bonds as an equity hedge and an overall source of portfolio protection.
Mr. Doe: Okay, we've kind of jumped around. Help me pull it all together. What are some of the key investment themes that we should be positioned for as we head into 2016? Notice I asked for "themes" not predictions.
Schaefer: Let me see if I can summarize our thinking.
Mr. Doe: Well, Bob, the markets may not be pleasant right now, but I do take comfort in knowing Oxford is on top of it. As always, I appreciate your time and insights.
Schaefer: What, that's it? I have to say you're letting me off the hook pretty easy this year. We've not even talked about the upcoming presidential election?!
Mr. Doe: No thank you. My Venti isn't big enough for that one. As The Donald would say, that conversation would be HUGE!
The above article represents the opinions of the author as of 1.28.16 and is subject to change at any time due to market or economic conditions or other factors.Print