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News, research and market insights from our team of experts.
Second quarter equity performance was remarkable for just how unremarkable it was. Following an unnerving first quarter – one that featured a deep plunge followed by an explosive recovery – the stock market largely took the second quarter off, moving sideways throughout much of the period. Even the United Kingdom's surprising decision to leave the European Union (a.k.a. "Brexit") proved nothing more than a momentary speed bump. The much-watched S&P 500 Index, a proxy for large cap US stock performance, managed a 2.5% increase for the quarter, bringing first-half results to a respectable 3.8% gain. International Developed Market stocks (MSCI EAFE Index) continued a six-year stretch of relative under-performance, declining 1.5% in 2Q and 4.4% for the year-to-date period. With international losses offsetting domestic gains, globally-diversified equity investors have essentially experienced flat results through the first half of 2016.
Whereas stocks have delivered precious little, bonds have exceeded all expectations. With interest rates around the world plunging to new all-time lows, the US bond market (Barclays Aggregate Bond Index) gained 2.2% for the quarter, pushing YTD gains to an impressive 5.3%. Of course record low yields – the 10-year Treasury recently touched 1.37% - could very well spell record low returns in the future for fixed income investors. Still, the experience of Japan and Europe proves that yields in the US have room to fall further, with even zero representing no bound.
Like bonds, alternative investments have been a valuable component of a well-diversified investment portfolio so far in 2016. In particular, MLPs and natural resource equities continue to rebound strongly, putting a dismal 2015 further into the rearview mirror. Conversely, the hedge fund industry continues to suffer from growing pains and market headwinds, though performance varies widely across individual funds.
Since it's short-lived post-Brixit dip, the S&P 500 Index has experienced something of a mini-surge recently, climbing 8% higher in just four weeks. On the surface, this sudden jump to new all-time highs seems more than a little puzzling in the wake of the UK's decision. Add in recent news of escalating nonperforming loans at Italian banks, a raft of global terrorist attacks and a presidential campaign pitting two of the least popular candidates in history, and one might reasonably conclude that investors have fallen asleep at the equity wheel. We're not so sure.
Since the financial crisis of 2008, investors have become conditioned to expect central bank-directed monetary stimulus every time the global economy hits a rough patch. That appears to be the case now. Investors are betting that the US Federal Reserve Bank will be forced to delay interest rate increases, while other major central banks around the world - the Bank of England, the European Central Bank, the Bank of Japan – will continue to dial up their quantitative easing and negative interest rate polices. Even talk of "helicopter money" (i.e., countries creating money out of thin air for spending or debt monetization) seems to be gaining credence in some investment circles. We doubt any major countries - and Japan seems the closest - are ready to start dropping dollars/yen/euros/pounds from the sky, but the fact such talk has even surfaced underscores the "do-whatever-it-takes" mantra of our monetary authorities. In this environment, it is little wonder that some investors have taken to treating "bad" news as good news for stock market prices.
Are Stocks Overvalued?
Since 2013, a year the S&P 500 Index ripped to a 32% gain, Oxford has cautioned clients not to expect too much from their equity portfolio. We have consistently noted the stretched valuations of equities based on such historically reliable long-term measures as the cyclically adjusted price-to-earnings ratio (a.k.a. the "Shiller P/E") and the market capitalization-to-GDP ratio. These and other gauges of stock market valuation indicate stocks have become overpriced and are therefore vulnerable to a painful reversion to the mean.
However, a weakness of valuation measures such as the ones cited above is that they fail to adjust for present market conditions. It was legendary investor Sir John Templeton who once said, "the four most dangerous words in investing are: 'this time it's different.'" Wise words from a wise man. But we suspect even Templeton would acknowledge that every market cycle presents a different set of circumstances and follows its own unique script - one that ultimately results in differing (and often unpredictable) outcomes. A key feature of the current market cycle that is undisputedly different this time is the record low yields on fixed income securities. Never before have bonds in the US or around the globe offered so little compensation to investors. As the first half of 2016 proved, low yields can move lower still, producing short-term bond price appreciation. Ultimately, however, investors cannot escape the gravitational pull of ultra-low starting yields. For bonds, the future is largely written.
In a world where fixed income securities offer such little upside, a rational argument can be made that a premium valuation for equities is warranted. After all, if investors can't achieve acceptable returns from their bond portfolio, they must at least consider directing a greater slice of their portfolios to equities (or other risky assets) in order to earn better potential results. This relative valuation argument seems to be the core justification for buying equities used by every bullish strategist on Wall Street today. We are sympathetic to this view and believe it is not entirely without merit. However, it is important to also point out that Wall Street strategists using the relative valuation argument are comparing apples to oranges (or Ferraris to Hondas). A truly bad year for stocks looks nothing like a bad year for bonds. Investors accept substantially more risk when they invest in stocks instead of bonds and should never forget that the consequences of being wrong are far greater.
What To Do
We believe the current financial landscape presents a particularly challenging set of circumstances for investors. Central bankers are seemingly forcing market participants into an unappetizing choice: accept extremely low returns on safe securities or stretch for returns using riskier (and quite possibly overvalued) ones. Nobody, including Oxford, knows how the unique conditions of today will ultimately play out. In this environment, we urge investors to:
Most of all, understand that successful investors needn't choose sides. Falling too deeply into the bear or bull camps has been the undoing of many investors. The mucky middle is okay. Confusion is to be expected. In fact, recognizing and accepting what little we know about the future is half the battle to becoming a good long-term investor.
The above commentary represent the opinions of the authors as of 7.28.16 and are subject to change at any time due to market or economic conditions or other factors.Print