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From The No-Load Fund Investor, 1/16...
A Difficult Year
The stock market ended a difficult year with a difficult month. The broad U.S. equity market lost more than 3% in December, as small caps led the way lower. The Russell 2000 small-cap index lost 5.2%. For the year, the S&P 500 was up a little with dividends, with the large-cap growth sector of the market performing best. Virtually all other types of stocks had down years.
The equity market has become more volatile on the cratering pricing for oil and natural gas and what it signals for the global economy at large. As a growing number of investors become afraid once again of a global economic downturn, various types of riskier assets in addition to those related to energy are experiencing especially unnerving declines: economically sensitive equities, sure, but also small-cap stocks generally and high-yield bonds.
The declines in the high-yield market even led the managers of Third Avenue Focused Credit (TFCVX), a significant high yield bond fund, to take the virtually unprecedented steps of blocking withdrawals and announcing the liquidation of the entire fund over the next several months. Apparently, after many months of poor performance, withdrawal requests from this once-popular fund had become so substantial that the managers believed that to meet them, they would have to sell off the fund’s holdings at such low prices that remaining shareholders would be crushed. News of the withdrawal halt and fund liquidation sent shockwaves through the market for high-yield bonds, as investors figured other such funds would have to sell bonds at fire sale prices to generate the cash for redemption requests.
The turmoil in the high-yield market suggests another issue. When considering investment risk, most people ignore a biggie: liquidity. Instead, they focus on past volatility, valuations, or operations, all of which are important. However, for many fixed income, “alternative” and proprietary instruments from various investment houses, the risk that the investment becomes hard to sell in a decline can be the most important one of all.
Forecast for 2016
In our stock market outlook for 2015 (“Forecast for 2015,” January 2015), we expressed a cautiously bullish view. We identified several positive factors, including low interest rates; reasonable equity valuations in the context of low interest rates; an improving economy with little inflation; and exceptionally friendly monetary policy from central banks around the world, including the Federal Reserve Board. Specifically, we forecast a total return for the year from the U.S. stock market of between 5% and 10%. We also said we felt large-cap U.S. stocks were much more attractively valued than small and midsize stocks, and would have a better year as a result. We also wrote that we preferred the U.S. to foreign markets.
Our forecasts were a mixed bag. The stock market did not perform as well as we had expected. The S&P 500 Index of large U.S. stocks lost a little before dividends, and was up only 1.4% with dividends reinvested. This meager result, however, was much better than what most other indexes achieved, including those for smaller stocks. For example, while the Russell 1000 Index of relatively large companies gained 0.9% for the year, the Russell Mid Cap Index lost 2.9% while the small-cap Russell 2000 Index lost 4.4%. Meanwhile, broad indexes of foreign developed markets were essentially unchanged for the year, while those for emerging markets produced huge losses on the order of 15% or more.
Most of the year’s worst performers were in the natural resources/commodities area. Because we generally avoid commodity-oriented mutual funds, our Best Buys models performed acceptably, given the mediocre performance (or worse) of virtually all types of liquid assets.
1.) Because of a tough earnings environment especially in energy, the stock market is quite expensive relative to corporate operating earnings of the past 12 months.
The S&P 500 has a price/earnings (P/E) ratio of almost 22 on operating earnings achieved over the past 12 months (‘trailing’ earnings). A year ago, the P/E on trailing 12-month earnings was about 19. However, on cumulative, projected per-share earnings for the next 12 months (‘forward’ P/E), the S&P 500 has a P/E of about 17. Of course, this suggests optimistic earnings assumptions for the market on the part of Wall Street analysts. If the global economy grows only slowly (and earnings are lower as a result), the actual P/E a year from now is likely to be higher.
The median P/E of the S&P 500 during the post-World War II period has been slightly more than 15. However, the market has generally performed at least okay with a P/E within a few percentage points of the median. It has mainly been when the market P/E has exceeded 20 or so that returns over the next several years have been paltry, or negative. (There are exceptions to this, of course.)
It’s also important to weigh valuations across various market components. For example, if the largest stocks within an index have low valuations, their outsized weightings will bring down the overall P/E and present a misleading picture. This is especially relevant to investors in actively managed stock funds, few of which concentrate their assets in an index’s largest companies.
Though the largest stocks within the S&P 500 began 2015 with lower valuations, on average, than smaller companies within it, the outperformance of the former has caused their average P/E to rise to approximately the same level as that of their siblings. You can read more of our 2016 market forecast in the January issue of The No-Load Fund Investor.
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