OVERVIEW
The U.S. economy continues to exhibit strength and is an economic growth leader amongst developed economies; but still relies heavily on easy monetary policy (zero short term interest rates). There is also evidence that the strong dollar is having a negative impact on corporate earnings. Meanwhile the rest of the global economy continues to rely on monetary policy (zero short term rates and quantitative easing), and fiscal stimulus spending. China is seemingly having difficulty with their transition from an export driven economy to a domestic consumer spending driven economy. All global asset class returns were positive in the first quarter of 2015.
Market Summary – First Quarter 2015 Index Returns:
World Stock Market Performance with selected headlines from Q1 2015:
Most foreign countries that export to the U.S. are benefiting from the recent strength of the U.S. dollar; as the currency exchange makes their products more competitive on the global market and cheaper to U.S. consumers. The U.S. dollar has continued its strengthening trend and the Euro, which traded for $1.47 one year ago, currently sits at $1.06. This 28% change between the value of the two currencies makes it harder for U.S companies to sell their goods in the Euro zone and easier for Euro zone companies to sell their goods in the US. The German stock market, which relies heavily on exports, is up over 20% so far this year in local currency (Euros). One reason for the massive change in the exchange rate is that the European Central Bank (ECB) just started their $1 Trillion Euro quantitative easing program of monthly bonds purchases (sending interest rates lower and decreasing money flows into the Euro); whereas the Federal Reserve is about to raise short term interest rates, which attracts money flow into the US Dollar.
World Asset Classes First Quarter Index Returns:
Fixed Income Results First Quarter 2015:
The Fixed Income markets were surprisingly strong, pushing prices higher and yields lower across many bond categories.
A DEEPER LOOK
Given the strong performance of the six year bull market, we would like to examine broad measures of valuation; with the caveat that while valuation reverts back to mean levels over the intermediate term, valuation alone will not cause a bull market to correct. High valuations and low valuations can persist for long periods of time, and one cannot use them to time the markets.
With that said, there are two primary reasons for a stock bull market to end: recession and rising interest rates. At the beginning of the year, investors in the U.S. expected the Federal Reserve to raise the overnight lending rate for the first time since prior to the Great Recession during their meeting this coming June. Due to the very strong dollar, the Fed has now communicated that it may wait until later in the year. Investors now expect a rate hike near September, and potentially later. The yield curve has dropped substantially from one year ago and since December, pushing bond prices up and extending the long term bull market in bonds.
We have spoken in the past about the Shiller P/E or cyclically adjusted price earnings (CAPE) ratio, which adjusts P/E ratios over a full business cycle of 10 years. The bottom line is that the Shiller CAPE ratio is so high for US Large Cap and Small Cap stocks that the real expected return is close to zero; while the expected return for International Developed and Emerging Markets is higher but more volatile. Research Affiliates has provided a great chart of numerous countries and asset classes, which can be viewed here:
https://www.researchaffiliates.com/AssetAllocation/Pages/Equities.aspx
A second measure of broad market valuation is Tobin’s Q, which compares the total stock market valuation to the net worth or replacement costs of all publicly traded companies. The ratio is now at the highest level at any time since 1900 except for the dot.com bubble of 2000. An excellent graph can be viewed at:
http://www.advisorperspectives.com/dshort/updates/Q-Ratio-and-Market-Valuation.php
Low oil prices have only led to a couple of small bankruptcies in the energy sector this year. West Texas Intermediate (WTI) has dropped from a peak 2014 summer price of $107 a barrel to a $44 low and sits at $55.74 a barrel today. U.S. exploration and production, including fracking, is slowing down since it became unprofitable to drill. Schlumberger, the world’s largest oil exploration and production (E&P), company just announced layoffs for 15% of their workforce or 11,000 employees. More waves of layoffs in the energy sector are expected. While reductions will help reduce oil supply, there is also an issue with oil demand from the slowing global economy. The energy sector pain from such a price change is difficult to predict and depends on how long oil prices stay this low. Earnings estimates for S&P 500 companies are coming down due to the lower revenue in the energy sector and the lower value of overseas profits from the much stronger dollar/weaker Euro. The reduction in expected global growth is affecting commodity prices, which declined significantly during the quarter. A significant part of the declining global growth is the slowdown in China and their recent heavy drop in imports and exports. China’s imports decreased 12.3% in March from a year earlier and exports fell 14.6% vs. expectations of an 8.2% increase. China is the leading trade partner for many countries around the globe and a driver of demand for commodities.
The other dominating headline affecting stocks during the first quarter is the political maneuvering in the Euro zone between the European Central Bank, Germany, and Greece. Greece voted for a new government on January 25 that continues to attempt to re-negotiate their aid-for-austerity package. The negotiations continue to dominate headlines. So far, Greece has made all debt payments due, but there is question as to what will happen by May.
CONCLUSION
After reviewing many broad market valuation metrics, including P/S, MCAP/GDP, Shiller CAPE and Tobin’s Q, all appear close or above two standard deviations of the mean; and with the potential for the Federal Reserve to raise interest rates, the bull market of six years for U.S. stocks may be challenged. It is wise to remember that no one has the ability to reliably time the markets and that valuations may stretch even more before reverting to their historic mean. Valuations can also come down due to increased earnings and Book Values without the need for the stock price to fall. On top of valuation metrics being unreliable for market timing, there is also the additional complication in the investing environment of Central Banks (Fed, ECB, PBOC, BOJ, etc.) around the world actively engaging in financial markets either directly through quantitative easing or indirectly through traditional monetary tools. "Don't fight the Central Banks" has been a broad market mantra over the past couple of years, however there is growing concern about what will occur when the Fed raises rates while the rest of the world continues with low interest rates and quantitative easing. We plan to maintain current asset allocation targets for all portfolios with a focus on rebalancing strong asset classes back to target. We also will delay new cash investments or extend dollar cost averaging programs when purchases are needed in asset classes where the values are well above the historic mean. This means that a portfolio may not have the full target allocation in the overvalued asset class, causing a temporary "under weighting". It is important to note that we are not timing the market and are not calling the end of the bull market; we are simply exercising prudence and caution and recognizing the evidence that there may be increased risk and reduced upside in certain asset classes where the values have become lofty relative to the long term average; however these asset classes will remain in all portfolios. Our current fixed income strategy is short in duration with high credit quality with the expectation of higher rates later in 2015. Asset class valuations will also affect our financial planning recommendations, as the sustainable withdrawal rate from portfolios when asset class valuations are high is lower than when asset class values are normal or low. Furthermore, Monte Carlo scores in financial plans are likely overestimated when asset class values are lofty (just as Monte Carlo scores are likely underestimated when asset class values are low, such as during the Great Recession). We will be discussing the implications of this with clients as we review their financial plans with them.
1. Standardized Performance Data and Disclosures
Russell data © Russell Investment Group 1995-2014, all rights reserved. Dow Jones data provided by Dow Jones Indexes. MSCI data copyright MSCI 2014, all rights reserved. S&P data provided by Standard & Poor’s Index Services Group. The BofA Merrill Lynch Indices are used with permission; © 2013 Merrill Lynch, Pierce, Fenner & Smith Inc.; all rights reserved. Citigroup bond indices copyright 2014 by Citigroup. Barclays data provided by Barclays Bank PLC. Indices are not available for direct investment; their performance does not reflect the expenses associated with the management of an actual portfolio.
Past performance is no guarantee of future results. This information is provided for educational purposes only and should not be considered investment advice or a solicitation to buy or sell securities. Diversification does not guarantee investment returns and does not eliminate the risk of loss.
Investing risks include loss of principal and fluctuating value. Small cap securities are subject to greater volatility than those in other asset categories. International investing involves special risks such as currency fluctuation and political instability. Investing in emerging markets may accentuate these risks. Sector-specific investments can also increase these risks.
Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, liquidity, prepayments, and other factors. REIT risks include changes in real estate values and property taxes, interest rates, cash flow of underlying real estate assets, supply and demand, and the management skill and creditworthiness of the issuer.
Lake Tahoe Wealth Management, LLC is an investment advisor registered in the States of Nevada, New York, North Carolina, South Carolina, and Texas.
Principal Risks:
The principal risks of investing may include one or more of the following: market risk, small companies risk, risk of concentrating in the real estate industry, foreign securities risk and currencies risk, emerging markets risk, banking concentration risk, foreign government debt risk, interest rate risk, risk of investing for inflation protection, credit risk, risk of municipal securities, derivatives risk, securities lending risk, call risk, liquidity risk, income risk. Value investment risk. Investing strategy risk. To more fully understand the risks related to investment in the funds, investors should read each fund’s prospectus.
Investments in foreign issuers are subject to certain considerations that are not associated with investment in US public companies. Investment in the International Equity, Emerging Markets Equity and the Global Fixed Income Portfolios and Indices will be denominated in foreign currencies. Changes in the relative value of these foreign currencies and the US dollar, therefore, will affect the value of investments in the Portfolios. However, the Global Fixed Income Portfolios and Indices may utilize forward currency contracts to attempt to protect against uncertainty in the level of future currency rates (if applicable), to hedge against fluctuations in currency exchange rates or to transfer balances from one currency to another. Foreign Securities prices may decline or fluctuate because of (a) economic or political actions of foreign governments, and/or (b) less regulated or liquid securities markets.
The Real Estate Indices are each concentrated in the real estate industry. The exclusive focus by Real Estate Securities Portfolios on the real estate industry will cause the Real Estate Securities Portfolios to be exposed to the general risks of direct real estate ownership. The value of securities in the real estate industry can be affected by changes in real estate values and rental income, property taxes, and tax and regulatory requirements. Also, the value of securities in the real estate industry may decline with changes in interest rate. Investing in REITS and REIT-like entities involves certain unique risks in addition to those risks associated with investing in the real estate industry in general. REITS and REIT-like entities are dependent upon management skill, may not be diversified, and are subject to heavy cash flow dependency and self-liquidations. REITS and REIT-like entities also are subject to the possibility of failing to qualify for tax free pass through of income. Also, many foreign REIT-like entities are deemed for tax purposes as passive foreign investment companies (PFICs), which could result in the receipt of taxable dividends to shareholders at an unfavorable tax rate. Also, because REITS and REIT-like entities typically are invested in a limited number of projects or in a particular market segment, these entities are more susceptible to adverse developments affecting a single project or market segment than more broadly diversified investments. The performance of Real Estate Securities Portfolios may be materially different from the broad equity market.
Fixed Income Portfolios:
The net asset value of a fund that invests in fixed income securities will fluctuate when interest rates rise. An investor can lose principal value investing in a fixed income fund during a rising interest rate environment. The Portfolio may also be affected by: call risk, which is the risk that during periods of falling interest rates, a bond issuer will call or repay a higher-yielding bond before its maturity date; credit risk, which is the risk that a bond issuer will fail to pay interest and principal in a timely manner.
Risk of Banking Concentration:
Focus on the banking industry would link the performance of the short term fixed income indices to changes in performance of the banking industry generally. For example, a change in the market’s perception of the riskiness of banks compared to non-banks would cause the Portfolio’s values to fluctuate.
The material is solely for informational purposes and shall not constitute an offer to sell or the solicitation to buy securities. The opinions expressed herein represent the current, good faith views of Lake Tahoe Wealth Management, LLC (LTWM) as of the date indicated and are provided for limited purposes, are not definitive investment advice, and should not be relied on as such. The information presented in this presentation has been developed internally and/or obtained from sources believed to be reliable; however, LTWM does not guarantee the accuracy, adequacy or completeness of such information.
Predictions, opinions, and other information contained in this presentation are subject to change continually and without notice of any kind and may no longer be true after the date indicated. Any forward-looking statements speak only as of the date they are made, and LTWM assumes no duty to and does not undertake to update forward-looking statements. Forward-looking statements are subject to numerous assumptions, risks and uncertainties, which change over time. Actual results could differ materially from those anticipated in forward looking statements. No investment strategy can guarantee performance results. All investments are subject to investment risk, including loss of principal invested.
Lake Tahoe Wealth Management, LLC is an investment advisor registered in the States of Nevada, New York, North Carolina, South Carolina, and Texas.