hanks
to a rollicking year-end post-election rally, the stock market is up big
time, and who can doubt that buyers are correct in thinking that happy
days are almost here again! Surely unleashed animal spirits can only
mean that a return to vibrant growth is nigh! Perhaps now the captains
of industry will regain their optimism and overcome a reticence towards
investing in their businesses that for too long could only be assuaged
through massive debt issuance and share buy-backs. Just maybe, at long
last, real earnings will come through and justify those bonuses and
stock option awards.
All
sarcasm aside, it is true that 2016 ended on a surprisingly high level
of optimism in the markets. In the midst of such cheer on Wall Street,
it is easy to forget that the year began in a very different mood. The
S&P 500 equity index suffered its worst start to a year in its
history — down 10.5% year-to-date at the low point in February. Globally,
equities lost $5 trillion of value in the year's opening weeks.
Indeed,
a year ago there were good reasons to be concerned about the world's
economic and financial health. The possibility of a slowdown in the U.S
economy increased uncertainty about the course of interest rates and the
fate of the banking sector, still under a cloud from the financial
crisis. Additionally there was doubt about China's ability to maintain
its robust growth rate; China's demand for commodities, technology and
other goods to support its increasing prosperity had helped to prop up
global economic activity during the fragile period following the
financial crisis. Fears of repercussions from a collapse in petroleum
prices to about $27 per barrel depressed sentiment, and a rash of
bankruptcies in a debt-laden oil sector added to fears about banks'
exposure to energy industry lending. Banks — seemingly at the epicenter of
every financial crisis real or imagined—saw their stock prices fall 18%
at their mid-February lows.
It was
a nail-biting year for politics as well. Britain's "Brexit" referendum
on European Union membership in late June loomed large during the year's
first half. The negative result at first shocked stock markets — with
European banks hit especially hard — and roiled currencies. Stocks
promptly recovered, however, as markets realized that changes in
Europe's financial system and trade links would not occur quickly, and
fears for the worst might not be realized at all. An increasingly nasty
political fight in the U.S. also added to market unease, as did the
usual suspects — Middle East conflict, terrorism, and aggressiveness on
the part of former Cold War adversaries.
As the
year progressed, market action reflected the flow of news. Developments
in the global bond markets were extraordinary. A "flight to safety"
phenomenon led to very low yields in the European government bond
sector; at its peak last summer fully $14 trillion of debt traded to
yield the purchasers a negative return.* Switzerland's entire stock of sovereign debt traded at a
negative yield at one point. Such conditions do not go unnoticed.
Corporations, seeing an opportunity to raise capital at a historically
low cost, issued a record amount of debt in 2016, as the "low for long"
interest rate environment persisted through the year.
Interestingly, despite the discouraging rout in January and February,
equities gradually recovered, overcame various upsets (such as the
Brexit vote) and by the end of the third quarter had produced average
gains for holders. The S&P 500, in fact, enjoyed its biggest rebound
from a significant decline since 2009. Some improvement in business
profitability, and perhaps a dawning realization that not all was lost
in the world, increased demand for equities. Industrial and financial
issues, shunned at various times in the preceding months, came to life.
The perverse tendency of stock markets to rise in spite of worrisome
news and depressed sentiment was in full display.
The
real fireworks for stocks began when the results of the U.S. election
became known. Prices in after-hours markets initially plunged, but
buying began in earnest before exchanges opened the next morning as
buyers realized that a new, "unified" American regime was likely to
promote highly stimulative fiscal and tax policies. Banking shares,
shunned for so long, were among the top beneficiaries as promises of
lightened regulation helped improve sentiment towards banks. Stimulative
actions by governments tend to increase inflation and, in turn, interest
rates—already on the rise due to Federal Reserve rate decisions, as well
as market conditions. Short-term treasury bills, for example, offered
their highest yields since 2008. Following the election, longer-term
rates rose significantly as well: the yield on the ten-year treasury
note rose to about 2.5% after having hit a low of 1.3% last summer. A
higher-rate environment permits banks to lend money more profitably.
(Mortgages, a banking staple, now cost homebuyers over 4%, up from about
3.3% earlier in the year). Small wonder that banking stocks rose 22% in
the post-election period.
Despite
a little weakness in the waning days of December, the popular equity
averages finished the fourth quarter with solid gains, after hitting new
highs as well: the Dow Jones Industrials and S&P 500 gained 8% & 3.3%
respectively in the final three months of 2016. Annual returns came to
16.5% & 12%. The averages broke a string of records over the course of
the year, and even "Dow 20,000" looked like a shoo-in for a while. As
frequently happens, industry sectors that had been viewed most
negatively earlier in the year produced some of the better results by
year-end. The aforementioned banks were a standout. Energy, too, proved
resilient. Helped by a production curtailment agreement among major oil
producers towards year-end, the commodity's price rose 50% in 2016.
After being pummeled at the beginning of the year, energy-related equity
indexes rose 24% for the year. In the markets for commodities
themselves, oil was not alone in showing strength — sugar, gas, soybeans,
and copper gained more than 10%. Even coal, shunned by all, saw a
doubling of prices following production cutbacks in China.
From a
long-term perspective, the eighth year of recovery after the financial
crisis was a good one. Investors who maintained their cool in the dark
days of 2008-09, buying when stocks were on sale, and holding their
positions through the years rather than fleeing the equity markets as so
many have done, have been suitably rewarded. As the saying goes, one
should "never let a good crisis go to waste." Markets consumed by fear
and loathing occur infrequently; commitments made at such times, when
valuations are deeply depressed, can serve the bold and patient investor
well for a lifetime.
While
2016 was a good year for owners of stocks, market volatility also
produced some reasonably good opportunities for buyers who were nimble
enough to jump at bargains. The year's turbulent opening weeks depressed
valuations, notably in the finance- and commodity-related sectors.
Likewise, the swoon after Britain's Brexit vote produced some notable
discounts, especially in European shares. As usual, focusing on the
value of stocks, instead of worrying about what might or might not
happen in the future, revealed some interesting candidates for purchase.
As the
New Year begins, however, we face the all-too-familiar challenge of
determining what to do next. The fourth quarter market bounce brought
already stretched equity valuations to levels seldom surpassed in the
last 90 years, according to at least one valuation measure, the "CAPE"
index, which values equity markets on long-term average earnings, thus
smoothing short-term fluctuations in profitability. While such valuation
measures have little predictive power in the short term, they have
tended to successfully highlight periods of elevated risk that have
preceded times of market turmoil and weakness, such as 1929 and 1999. It
is best not to ignore these indicators and to be cognizant of risks.
Pockets of opportunity are now few and far between.
Interest rates, having risen significantly in recent months, present
another challenge. While higher rates could be a welcome relief to many
looking for reasonably "safe" income, they can represent a headwind for
stocks. Higher rates resulting from stronger economic growth may be
relatively benign, since higher growth tends to be good for stocks as
well. But with the latter already trading at record highs, one now faces
a question familiar to all with experience in dealing with securities:
how much good news is already priced into the markets?
The answer can never be known with precision and is, instead, a matter
of experience and judgment. With markets at record highs, and enthusiasm
rising, our experience tells us that "what to do next" is the same as
what we always do: patiently and painstakingly continue our search for
opportunities.
* For those who wonder why anyone would buy a bond that would pay you
back less than you put in, think of it this way: if you had a billion
dollars in cash, you couldn't exactly stuff it in a mattress. You'd have
to pay someone to store it, and someone else for insurance. It's far
more efficient and less bothersome to let the government take care of
these services.
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