Respite from the Storm

Calmer waters are welcome

Probably the simplest reasons anyone invests in stocks are to make money (capital gains), generate income (dividends), or some combination of the two. Of course, that really is putting it in the simplest of terms.

Many of you have chosen to follow recommendations to place a portion of your nest egg in a diversified portfolio that includes equities, because the stock market has historically offered superior long-term returns.

Others are nearing or at retirement. For you, the empirical research suggests that a limited exposure to a diversified and conservative stock portfolio will not only generate income, but also allows for some growth.

It’s not a strategy that guarantees against short-term losses in the equity portion of your investments, but the limited exposure to the market mitigates much of the risk to your entire nest egg.

Collective wisdom, market volatility, and how stocks are priced

There is an enormous amount of research that has gone into how stocks are priced. In our short time today, I will keep things simple.

Whether we are reviewing an individual stock or a broad measure of equities such as the S&P 500 Index, in reality the price is a gauge of market sentiment that takes into account the collective wisdom of all market participants.

These participants include everyone from the small investor to sophisticated institutions that have created complex models to value stocks.

Simply put, they incorporate all publicly available information; collectively generating what they believe is a fair price for the stock or industry metric at that moment. As sentiment shifts, so does the price.

These participants are all “putting their money where their collective mouths are,” so to speak.

Since information is so readily available and is so quickly distributed, analysts and academics like to say that markets are efficient.

While I would argue in favor of market efficiency, I believe the collective wisdom of investors can sometimes misprice risk, especially when emotions come into play.

Still, I strongly encourage investors to avoid trying to time the market. When you come across an article that seems to have special insights into what the future says, disregard it; no one has a crystal ball that consistently calls highs and lows.

That brings us to the ups and downs in the market we’ve recently experienced – what analysts call ‘volatility.’

In some respects, the declines of just over 10% in the late summer 2015 selloff and the early 2016 selloff really weren’t particularly significant. Market corrections in the broader context of a bull market will happen from time to time. Our goal is to manage and mitigate risk, but we can’t eliminate it.

Key Index Returns

Source: Wall Street Journal, MSCI.com

MTD returns: February 29, 2016—March 31, 2016

YTD returns: December 31, 2015–March 31, 2016

*Annualized

**USD

Economically speaking

One recent fear is that the economy was set to slip into a recession.

Recessions will take a big bite out of corporate profits, and profits are the biggest medium and long-term factor that affect stock prices.

While recent data are not suggesting the economy is running on all cylinders, it does signal that the expansion is muddling along at a modest pace.

Yet, that’s not what stocks seemed to be telegraphing early this year. Everything from China worries, falling oil prices, and fears about earnings seemed to be suggesting the economy was set to stall.

While markets typically process information efficiently, once in a while the collective wisdom overshoots to the upside or the downside. We see it in hindsight.

Expect to see headlines screaming of an impending bear market or even a market crash. They really don’t offer much in the way of solid market analysis, but they are designed to get “eyeballs,” or page clicks. The old news adage, “If it bleeds, it leads,” applies to sensational financial articles, too.

The case of China

China provides an excellent case in point. U.S. exports to China account for just under 1.0% of U.S. GDP (U.S. Bureau of Economic Analysis), but China just seems to have this way of creeping into investor psychology with scary headlines.

While China has not gotten its problems under control, its economy avoided the proverbial brick wall. Its currency, the yuan, has stabilized and has even begun to appreciate against the dollar, rising to roughly a four-month high (St. Louis Federal Reserve).

More importantly, stocks have closely tracked crude oil in recent months (St. Louis Federal Reserve), and the uptick in oil has benefited stocks.

On the subject of oil…

What’s been going on in oil has really been counterintuitive and has defied the predictions of most analysts.

You see, oil was supposed to act like a huge tax cut for consumers, fueling spending and growth. In reality, it’s not a tax cut. Instead, it’s a transfer of wealth from producers to consumers.

So far, energy producers have slashed spending and fired employees, without a corresponding pick up in spending by consumers.

While I must admit that filling up for $2 per gallon is satisfying, we’ve witnessed economic pain without economic gain. And it’s spilled over into the broader stock market.

Furthermore, the steep decline in energy earnings has pulled down profits for the overall S&P 500 Index and wreaked havoc on high-yield bonds.

That’s why the recent recovery in oil has aided stocks. As we head into late spring and summer, we are entering what has traditionally been a strong period for oil (St. Louis Federal Reserve, Energy Information Administration).

The dollar dip

Finally, investors are also trying to price in the impact from the recent dip in the dollar into stocks, especially the larger industrials that do a fair amount of business overseas.

Remember, the collective wisdom of the market? It is millions of investors, both large and small, quickly pricing new information into buy/sell decisions. In turn, it’s reflected in changing prices.

A stronger dollar is a big benefit to those traveling overseas, and it helps keep a lid on the price of imported goods. But companies doing business abroad must translate those foreign sales back into more expensive dollars, which hurts earnings.

Notably, the rise in stocks last month was inversely correlated to changes in the dollar (in fact, it was a very steep inverse correlation – St. Louis Federal Reserve), as investors cautiously anticipate, dollar headwinds will abate when multinationals begin reporting Q1 earnings later in the month.

Bottom line

Markets will experience periods of tranquility and markets will experience periods of volatility. In some respects, it’s much like the weather. Even then, I might put more faith in the three-month temperature outlook then I’d put in the many and varied forecasts for stocks. It’s noise and best to be avoided.

All investors have financial goals. If you are to hit your goals, a plan, i.e., a financial roadmap, is crucial. Imagine starting out on a vacation without a roadmap?! Each investor should have a financial roadmap that is specifically tailored to their specific situation. It doesn’t matter what the S&P 500 does in any given year, it matters how you do relative to your goals over time.

Unless new circumstances have arisen, I strongly encourage all investors to do their best to stick with the plan that they have created. This includes an exposure to stocks. It’s a mistake to try to manage investment returns for a short period of time. Keep the long term in focus, and keep investing in alignment with your goals, even when the market goes down.