SWP Market Insights – Summer 2015
SWP Market Insights – Summer 2015
State of the Stock Market
August 24, 2015
Recent headlines have been filled with news about the decline and increased volatility in the equity markets. This edition of SWP Market Insights was written before the decline in the markets the week of August 17, but is very much relevant to remind our clients of the importance of a well-constructed portfolio for the long-run.
With a relatively flat first half of 2015 now in the books, the public’s attention has turned to the recent increase in volatility in the stock market. After several years of double-digit returns, it may appear the US stock market’s rate of progress is slowing down. We’d like to use this piece to examine the reasons for continued optimism for the stock market, why clients may wish to proceed though with caution, and the potential effect on our client portfolios.
THE ARGUMENT FOR STAYING INVESTED
Although overall stock returns haven’t been exciting so far this year, US stocks are holding their own, as the S&P 500 has gained 1.2% through June 30th. Not exactly a robust return, but better than many other asset classes. The table below shows year-to-date returns on commodities, bonds, cash, and large U.S. stocks.
During this same time, for example, many bond investors actually lost money as long-term interest rates moved modestly higher. The stock market’s valuation level is slightly above average today (with a forward P/E ratio of 16.4x vs. the 25-year average of 15.7x), as shown in the graph below, but valuation levels can actually remain average for long periods of time without a correction. Valuations exceeded the long-term averages beginning in 1996 before peaking in 2000 at a forward P/E ratio of 24.4x.
In addition, many analysts have pointed out that the economy is poised for continued growth. As corporate earnings grow (the “E” part of a P/E ratio), higher stock prices are justified and warranted. Despite a slow start to the year, largely stemming from a stronger U.S. dollar and a decline in investment by oil companies, the U.S. economy is expected to expand at a moderate pace in 2015. With equity valuations hovering around long-term averages, stocks can still benefit from a growing economy.
THE ARGUMENT FOR CAUTION
Etched in the memory of many investors are the two historic bear markets beginning with the aforementioned tech bubble in 2000 and the financial crisis of 2008. It has now been more than six years since the 2009 market lows. Since March 2009, the S&P 500 has enjoyed an average gain of over 20% per year.
With the stock market at new highs, some investors fear another big bear market is on its way. Moreover, we are currently in the third longest period in history without a 20% stock market decline. The longest time period without any 20% decline in the stock market occurred during the 1990s.
While that bull market lasted for over 9 years, the economic environment during that time period was very different than what we have experienced over the current cycle. Economic growth during the 1990s, as measured by GDP, was much stronger than it has been in the recent past, as shown in the graph below. Specifically, from 1992 to 2000, GDP growth averaged 3.8% per year. From 2010-2014, however, GDP growth has only averaged 2.2% per year.
Today’s bull market has been supported by three rounds of Quantitative Easing and six years of near zero interest rates. We are certainly in unprecedented times, and there is a very compelling argument for relatively muted stock market returns moving forward. As such, we believe that investors may wish to proceed with caution.
Portfolio construction moving forward
While modest single digit stock returns are a possibility, some believe that stock market returns may still be more attractive than many alternatives. Return expectations alone, however, are only part of the mix; as our clients and friends well know, volatility is an important consideration too, and the prospect of rising stock market volatility is very real.
Historically, investors have used bonds to control volatility in their portfolios. With interest rates near historical lows, bonds have returned only approximately 1.8% for investors per year over the past three years. These low returns, along with the very real prospect of rising rates (which result in lower prices, which in turn reduce the return) makes it very challenging for bonds to meet the needs of investors, both from a return and risk-control perspective.
As a result, some investors will continue to push money into the stock market, as they feel that there is no other option. This decision, however, may materially increase the overall risk profile of an individual portfolio.
The stock market has been very easy to live with in recent years, but history tells us “trees don’t grow to the sky.” Setbacks of greater than 20% in the stock market are both inevitable and nearly impossible to forecast. There will always be reasons to both plow ahead and invest in the stock market, just as there will always be issues that trigger apprehension. Today’s market is no different.
We design portfolios for our clients with our sights set on the long-run, particularly when it comes to risk-based assets such as stocks. As such, we will continue to brace ourselves and our clients for prolonged stock market volatility.
Ultimately, helping our clients achieve their financial goals is the only benchmark that matters. While a change in a client’s circumstance, goals, or needs will always cause us to review their portfolio and allocation to stocks, we continue to believe that a reasonable allocation to the stock market is appropriate for clients whose strategic investment plan calls for it.
- JP Morgan Guide to the Markets June 30, 2015
- The Statistics Portal: https://www.statista.com/statistics/188165/annual-gdp-growth-of-the-united-states-since-1990/
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