A quick glance at the 2015 price returns of the S&P 500 (-0.7%), Dow Jones (-2.2%) or even US Aggregate Bond Index (-1.9%) might give one the impression of a fairly flat investment landscape. A closer study reveals that 2015 was a very volatile and fairly negative year, and in many ways, humbling. Broader based indexes like the Russell 2000 (-5.7%), NYSE Composite (-6.4%) and Value Line Composite (-11.2%) better represent how widespread the year’s poor performance was. Many long-term and successful investors, ourselves included, struggled to correctly predict the movements in energy prices, interest rates and ultimately stock prices. The numbers are murky and are not fully tallied but some estimates have over 850 hedge funds closing in 2015. Keep in mind, hedge fund managers are thought to be among the best and brightest in our industry. Legendary hedge fund managers David Einhorn and Bill Ackman were down -20% and -20.5%, respectively. for 2015. Even billionaire investor Warren Buffett’s Berkshire Hathaway racked up a -12.5% thumping for calendar year 2015. The heavy market anxiety truly tested investors’ fortitude in a way not obvious to anyone just looking at the S&P 500, Dow Jones or US bond indices, which all posted essentially flat returns for 2015. The carnage investors felt in 2015 was concentrated in two asset classes and three sectors. As an asset class, emerging market stocks led by China were off -16.9% and commodities declined sharply by -24.7%, on a price return basis. Three stock sectors in 2015 accounted for most of the angst: Utilities -5%, materials -8.4% and energy -21.1%. 2015 was quite challenging for both individual investors and professional money managers. Both groups generally expected stocks, oil prices and interest rates to rise. Instead, all three fell or were flat. Again, humbling. Some will see 2015 as foreshadowing what is to come in 2016. We see the 2015 declines and any early 2016 declines as an opportunity to complete the first half of the mantra, buy low, sell high. Often after the market posts a negative year it is followed by a rebound year such as 1978, 1982, 1991, 1995, 2009 and 2012 where returns averaged 18.9%.
Throughout 2015 crude oil was constantly being whipsawed by news stories of oil oversupplies and geopolitical risks in the Middle East. We counted 5 instances where oil traded up or down by 15% or more during 2 week intervals. At IMS, we did not correctly predict the direction of oil in 2015, as we expected to see the price rise over the course of the year. The energy market volatility has been impossible to predict or explain. We expect the volatility to continue in 2016, and we expect prices to be higher by year end. Plummeting oil price headlines keep financial journalists busy musing their next disaster scenario about the U.S. economy and the U.S. stock and bond markets. We see things a bit differently. The collapse in energy prices was a surprise and will certainly have widespread impacts on the global economy. For example, China’s economy continues to slow and is now showing more severe damage than was originally thought. Over the last decade the energy and commodity markets have been reinforced by China’s truly astounding economic growth. China’s slowing demand for both energy and raw materials will weigh on commodity exporting nations and sectors in 2016. Energy and commodity markets are now seeing the dangerous side of relying too much on one customer. However, we see some real benefits from cheap oil and commodities for US consumers and manufacturers. What consumers save at the pump will go toward spending, saving and paying down debt, which are positives for our economy. Some estimate the average household is realizing cost savings of over $100 a month compared to 2013, due to the impact of lower energy prices. Manufacturers that consume energy and use commodities for production and shipping are experiencing lower costs. A little less obvious benefit of cheap oil and raw materials is that both tend to be drivers of inflation. One of the reasons the Federal Reserve was able to keep interest rates at zero for such an unprecedented length of time was the absence of inflation. We expected interest rates to rise during 2015 and again, it was humbling when it didn’t happen. The Federal Reserve will have added flexibility with respect to future decisions about interest rates if energy and raw materials prices continue to show weakness in 2016. We expect to be right about higher interest rates by the end of 2016, but only time will tell.
Those who are inclined to see the glass half empty will look at the decline in year over year S&P 500 earnings as another negative, telling sign. However, we see the glass half full. Earnings actually grew in every sector of the S&P 500 except energy and basic materials in 2015. Additionally, almost half of S&P 500 earnings come from outside the US and the strong US dollar made our goods and services more expensive abroad. The strong dollar essentially shaved another 1-2% off S&P 500 earnings during the year. Successful long-term investors realize things like commodity prices and currency values will bounce around and what really matters is how well U.S. firms are operating. We see the operating results of US firms (excluding the energy sector) as positive. Strong operating results tend to be a good backdrop for increased hiring, wage growth and additional business activity, which are all constructive signs for the US economy and financial markets in 2016.
What if the Federal Reserve made a mistake? A Fed mistake is a valid concern for those of us who are financial market historians. Federal Reserve policies arguably contributed significantly to 4 of the last 10 bear markets (1937, 1970, 1980 and 2007). A review of the last 5 times the Federal Reserve has been on an “increasing” interest rate mode shows the financial markets can and usually do weather the storm without financial armageddon. The average Fed “tightening” cycle contains 9 hikes over 14 months and sees the Fed Funds increase about 3%. The stock market marched higher 3 out of 5 of those periods. The S&P 500 rose on average just over 3% during the 5 tightening cycles. In short, a gradually rising interest rate environment has not historically spelled doom for stocks.
Since 1975, the S&P 500 on a price basis had yearly declines on 10 occasions or about 25% of the time. Only during the tech bubble collapse of 2000 followed by the September 11th 2001 terror attacks has the S&P 500 produced yearly declines consecutively. This period actually produced 3 consecutive years of declines. The 6 remaining negative years all had bounce back years that averaged 18.9%. Again, we see this phenomenon as the market providing the opportunity for investors to buy low and sell high. Disappointing periods in the financial markets provide opportunities to purchase assets at discounts to their fair value. One can not sell high unless one first is given opportunities to buy low. Unfortunately, the gift of buying low is often overlooked by investors because it’s camouflaged by things like political rhetoric, terrorist attacks, slowing growth in China, a strong dollar and plunging energy prices.
We remain steadfast in our value investing approach and relentlessly seek opportunities to buy low and sell high. The key in 2016 will be to invest selectively in the industries and companies that are well positioned for this challenging environment. We know that staying grounded to our value approach will benefit our clients and shareholders, over the long-term. We continue to invest alongside you as we focus on building wealth wisely.