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2015 Review, 2016 Preview



A Look Back

In our previous commentary, written in July 2015, we explained why we thought equity markets were overvalued and investors should prepare for a pullback.  We made many of our client portfolios slightly more cautious as a result, keeping our allocations positioned for the long term.  As we often say, we are long term investors who manage money for long term investors.

Our purpose in this newsletter is to review what happened in 2015, look ahead to what we might see in 2016, and give guidance on the best (and worst) ways for clients to respond accordingly.

2015 was the year of:

  • Low oil prices
  • China’s economic slowdown
  • Federal Reserve’s long anticipated rate hike
  • Sluggish growth in US and Europe

These, and other factors, led to US stock returns being mostly flat for 2015, while emerging markets (-14%) and commodities (-24%) struggled because of the decline in China and in oil prices.  It is worth noting that the positive performance that had accumulated in the US stock market from January to July of 2015 was erased quickly in one week’s time, during a 9.4% correction that occurred in mid August (8/14-8/25).  As of the writing of this newsletter, we have recently seen another quick correction (12/28 – 1/11) where the U.S. stock market has given up 6.3% of its value in a relatively short period of time.  Therefore, as we look forward to 2016, we want to briefly review the frequency and nature of historical corrections so that our clients can be well equipped when they inevitably come.

We mentioned in our last newsletter that short term market corrections are both normal and healthy for disciplined long term investors.  We do not want to be redundant, but the lessons from the chart below are worth repeating. They are just as relevant today as they were when we introduced them last July.  In the updated chart below, the solid bars represent the annual rates of return of the US stock market for every calendar year (1/1 – 12/31) dating back to 1980.  As you survey the solid gray bars, you’ll notice there are more positive bars than negative bars.  In fact, the US market experienced positive rates of return in 27 of the 36 years measured, or 75% of the time.

Below each bar, there is a red dot. Each red dot represents the maximum short term decline within that year, from peak to trough.  Even if the year finished with positive returns, they still experienced intra-year pullbacks.  How frequently do these short term corrections happen?  Consider the chart below:

 

Even though the American stock market experienced positive rates of return in 75% of the last 35 years, the chart above shows us we can expect, on average, at least 5 short term pullbacks of 5% or more each year.  On a $1 million portfolio, a 5% pullback represents a temporary $50,000 decline.  Though it may not feel like it at the time, short term market corrections are both normal and healthy for disciplined long term investors because it gives them an opportunity to buy stocks when they are less expensive.  Over the long term, equity markets have rewarded such discipline. Consider the last century.  The chart below shows stock market performance since 1900.

What to expect for 2016?

So now that we’ve reviewed the long term trend for stocks, what do we anticipate for 2016?  Our team does not anticipate a recession this year, but we do believe economic growth will continue to be slow in the US and across the globe.  In fact, the World Bank projects the following real GDP growth rates in their January 2016 Global Economic Prospects report:

 

Country
Projected Real GDP Growth (%)
United States
2.7%
Europe
1.7%
Japan
1.3%

 

They also project China’s real GDP growth to slow to 6.7%, though some economists, such as Darrell Spence, believe a more accurate number to be closer to 4.5%.  As a review, GDP growth is a measure of how quickly an economy is growing versus the previous year. Ideally, no economy wants to grow too fast (leading to inflation) or too slow (leading to recession).  For reference, the long term economic growth rate in the United States has been between 2% and 5% annually.  We believe these slower growth rates will hamper stock market returns in 2016.  While we do believe equity markets will outperform bonds and cash in 2016, we are tempering expectations for portfolios in 2016 given the slow economic growth and low interest rate environment.

However, there are some reasons for optimism that we’d like to share as well.

Low oil prices benefit consumers.  We have discussed the rise in US energy production in past newsletters.  The US is now the world’s largest producer of crude oil and liquids.  The chart below compares the rise in US oil production over the last 5 years to the decline in retail gas prices over the same period of time.  As oil production has doubled, gas prices have fallen 50%.  Though US production is not solely responsible for the decline in gas prices, it has heavily contributed.

 

A decline of $4/gallon to $2/gallon represents a substantial savings for consumers.  Consider that the average American spent $2,500/year in 2011 on gasoline according to the US Department of Energy.  Not every American drives a car, but according to the Office of Highway Policy Information, there are approximately 211 million licensed drivers in the US. With gas costs falling by 50%, that means that 211 million drivers have a combined $263 billion that they can spend on things other than gas. (211m drivers x $1,250 annual savings = $263 billion).  That $263 billion represents substantial savings to consumers and, hopefully, a future boost to the US economy as they use those savings to buy other goods and services.

Technological advances and disruptive innovation.  Take a moment to consider the magnitude of technological advances in the last 50 years.  Think about the ripple effects from the rise of the PC, the internet, the smartphone.  Consider that the phone in your pocket has more computing power than NASA’s supercomputer had in 1970.  This rapid advance in computing power is attributed to Moore’s Law, which is named for Gordon Moore, a co-founder of Intel.  He noted in 1965 that the rate of computing speed in semiconductors doubled consistently every 12-24 months.  This power of doubling creates exponential, rather than linear growth in computing speed.  The application of this exponential computational ability will lead to significant innovations in a variety of industries.

Computing
Agriculture
Healthcare
Robotics
Artificial Intelligence
Energy
Manufacturing
Nanotechnology
Education

 

In our next newsletter, we will try to flesh out and explain some of these innovations that could potentially shape the next 30-50 years.  The technologies are fascinating, and the implications could significantly improve the standard of living across the globe.

Conclusion

Given our expectation of pullbacks, slow economic growth and low interest rates, how should clients respond to this newsletter?  Pullbacks and market declines understandably make many investors nervous.  However, research suggests the average investor is vulnerable to making poor investment choices during these temporary pullbacks.

In fact, the most recent edition of Dalbar’s Quantitative Analysis of Investor Behavior (QAIB) found that the greatest losses for the average investor occur shortly after market declines.  “Investors tend to sell after experiencing a paper loss and start investing only after the markets have recovered their value.  The devastating result of this behavior is participation in the downside while being out of the market during the rise.”  In other words, average investors have a tendency to buy when prices are high, and sell when prices are low.

As you are reading this, you are likely saying to yourself, “That’s not me.  I’m not susceptible to those emotional tendencies.  I’m not like everyone else.”  But before you dismiss Dalbar’s research, consider how you responded to the last time the market fell 10%.  Did you panic?  Did you take advantage of the buying opportunity?

So, how can you overcome this all-too-common investor behavior of buying high and selling low?  Have a financial plan and stick to it.  When we help clients put together a comprehensive financial plan, we help them identify specific financial goals that become their benchmark for success.  We then run their nest egg through a gauntlet of 10,000 statistical simulations. These simulations stress test their portfolio against the possibility of multiple bad markets in the future.

By anticipating the inevitability of market downturns and factoring those scenarios into our projections, we can give our clients much more peace of mind.  In fact, many of our clients want us to simulate a worst case scenario plan for them so that when the markets experience a decline of 10% in any given year, they know we have already factored multiple pullbacks in to their financial stress test.  If their nest egg can survive our stress test simulations, we have confidence it can survive this:

A Personal Update

As 2015 is behind us and we look forward to 2016, we wanted to again take an opportunity to thank you, our clients, for your encouragement and support over the last year as we have successfully made the transition to an independent registered investment advisory (RIA) firm.  Thank you for having the confidence in us to guide you and help you reach your financial goals.  We have so much to be thankful for, and so much to look forward to. Please know that we are grateful for you.

The past performance of a mutual fund, stock, or investment strategy cannot guarantee its future performance. Diversification does not guarantee investment returns and does not eliminate the risk of loss. This report contains statements and statistics that have been obtained from sources believed to be reliable but are not guaranteed as to accuracy or completeness.