CKBlog: The Market
Tuesday, January 26, 2016
2015 Market Review
by Charlie Haberstroh, CEO & CIO
It is difficult to write this annual message without taking undue account of the drop in equity markets in early 2016. However, it is important to review what happened in 2015.
A little background: As we entered 2015 we believed that the US equity markets were â€œfullyâ€ valued and that the European markets showed better equity values. We also believed that traditional fixed income would not be a winning investment. In addition, we believed that investors should avoid emerging marketsâ€™ debt and equities. We continued to maintain exposure to US equities principally (1) through managers who bought equities which they believed were undervalued compared to their intrinsic value (in some cases by an estimated 30%) and (2) through two proprietary strategies: (a) one of which purchases companiesâ€™ equities which are valued 25% lower than the average market price earnings ratio but have above average growth prospects; and (b) the other identifies high quality companies which have increased dividends consistently over the last 10 years.
Interestingly enough, 2015 proved to be one of the â€œworst bestâ€ years in terms of the performance of major asset classes. What do we mean by â€œworst bestâ€? If you measure the performance of equities, fixed income, currencies and commodities during the year, and selected the best performer among those asset classes, the â€œwinnerâ€ was the S&P 500 Index with a return of +1.38% including dividends. That was the worst best top performer among those asset classes since 1937! It was a tough year for investors to make money.
The US Dollar was the strongest currency in the land and commodities overall were big losers. Even so, the S&P 500 Index, while positive, did not describe what was happening within the 500 equities in its index. The top ten equities in the index were up by approximately 17% in aggregate, while the bottom 490 equities suffered a collective -5% return (courtesy of Craig Hodges of the Hodges Mutual Funds). So the equities which â€œdroveâ€ the index constituted a very small sliver of actual number of equities, the so-called â€œhigh momentumâ€ equities. The punditsâ€™ poster children of that segment were labeled â€œFANGâ€ by a popular CNBC pundit (remember the now ill-fated BRIC acronym), namely, Facebook (+34.15%), Amazon (+117.78%), Netflix (+134.38%) and Google (now called Alphabet, +44.56%).
In addition, value managers who we follow and who have beaten their growth manager counterparts over the long haul, have, in general, underperformed for over 18 months. In 2015 the so-called value based equities were largely ignored in favor of the momentum equities.
Other markets: European equities (MSCI Europe Index) did very well though August (up about 20% in Euro terms), but finished the year up 8.89%. However, in USD terms it was down -2.21% for the year. Worth noting is that unlike most active managers in the US, all the managers we used for European equity exposure enjoyed significant outperformance relative to their benchmarks on the year.
One of the better global market returns was Japanâ€™s Nikkei 225 Index which showed a positive +10.97% in Yen terms (+9.92% in USD terms). Since its performance depended so much on government policy we did not make a direct allocation to Japanese equities (several of our managers, however, did own Japanese equities during the year).
Emerging marketsâ€™ equities reflected the steep fall off in commodity prices and generally were poor performers, especially Brazil and China.
Currencies: Most pundits at the beginning of 2015 favored a strong US Dollar relative to the remainder of the year but the consensus view was also that the Euro would achieve parity against the US Dollar. While over the period the Euro dropped from 1.21 on January 1st, 2015 to 1.09 at year end, it traded in a range from its March 13th, 2015 low of 1.05 to 1.16 for the rest of the year.
Fixed Income: Depending on the mix of fixed income instruments in a portfolio, fixed income either lost money or ranged from breakeven to a small gain during the year. There were few winning strategies, one of which was mortgage backed debt securities. On the other hand, high yield debt and emerging market bonds were big losers.
Commodities: Most hard and soft commodities fell sharply in 2015 due primarily to the unwinding of speculative positions taken under the anticipation of robust Chinese consumption based on previous years. However, if you believe the numbers coming out of China, it appears that the Chinese economyâ€™s growth has slowed.
Hedge funds: In general hedge funds had a dismal year. Obviously actual performance depended greatly on the fundâ€™s specific strategy, however, the HFRX Global Hedge Fund Index was down -3.64% for the year with many â€œstarâ€ managers posting losses in excess of 15% (David Einhornâ€™s Greenlight Capital and Bill Ackmanâ€™s Pershing Square were both down more than 20% in 2015).
2016 Market Outlook
Also it is difficult to write about 2016 without overemphasizing the drop in equities since the beginning of the year.
In general the uncertainty in the markets reflects several factors, among them the following:
- Slowing economic growth, especially in China. The Chinese economy continues to be opaque. In general many respected economists believe that the Chinese government has overstated annual growth by at least 2%;
- Plunging petroleum (and commodity) prices. While for many net consuming economies (including the US, Europe, China and Japan), the net effect on consumers and non-energy related companies is quite positive. The global stock markets seem to be making the case that a â€œcrashâ€ in oil prices is more negative than the savings as a result of lower energy prices. Many pundits and economists are now taking the position that the plunging of non-oil commodity prices represents slowing economic growth, especially in China. It is true that for many emerging markets such as Brazil, the plummeting commodity prices have hurt local economies;
- Continued unrest in the Middle East. Despite the fact that this has been a concern for many years and that the petroleum surplus shouldnâ€™t cause a rapid increase in petroleum prices or disruption in supply, stock markets have viewed this as further uncertainty;
- Low inflation/disinflation/US Federal Reserve monetary policy tightening. These subjects plus weakness in emerging markets and the prospect of falling Chinese (and US) growth have prompted the use of the â€œRâ€ word (recession) since the beginning of the year;
- High valuations in the US equity markets with the expectation of flat to down earnings for the companies in the S&P 500 (largely because of higher wages, higher interest rates and poor earnings in the energy sector);
- Uncertainty about the upcoming US presidential election due to the apparent relative success of â€œunconventionalâ€ candidates such as Donald Trump and Bernie Sanders and the prospect of higher tariffs (Trump) or higher taxes and anti-company rhetoric (Sanders). There is also some trepidation about the proposal of Democrat front-runner, Hillary Clinton, for higher income taxes, especially on the wealthy.
While it is difficult to predict the trajectory of the economy and impossible to foresee international or domestic events, it appears as though the wide majority of economists are forecasting low global economic growth. In fact, on January 19th, 2016 the IMF published its Global Economic Outlook. In it, their economists are forecasting that global economic output will grow by just 3.4% in 2016 and 3.6% in 2017.
Interest rates in the developed countries should remain low (even if the Federal Reserve increases interest rates four times in the US, as some suggest). Petroleum prices are closer to their lows than their highs, as are the major industrial metals. Lower exchange rates in Brazil, China, Europe and Russia should help to improve their exports (depending on whom you ask).
We expect that fixed income instruments will continue to give very small, positive results if interest rates remain low or negative results if interest rates move higher. However, fixed income instruments do play a role in most portfolios as bonds typically help reduce overall volatility. We continue to recommend that investors employ fixed income managers who have the flexibility to reduce the interest rate risk within their portfolio.
Depending on the rate of increase in US interest rates by the Federal Reserve, the US Dollar could still exhibit strength against most developed countriesâ€™ currencies. However, we believe that two or three increases in interest rates have been factored into the markets at the present time. Absent any surprises in the velocity of interest rate increases, most currencies will interact based on relative growth rates or, said in another way, the prospects of further easing (Europe and Japan) or tightening (US).
We prefer to remain invested with investment managers that have proven, long-term track records for client exposure to equities through active management. We expect that value oriented managers should outperform growth managers in the year ahead (as has been the case in the past), especially in a low growth environment. It is unclear when we will reach the bottom in either petroleum or industrial metals prices, so it is difficult to predict a recovery in those securities and their related counterparts (especially in emerging markets). We expect continued volatility given the â€œherd mentalityâ€ of many investors and lack of liquidity in the fixed income markets.
We do see some pockets of opportunities with great upward potential. One is high quality companies that have a proven record of increasing earnings and dividends even in difficult years. Another is what is called Master Limited Partnerships [MLPs] (basically energy infrastructure investments). They are probably the most misunderstood investment in recent times. Operating like toll roads, they tend to earn money unless there are disruptions in supply or demand (primarily demand). We see continued demand for natural gas and petroleum especially in the Northeast US. However, the equity prices of the MLPs have sold off with other elements in the energy industry in the US, even though most have little direct exposure to petroleum or natural gas prices. We have written a special segment on MLPs which we have included in your package. Lastly we see opportunity in those equity securities which have dropped substantially below their intrinsic values. The group of value managers we have selected have proven their prowess in identifying and investing in those situations and we expect that to continue despite their underperformance in 2015. We also believe the housing recovery in the US should continue as household income continues to improve and interest rates remain low.
A reminder about CastleKeepâ€™s investment process:
First, and paramount to our process, is the discussion about the clientâ€™s financial objectives, risk tolerance, tax status, unique circumstances, and other factors. With the foundation of the clientâ€™s risk parameters and goals in mind, the Investment Committee, led by CEO/CIO Charles Haberstroh, builds the clientâ€™s proper asset allocation mix. We spend a lot of time and focus on this as studies show that 90% of returns can directly be attributed to asset allocation. We do not use model portfolios where clients with similar objectives have identical portfolios. Each clientâ€™s portfolio is unique to their very specific circumstances.
The committee then fills each asset class with exchange traded funds, index funds, mutual funds, individual equities and/or separately managed accounts. For certain clients, we also employ hedge and private equity funds.
Asset classes or sectors for which we do not believe to have an â€œin-house edge,â€ are assigned to investment managers which we believe, using our own analysis as well as third party research, to be â€œbest in class.” It is important to note that we employ these strategies at the lowest possible cost (commonly institutional share classes for mutual funds, as an example).
We analyze performance and risk measures first over the long term (usually 5-10 years), then over more recent periods to ensure consistency in performance reflective of their investment parameters in both up and down markets. We pay close attention to style drift (where a manager begins investing in securities outside of his or her historical area of focus), asset bloat (where a huge influx of assets over a short period of time can disrupt a fundâ€™s process) and manager continuity.
We meet with portfolio managers on a regular basis (usually quarterly) for insight into their current holdings and for more color on their recent performance and expectations. We have been investing with many of these managers on behalf of our clients for 10+ years. However, if their management undergoes material changes or performance lags for an extended period of time, we will remove the manager from our portfolios. Additionally, we are constantly scouring the investment universe for additional managers and strategies that will add value to our clients.
We do not receive any remuneration from any manager or fund. In the rare case that a fund or manager, as a matter of their policy, insists on paying us a fee we return 100% to the clients invested in that fund on a pro-rata basis. Our interests are thus aligned with our clientsâ€™ interests.
In addition to making tactical changes to portfolios, we look to rebalance our clients as we see opportunities to take profits, taking into consideration the costs and tax implications of doing so. This process tends to reduce investorâ€™s risk over time as it enables the investor to take profits in those investments which have performed well and invest the proceeds in those investments which have suffered paper losses in the near term. The result is executing the old adage â€œbuy low and sell highâ€.
We have honed our process over our 15 year history and will continue to institute changes that we believe will benefit our clients.
Lastly, given the recent volatility in the markets, we want to remind investors that it is important to stay the course, focus on investment objectives and ignore the day-to-day (or minute-to-minute) fluctuations in the markets. Weâ€™d like to leave you with a quote by Warren Buffett:
If the investor, instead, fears price volatility, erroneously viewing it as a measure of risk, he may, ironically, end up doing some very risky things. Recall, if you will, the pundits who six years ago bemoaned falling stock prices and advised investing in â€œsafeâ€ Treasury bills or bank certificates of deposit. People who heeded this sermon are now earning a pittance on sums they had previously expected would finance a pleasant retirement. (The S&P 500 was then below 700; now it is about 2,100.) If not for their fear of meaningless price volatility, these investors could have assured themselves of a good income ...
Investors, of course, can, by their own behavior, make stock ownership highly risky. And many do. Active trading, attempts to â€œtimeâ€ market movements, inadequate diversification, the payment of high and unnecessary fees to managers and advisors, and the use of borrowed money can destroy the decent returns that a life-long owner of equities would otherwise enjoy. Indeed, borrowed money has no place in the investorâ€™s tool kit: Anything can happen anytime in markets. And no advisor, economist, or TV commentator—and definitely not Charlie [Munger] nor I—can tell you when chaos will occur. Market forecasters will fill your ear but will never fill your wallet.
We thank you for your trust and confidence placed in us and are looking forward to our continued partnership.