FMA Market Update – August 2015 Edition
August 26, 2015 | John J. Klobusicky CIO, CFA®, CAIA
Volatile Markets, but Fundamentals Remain Attractive
This month we witnessed the first broad correction to global equity markets in several years, with the Standard & Poor’s 500 Index and EAFE Index (Europe and Developed Asia) both closing down more than 12% below their peak values from May. Other regions and asset classes suffered a worse fate: emerging markets joined a horrific sell-off in Chinese equities where the Shanghai Composite Index fell over 40% from June to present after a run-up of almost 50% during the first half of the year. Non-U.S. currencies declined with the commodity-driven Brazilian Real down 25% year-to-date. Oil prices measured by near-term West Texas Intermediate Crude are holding at approximately $40/barrel on excess supplies, and several leveraged energy companies have defaulted or forced debt exchanges on investors. Against this backdrop, the bond market benefited with the Barclays Capital Aggregate Bond Index moving into positive territory for the year after slipping this summer on the expectation of a Fed interest rate increase.
It is unclear what caused the turmoil or resulted from the feedback loop, but the stronger dollar, dueling deflationary and inflationary pressures, and moderating earnings growth are creating near-term headwinds. Yet, quietly, U.S. Real Gross Domestic Product for the first quarter was revised up by .8% and stands at an annual growth rate of 2.3% as our economy trudges onward. Further, corporations (especially banks) are in their best fiscal shape in years backed by strong balance sheets and capital levels. What’s an investor to do? We continue to believe that the U.S. and primary international markets are positioned for a better year-end into 2016 barring any extraordinary developments. To that end, we focused this month’s update on two principles: (1) Why the “risk premium” from equities remains attractive and should drive stocks compared to bonds and cash, and (2) Why holding dividend-paying stocks reduces volatility and enhances total return. There really are no shortcuts. Diversify, build a series of cash flows, and compound over time. These words are easy to say but harder to live by when markets become irrational.
What’s an investor to do? We continue to believe that the U.S. and primary international markets are positioned for a better year-end into 2016 barring any extraordinary developments. To that end, we focused this month’s update on two principles: (1) Why the “risk premium” from equities remains attractive and should drive stocks compared to bonds and cash, and (2) Why holding dividend-paying stocks reduces volatility and enhances total return. There really are no shortcuts. Diversify, build a series of cash flows, and compound over time. These words are easy to say but harder to live by when markets become irrational.
Favorable “Equity Risk Premium”
Equity Risk Premium refers to the excess return that an investor demands of a stock or the overall stock market above the “risk-free” rate for taking this risk. The investor’s alternative to holding stocks is to place funds in a savings account or a medium-term bond, which provides stability but little income these days. Remarkably, in a diversified portfolio over time, stock prices tend to adjust until the holder gets paid at least this risk premium through total return (dividend yield plus price appreciation). While not immune to market and economic forces, this measure is a time-tested indicator of how equity prices should respond to the perceived risk relative to cash and bonds. The following is a snapshot of the earnings yield from stocks above the local 10-year bond with the U.S. equity market retaining a reasonable value, and Europe and Japan looking attractive:
Equity Market Survey: Valuations Remain Intact
Dividend stocks have historically participated in the market’s gains during up markets but offer some protection over non-payers during down markets. Additionally, many companies establish and follow clear dividend policies with predicable amounts (plus any increases) providing a persistent income stream with less volatility than the equity price itself. Throwing aside market forecasts and other Wall Street wizardry, the simple fact is that since 1930, the payment and reinvestment of dividends accounted for roughly 40% of the total return of the S&P 500® Index. We believe that investors may benefit from active selection when choosing the specific stocks or markets producing the dividends.
Dividends have been a key contributor to total returns.
Dividend-paying stocks have performed in all types of markets.
We are maintaining our current equity allocation. We remain positive on international equities and in particular Europe and Japan, as these areas will likely continue to benefit from strong Central Bank support, a weaker currency, cheaper energy, and attractive valuations relative to the U.S. In the U.S., 2Q earnings reports have already been released and price excesses that occurred in technology, cable, and consumer discretionary sectors have been reset. Dividend yields were boosted by the correction, and we will look for new market leadership to emerge in the coming weeks. For bonds, the Federal Reserve could pause on its plan to raise rates during the third quarter, which has momentarily boosted bond prices especially on the shorter end. For any sound investment plan, bonds play an important role in the portfolio, and we continue to allocate to high-quality bonds across short- and medium-term durations. Each month we’ll share insights and analyses on global financial market trends. Please feel free to call or meet with any of FMA Advisory’s investment team. We’re only a call, click, or conversation away.