A growing theme in investing is to target and invest only in the least volatile stocks in the market. One simple example of this is take the S&P500, which is a representation of the 500 largest publicly traded stocks in the United States, and only invest in the 10% of companies with the lowest standard deviation of the 500. This would produce names such as AT&T, Coca-Cola, and Johnson & Johnson.
This simple concept traditionally would result in an investor owning a lot more safety, blue chip, and high dividend yielding stocks. Not a bad bet in a historic context. Looking forward however, we have an accelerating concern over the price of these types of companies, which may lead to them not being as safe as one would expect.
One metric we look at to value stocks is the Price to Earnings ratio, the easiest way to describe this is what price is an investor willing to pay for every dollar a company earns in profit? A higher P/E ratio implies more expensive, a lower one implies cheap. Comparing a stock, or an index, such as the S&P500 to its historical average P/E can give you a relative idea of whether something is expensive or cheap compared to historical standards.
Historically, going back to 1972, the companies in the lowest 10% volatility bucket in the S&P500 (as measured by standard deviation) produce a historical median P/E ratio of roughly 13. As is stands today that same low volatility class of stocks trades between a P/E ratio of 23 to 24.
Why is this troubling? Well, when prices revert to the mean, and investors are willing to pay less for those same dollars of earnings, it spells trouble for those who hold these assets, especially those who have been chasing the stability and dividends these stocks were expected to provide.
What is causing this? Let’s take a look at the major contributors:
Fed policy. While artificially low interest rate policy is intended to push investors into riskier assets, some investors still want safer assets. Low volatility stocks have higher dividend yields, making them bond proxies.
Sector attribution. The low volatility group is concentrated in Utilities, Financials, and Consumer Staples, which have high dividend yields and P/E ratios that are above their long-term averages.
High valuations for the broad market. The median P/E for the S&P 500 is 24.0, well above its historical norm, which has pushed investors into “safer” stocks.
Secular trends. Fear is a stronger emotion than greed, so investors have flocked to “safer” assets.
Industry innovation. ETFs have enabled investors to more easily buy themes like low volatility.
The first three factors are the most likely the first ones to threaten this crowded trade. The one that has me the most troubled is the fifth factor. Industry innovation has led to specialized investment products that make it very simple for retail investors to buy into this wave of low or minimum volatility assets. We’re seeing these assets recommended in droves to competitor’s clients, with little to no consideration given to how crowded or expensive the trade may be.
These assets in the broad context of a well diversified portfolio may make sense, but from my perspective every asset has a time and a place. Currently, I would not be overpaying for safety by using these low volatility factors we’ve explored above. There are other ways. Like always, when assets deviate from a historical valuation range, it can take quite awhile to be proven right and see them correct. We’re not yelling fire in a crowded theater but would like to see investors better educated on the risks ahead.
Thank you for reading!
Blake Street is an Investment Advisor Representative of Warren Street Wealth Advisors, a Registered Investment Advisor. The information posted here represents his opinions and is not meant as personal or actionable advice to any individual, corporation, or other entity. Any investments discussed carry unique risks and should be carefully considered and reviewed by you and your financial professional. Nothing in this commentary is a solicitation to buy, or sell, any securities, or an attempt to furnish personal investment advice. We may hold securities referenced in the blog and due to the static nature of content, those securities held may change over time and trades may be contrary to outdated posts.
Last week we watched our version of “The City” lose in Game 7 of the NBA Finals, after blowing a 3-1 lead in the series. This week we watch as London, aka, “The City” and the U.K. at large enter their own final referendum homestand on whether to leave or remain in the European Union. Whether the U.K. stays or leaves, most of this outcome will be short term noise, and will deliver little long term impact in our opinion. Similar to how Cleveland winning a championship has their town in hysterics right now, it still won’t change the fact that their rivers light on fire.
As the clock ticks down, most polls show a healthy balance of IN or OUT voting leading to a proverbial coin flip for the U.K referendum. Consult the odds makers or gambling experts and you’ll get a slightly more confident story for the U.K to remain in the European Union. Let’s see where the money is:
If the masses turn out to be asses in betting, which would not be a first, what ultimate impact would a “Brexit” have on the EU or U.K. as a whole? Your guess is as good as mine at this point. A successful “Brexit” vote would start a minimum two year process described in Article 50 of the Lisbon Treaty in which E.U. treaties would still apply as negotiations were carried out to determine how the exit is ultimately handled. Big takeaway here is we’re not dealing with a binary event where a switch is flipped and suddenly everything we know about the E.U. changes overnight.
One of the larger talking points we hear discussed is how the U.K. will lose the majority of existing trading agreements and will be on an economic island. This is simply just not true. Sure the U.K. will need to go back to the negotiation table but they’ll have ample opportunity to continue relationships with the common market via the European Economic Area, European Free Trade Area, and even other more regional trade groups. Here’s an example of how many tangled webs one can weave:
One could argue, and it is our personal sentiment, that much of the market is already pricing in a “Brexit” discount. It appears that the consensus view is that the U.K. would bear the brunt of the near term pain from an exit. This risk premium can be viewed in the form of currency volatility of the British Pound relative to the Euro as of late, shrinking British equity premiums relative to Eurozone stocks, and last but not least higher relative interest rates that lead to increased debt servicing costs. The U.K. and Germany for example have similar public debt loads, but it costs the U.K. approximately an extra $33 billion a year to service its public debt load.
Source: Haver Analytics, Ned Davis Research
Having seen that a “Brexit” discount may already be priced, whether it passes or not, we remain committed to our international holdings and will likely take any near term dip as an opportunity to buy into weakness. Ideally, a remain vote instills confidence in some of the countries on the E.U. periphery that are struggling with structural reform and the European Union as a whole can get back to trend level growth. Something we’ve been patiently waiting for now for years.
All in all, a small part of me will be sad to see the “Brexit” vote come and go, it was a welcome distraction from the impending circus of an election the United States is about to endure. On that note, my counsel remains the same, turn off the TV talking heads, spend time with those you love, grow your value in the workplace, and be a strong steward of your wealth. That’s what we’ll be doing.
Blake Street, CFP®
February 12, 2016 by Marcia Clark, CFA
On January 26, 2015, I wrote an article questioning the relationship between falling oil prices, slowing Chinese GDP, and the precipitous decline in the U.S. stock markets. I counseled readers to take a breath, that the stock market turmoil was overdone and the U.S. economy was secure.
Shortly after my article, the S&P 500 index rebounded from 1903.63 to 1949.24 as on January 29th the Bureau of Economic Analysis announced 4th quarter GDP growth at a modest 0.7%, slightly below analyst expectations of 0.8%.
U.S. Real Gross Domestic Product and Civilian Unemployment Rate
Stock Markets Stabilize with 4th Quarter GDP Report
Why did the stock market react so well to such modest GDP growth? Perhaps because, if you look deeper into the GDP components, the slow growth was primarily due to weak exports and low oil prices, while consumer spending and residential construction remained strong. When considered in light of positive trends in disposable income and job growth, investors seemed fairly content with the 4th GDP results. Concern about specific sectors of the economy are well-founded, however, as low oil prices are indeed causing an increasing number of shale oil drillers to default on their debt obligations. But lenders prepare for this type of risk by diversifying their investments, and there is little evidence that distress in the oil patch will spread throughout the broader economy.
S&P 500 Stock Market Index, February 2015 – February 2016
Do Stock Markets Really Predict Economic Recessions?
To twist a common phrase, every silver lining has a cloud, and in the days following the GDP announcement oil prices continued their downward trend and talk of an economic slowdown began to circulate in the financial press. By February 11, the S&P 500 index had plummeted to a low of 1829.08, before recovering a bit to end the week at 1864.78. Clearly, the turmoil was not over!
But does a falling stock market really foretell an economic decline in the U.S.? Let’s take another look at the evidence. The Brookings Institute published an article by George L. Perry on February 2, 2016[i] reviewing the relationship between stock market declines and economic recessions. Mr. Perry concludes that significant stock market declines – say 20% or so – do indeed tend to precede economic downturns. However, more moderate declines in the stock market happen much more frequently than do recessions. And when such declines are accompanied by decent economic figures, the predictive power of the stock market is unreliable.
In fact, the most recent Conference Board Leading Economic Index published January 22 shows a strong positive trend, despite the U.S. stock market being a component of the index. It’s important to note, however, that the index fell slightly in December due to weaker growth in housing and manufacturing. Also of note, the latest Leading Indicator Index does not include January’s stock market decline.
Leading Economic Index as of December 2015
So, Where Do We Go From Here?
As articulated by Fed Chairman Janet Yellen in her testimony to Congress on February 11, the U.S. economy remains on an upward trend at present, though the future is uncertain. On the positive side, employment gains, low interest rates, and falling oil prices provide consumers with more disposable income to support domestic businesses. On the negative side, slowing Chinese and commodity-based economies, combined with the strong dollar, continue to depress U.S. exports.
On balance, I reiterate my earlier advice. Stay strong, hold on tight, and wait for smoother sailing ahead. Investors with a tolerance for volatility might even consider buying into the distressed oil and gas sector. Be warned, however! A risky endeavor such as this requires an abundance of fundamental analysis and healthy skepticism when forecasting future earnings. Such a venture is best left to the boldest among us with the ability to withstand the choppy voyage ahead.
Marcia K. Clark, CFA
Warren Street Wealth Advisors
Senior Research Analyst, Wealth Advisor
Why is the turmoil in China and the drop in oil prices depressing the U.S. markets?
Marcia Clark, CFA, MBA, Senior Research Analyst & Wealth Advisor, Warren Street Wealth Advisors
January 25, 2016 10:43am Pacific time
In case you’ve been enjoying an extended holiday season, you may not realize that January 2016 is on track to become the worst January for the U.S. stock market since 2009. How worried should you be? Based on my analysis, my opinion is that the stock market has over-reacted to both the turmoil in the Chinese stock market and the drop in oil prices. Investments in companies other than oil producers, particularly those that benefit from cheaper oil prices, may deliver good results in the coming year.
S&P 500 February 1st, 2015 – January 2nd, 2016
And the bond market hasn’t been immune. Yields on below-investment grade bonds in particular spiked to levels not seen since 2012.
But why have the U.S. markets reacted so strongly to the Chinese market and oil prices? Has the U.S. economy encountered an unexpected pothole? Have an excessive amount of U.S. businesses or homeowners declared bankruptcy? Have scandals erupted in key corporations? Has the U.S. Congress threatened to shut down the government rather than pass a budget? No, none of these things has happened. Yes, industrial production and corporate profits have hit a bit of a slump. But the U.S. job market – probably the best indicator of imminent recession – continues to rebound with 292,000 new jobs in December and 2.7 million new jobs for the past year, according to the Bureau of Labor Statistics.
To recap the past few months in the Chinese stock market, as reported by The Economist (January 25, 2016), in early July 2015 China’s stock market crashed with share prices dropping by a third, wiping out some $3.5 trillion in wealth (more than the total value of India’s stock market).
A further plunge on August 24 followed by a fall of similar proportions the next day sent share prices down over 40% below their 2015 peak.
Since the summer, the Chinese stock market had rebounded approximately 20%, so one hoped that the worst was over. Unfortunately, on January 4th and again on January 7th the CSI 300 index of ‘blue chip’ Chinese stocks fell approximately 7% and fears of a serious economic decline were renewed.
Given that that Chinese stock market has indeed experienced a challenging 6 months, how can we extrapolate the severity of the problem to U.S. investors? Ultimately, the value of any stock market should reflect the profitability of domestic businesses.
On January 19th, China reported its official annual GDP growth figure for 2015 at 6.9%, just a shade lower than 2014’s 7.3%, and much stronger than average global forecast GDP of 2.8%, reported by the Conference Board.org in November 2015.
The worry seems to be that the official GDP figure may be manipulated by the Chinese government and that much worse lies ahead.
But how much of the decline in the Chinese economy should legitimately be reflected in the U.S. economy? It is difficult to calculate a precise figure, but for context see the table below.
|Country||Exports||Imports||Total Trade||Percent of Total|
As of November 2015, China was indeed the largest trade partner with the U.S., so changes in their economy could definitely impact ours. However, note that exports – which bring profits to U.S. businesses – are much smaller than imports. This should buffer the impact of the Chinese decline somewhat. So troubles in the Chinese economy can indeed impact the U.S., though by how much is very difficult to say.
But what about falling oil prices?
As an input to so much of what we consume, lower oil prices depress final goods prices – including gasoline – which leaves more money in consumers’ pocket to buy other things. Yes, a severe drop in oil prices driven by a lack of demand would definitely indicate a recession, but that’s not what’s happening these past months. The problem is an overabundance of supply.
With the widespread use of hydraulic fracturing in the U.S., crude oil production in the U.S. has spiked to levels not seen in the last 30 years. With OPEC countries maintaining production near historic levels, and global demand growth increasing only modestly, basic laws of economics indicate that the market price of oil must fall.
So where does that leave us? Yes, we should be concerned about the market turmoil in China as that country adjusts to a slower, but still strong, growth rate of their economy. Declining oil prices caused by excess supply is a good thing for consumers, but will depress profits of oil producers which can be a large component of stock market indexes.
On balance, the U.S. economy remains on an upward trajectory. Recent declines in the stock market should be viewed as a buying opportunity. But be selective! Companies whose revenues are strongly tied to the price of oil may continue to struggle until supply and demand reach a new equilibrium.
Warren Street Wealth Advisors, LLC
17822 E 17th Street, Suite 208
Tustin, CA 92780
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