You’ve
undoubtedly now seen multiple headlines about how weakly stock markets have
started the New Year, so we believe a brief note about this year’s markets is
in order.
The
S&P 500 Index fell 6% in price in the first week of 2016 and that was
followed by another 2% drop last week.
Compared with its highs last May, it has now fallen nearly 12%, putting
the decline squarely in “correction” territory.
Our message is three-fold: 1)
This kind of market decline is nothing to be alarmed about; 2) it has slightly
improved valuations; and 3) diversification outside of stocks has been
beneficial in this episode.
Stock
market corrections of 10% to 20% occur with some regularity. Recent years may have conditioned investors
otherwise since there was only one such dip between early 2009 and late last
year, but they historically occur more frequently than that. It could be said that the very reason stocks
are generally priced to earn a greater long term return than bonds is because
of the undesirability of just that sort of volatility. But historically, most market declines of 10%
do not go on to become bear markets (that is, declines of 20% or more), and in
all cases, markets have ultimately gone on to “recover”, or to achieve new
highs.
With
the 12% drop in the stock market, valuations have improved. The dividend yield of the S&P 500 Index
is now 2.39%, a meaningful improvement from yields of 2% and 2.1% as recently
as July, as dividends are up a bit and the S&P 500 price is down. Forward earnings expectations have been slipping
a bit in recent months, but stock prices have declined faster so valuations have
improved on the basis of earnings as well.
For some time, we have pointed out that stock valuations are quite
elevated on what we consider the most important measures, and this small
improvement does not correct all of that overvaluation by any means. But a step in the right direction is still
constructive, especially in light of lower bond yields.
Market
drops are ideal times to see the benefits of diversified portfolios in real
time. Balanced portfolios have dropped far
less than the 7.9% slide in the S&P 500.
As often happens when stocks fall, the bond market has gone up; around
1% year to date. Real estate has fallen
less than common stocks and gold is actually higher. Finally, market risk hedges, intended to be
highly resistant to market drops, have been virtually unchanged year to date.
We’re
not sounding the “All Clear” signal – that’s not something we’re ever likely to
do. But we believe a little perspective
always helps, especially when headlines get shrill. We do see some interesting opportunities
developing and we are maintaining our discipline and capitalizing on
opportunities the market decline has created to rebalance portfolios as needed.