Most investment categories recorded gains in the final three months of 2015, bouncing back after a rocky July-September quarter.  Major U.S. stock benchmarks posted three-month returns of 5% or better.  Most overseas equity markets rallied, too, though returns to U.S. investors were tempered by an appreciating dollar.  Real-estate securities were among the biggest gainers, while commodity-related investments and high-yield (below-investment-grade) bonds posted losses.  Interest rates edged higher: the 10-year Treasury ended the year yielding 2.27%, up from 2.06% on September 30th.  Widening credit spreads resulted in flat to slightly negative returns for many bonds, although most Treasury and high-quality municipal issues ended the year with modest gains.

Within the U.S. stock market, the best three-month performance was turned in by companies in the Consumer Staples, Health Care and Technology sectors; relatively weak groups included Basic Materials, Consumer Cyclicals, Energy and Utilities.  Large-company stocks outperformed those of smaller firms, while growth-oriented names bested their value counterparts.

Benchmark Performance – Equities

  Fourth Quarter 2015 Last Twelve Months
     S&P 500 Index +7.0% +1.4%
     Large-Cap. Core Mutual Fund Avg. (Morningstar) +5.6% -1.1%
     Small-Cap Stocks (Russell 2000) +3.6% -4.4%
     Non-U.S. Stocks (Developed – MSCI EAFE) +4.8% -0.2%
     Non-U.S. Stocks (Emerging – MSCI EM) +0.5% -14.8%


Benchmark Performance – Fixed Income

  Fourth Quarter 2015 Last Twelve Months
    Barclays Intermediate Gov’t/Credit Index (taxable) -0.7% +1.1%
    Intermediate Municipal Mutual Fund Avg. (Morningstar) +1.4% +2.5%



A number of trends that underpinned financial market performance during 2015 have been in place for some time.  The global economy, in its sixth full year of recovery following the 2008-2009 financial crisis/recession, again expanded at a well-below-average rate of around 3% – the weakest result since 2009.  The U.S. and U.K. paced the developed economies, the Euro Zone marginally exceeded (low) expectations, while Japan disappointed.  Emerging markets were mostly sources of weakness (Brazil, Russia) and uncertainty (much of Asia, following China’s lead); India was a lonely bright spot.  Prices of energy and other commodities continued to slide: following its plunge from over $100 to under $60 in the second half of 2014, the price of a barrel of crude oil dipped a further 30%.  With inflation remaining very low (averaging well below 1% across the world’s largest markets) and most economies sporting ample slack resources, central bankers continued to supply copious monetary support, helping keep bond yields at historic lows and bolstering the prices of other assets.

Notable new developments also confronted investors.  Chinese stocks were alarmingly volatile, gaining as much as 60% in the first half of the year before plummeting by more than a third in the July-September quarter.  Geopolitical risk, in the forms of terrorism, regional conflict, mass migration, and spreading populist/nationalist political movements, reclaimed a prominent spot on investors’ radar screens.  Buoyed by relatively healthy U.S. growth and anticipating a long-awaited shift in monetary policy, the foreign-exchange value of the dollar surged.

Corporate management teams found 2015 to be a challenging year.  When we wrote to you twelve months ago, we reported that, following a rise of 6% in 2014, Wall Street analysts were collectively eyeing a further 12% gain in aggregate profits for the year ahead.  As 2015 unfolded, however, many industries were confronted by lackluster demand and weak pricing power.  Meanwhile, dollar strength curbed demand for U.S.-manufactured exports as well as the dollar-denominated value of overseas sales and profits of U.S.-based multinationals like Procter & Gamble and Coca-Cola.  Finally, the commodity-price collapse crushed the earnings of energy/commodity-producers while noticeably dinging those of many capital-goods producers who sell into those markets.  The net result of these headwinds: earnings reported during the fourth quarter (mostly covering the July-September period) were some 14% below the year-earlier figure.  When the final tally is in, we expect calendar-2015 earnings for the companies that make up the S&P 500 Index to have declined by more than 5%.

Last year proved equally trying for many investors, with name-brand mutual funds and billion-dollar hedge funds posting substantial, even double-digit losses.  In a phenomenon reminiscent of the late-1990s, investors herded into the stocks of a few large companies – the so-called ‘FANGs’ (Facebook, Amazon, Netflix and Google) plus Microsoft and a mere handful of others – whose business models allowed them to maintain impressive growth in sales, if not necessarily profits.  As a result, the capitalization-weighted S&P 500 Index eked out a small positive return, even though the price of the average stock declined by almost 5%.

Performance among different market sectors was as divergent as we can remember: among U.S. large-company stocks, growth-oriented names gained more than 4%, on average, while the value category saw a decline of around 5%.  Within the S&P 500 Index, the 10% of stocks with the largest market capitalizations recorded gains as a group; the remaining 90% of index members declined, on average.  Similarly, the 10% of stocks paying the smallest dividends rose, while the 90% with higher yields fell.

Outside the U.S., varying local-currency performance (many European bourses gained, as did those in Japan and China; much of emerging Asia and Latin America declined) translated mainly into losses in appreciated U.S. dollars.  In fixed-income markets, prices of all but the highest-quality bonds fell modestly, as credit spreads widened; the non-investment-grade (high-yield) sector saw the biggest losses, though these were concentrated in the Energy and Materials industries.  Most U.S. Treasury and many municipal issues provided positive returns, but these were modest due to the historically low beginning level of yields.


What’s Changed?

To provide insight regarding recent stock market performance, we can deconstruct the three-month return from stocks into three components:

1)         Dividend Income (for three months this is the annual yield divided by four)

2)         +/- Change in Earnings per Share* (average for S&P 500 companies)

3)         +/- Change in Valuation (Price/Earnings Ratio)

= Total Return

            * based on forecast earnings for next 12 months (Source: S&P Outlook)

So, what changed during the recent quarter to give us the +7.0% S&P 500 total return?

Fourth Quarter (October-December) 2015
Dividend Income +0.5% +7.0%
+ Change in Earnings +6.1%
+ Change in Valuation +0.4%
= Total Return +7.0%

Our read
:  This model uses changes in expected year-ahead earnings, which improved as the worst of the commodity-price and dollar-appreciation headwinds are – presumably – in the past.  The market’s strong fourth-quarter rebound seems to corroborate that presumption; time will tell whether it is actually the case.


While U.S. presidential politics and volatile geopolitical developments will likely provide their share of distractions, financial-market participants will be keenly attuned in the months ahead to the prospects for corporate profits and interest rates.  The earnings outlook, it seems to us, will be shaped to an unusual degree by developments in commodity and currency markets, which were such a drag on 2015 results.  Meanwhile, evolving perceptions regarding the Fed’s plans to navigate back to a more normal monetary regime will determine the path taken by interest-rates.  We also expect investors to anxiously eye news from China, attempting to discern whether the authorities in Beijing will avoid the dreaded ‘hard-landing’ in the world’s second-largest and most dynamic economy.

The prospects for U.S. corporate profits may be as uncertain as at any time since the early days of the current economic expansion.  Sluggish global economic activity and nearly nonexistent inflation continue to hamper top-line growth.  Meanwhile, with profit margins at near-record levels, it seems many companies have exhausted major cost-cutting opportunities, while technology-driven productivity growth has been disappointing.  A recent uptick in wage growth, if it were to persist, would pose another obstacle to expanding profits.

Though we don’t expect major improvement in these underlying challenges during 2016, we are more optimistic regarding energy/commodity prices and dollar strength.  Although supply of the more capital-intensive industrial commodities (e.g., steel, copper) is notoriously slow to react to price signals, prices of such materials have been falling since 2011-2012, when Chinese industrial output began to slow.  And though energy prices peaked much more recently (in mid-2014), oil and gas output should be much more responsive to the subsequent collapse.  In fact, the number of active drilling rigs has plummeted and daily U.S. production has already fallen by a half-million barrels from its early-2105 peak.  Expected declines from U.S. shale and other high-cost, non-OPEC sources could reduce daily output by as much as two million additional barrels.  Given this rapidly changing dynamic, we think it likely energy prices will soon find a bottom and could be on the rise later in the year.

With its December decision to raise short-term interest rates for the first time in a decade, the Federal Reserve embarked on a policy path that diverges from other major central banks – the European Central Bank, Bank of Japan and People’s Bank of China – all of which are expected to ease monetary conditions further this year.  This divergence is unusual (major central banks have mostly moved in unison over the past several decades) and would be expected to have major market-moving impacts – in particular, higher U.S. bond yields and a stronger dollar.  However, the impending shift was so thoroughly telegraphed over the past two-plus years that most of its effects have already occurred: U.S. Treasury yields, though historically low, are much higher than those in the Euro Zone and Japan, while the dollar has appreciated by more than 20% on a trade-weighted basis.  Unless the Fed’s future actions deviate meaningfully from investor expectations (discussed below), we would not be surprised to see little additional change in longer-term interest rates or the value of the dollar.

The shape of the U.S. yield curve (i.e., the varying market-determined yields of Treasury securities ranging in maturity from a few months to 30 years) indicates investors think the Fed will raise rates very modestly over the next two or three years.  Specifically, the curve suggests investors expect the Fed Funds target (currently 0.25%-0.50%) to go no higher than approximately 2% over that timeframe, compared to the 4% to 5% level considered normal in the past.  Many economists concur with the market’s view, noting that persistently low inflation and dollar strength (which acts like a tightening of monetary policy) provide scant incentive to hike rates aggressively.  The Fed’s own communications, however, indicate some of its board members are disposed to raise rates more rapidly.  Accordingly, signs that inflation is accelerating meaningfully, which could tip the Fed’s deliberations in favor of more/faster rate hikes, could lead to a jump in longer-term bond yields as well as further appreciation of the dollar – with negative consequences throughout the global financial system.

We have been intent observers as investor sentiment toward China soured dramatically over the past several years.  Where once Beijing’s authorities were admired as technocratic geniuses astonishingly adept at piloting their gigantic economy, now every ‘ham-fisted’ policy move is second-guessed and each newly released statistic is dismissed as manipulated, if not fabricated.  We believe this pessimism may be overdone.  After all, according even to bearish observers, the Chinese economy – nearly as large as that of the U.S. – is growing at least twice (and probably more like three times) as fast.  Pessimists dismiss the fact that China’s evolution from a poor to a rich country is far from complete: growing at 6% a year, it would take almost 30 years to achieve the per capita output enjoyed today in Japan or Taiwan.  Similarly, to achieve the degree of urbanization in Japan or South Korea (which, by way of reference, is not much higher than in the U.S.), an additional 350-400 million Chinese must move to its cities in coming decades.  But what about China’s supposedly grossly overbuilt infrastructure?  With four times the population and a similar land mass, China has roughly half as many railroad miles as the U.S.  And while the U.S. boasts an airport for every 60,000 citizens, the corresponding figure for China is 3.2 million.  So, while we acknowledge that China faces daunting challenges – what large economy doesn’t? – and its leaders will likely make their share of mistakes, it seems to us that the Middle Kingdom is likely to retain its place as an important engine of global growth for a long time to come.

In closing, we wish to emphasize that the divergent performance within financial markets during 2015 presents some interesting opportunities.  With the shares of many high-quality companies down 30%, 40% or even 50%, the U.S. equity market now boasts a considerable number of stocks with attractive valuations.  Though it is impossible to know when investor predilections will shift, history has shown that prospective longer-term returns nearly always benefit from investments in good businesses made at below-average valuations.  And since many of these stocks also sport dividend yields of 3% to 4%, we also get paid to wait, as the saying goes.  In a similar vein, and as we have previously remarked, U.S. equities have outperformed their overseas counterparts by a very substantial margin over the past five years.  We believe the combination of divergent monetary policy (a potential headwind in the U.S., a tailwind almost everywhere else), a less-challenged earnings outlook in some major foreign markets, and perhaps even shifting investor sentiment with regard to emerging markets all augur well for a reversal in fortunes not far ahead.

We welcome your comments and questions regarding our management of your investments, and wish you a healthy and prosperous New Year.

Alan Purintun, CFA                                                             Robert W. Phelps, CFA
Principal & Portfolio Manager                                          Principal & Portfolio Manager


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