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Quarterly Review January 2016

A Tummy Tickler

Just like the feeling we get when a fast-moving car crests a rise in the road and begins downhill, the markets have given us a "tummy tickler" for the past several weeks. After six consecutive years of churning out gains, we reached a short-term crest and have witnessed a decline. This hasn't been anything to cheer about or to make one want more.It has given the average investor a bit of an unwanted thrill. We are likely to return to a more stable road as bargain-buyers return to the market.

Let's take a moment to review how various indices fared for the past quarter and for the year:
​Index 4th Quarter​ For the year 2015
​Dow Jones Industrial Average (the Dow)
+ 7.5%
​- 2.2%
​S&P 500 Stock Index (the S&P 500)
+ 6.5
​- 0.7%
​NASDAQ Composite
+ 8.4%
​+ 5.7%
​Russell 2000 (small companies)
+ 3.2%
​- 5.7%
​Dow Jones Global Stock Index (non-US)
+ 3.5%
​- 6.6%
​10-Year Treasury Bonds
​- 1.4%
​+ 1.0%
​Commodities Index (Reuter-Jeffries CRB)
- 8.4%
- 19.0%
​U.S. Dollar Index (WSJ Index)
+ 1.6%
+ 8.6%

All index values come from the Wall Street Journal. Stock indices do not include dividend return. 

The fourth quarter of the year provided a much-needed recovery from the preceding quarter, but even the robust advances shown above were not enough to bring the broad stock market averages into the black for the year. This past year was the first decline in stocks since the financial disaster of 2008—a particularly painful year. A "down" year after six straight years of positive performance shouldn't be considered unusual.

The broad market averages (Dow, S&P 500) and the technology sector led the way this past quarter with big gains.However, other than the NASDAQ index, stock averages ended in the red for the year. Small companies did not join the party in earnest and continued to lag larger companies.International stocks had a good quarter but fell far short of making up for declines suffered earlier in the year—a testament to economic weakness around the globe. Bonds provided what we expect of them: stability. The index for 10-year Treasury bonds declined a bit in response to the upward nudge in short-term interest rates executed by the Federal Reserve Bank ("the Fed"), but ended the year slightly in the black.Commodity prices continued to fall, declining 8.4% for the quarter and a huge 19% for the year due to an excess supply of oil and other natural resources combined with reduced demand. The U.S. dollar fared very well again, gaining 1.6% for the quarter and is up a noteworthy 8.6% for the year. The dollar gained more against some currencies than others. The index above compares the dollar to a diversified pool of foreign currencies.

The picture changed dramatically after the start of 2016, with U.S. and global investors succumbing to anxiety about (1) the ripple effect of a slowdown in the Chinese economy and (2) the virtual collapse of oil prices.China—after a ridiculously over-done surge in their stock market—has been falling back to earth in impressive fashion as investors rush the exits to sell as quickly as possible. As of this writing (January 25th), their stock market (measured by the Shanghai Composite) has already declined nearly 18% in 2016.

The adolescence of the Chinese markets has come into focus as their regulators have experimented with strategies to slow the selloff by limiting and/or halting trading and also trying to manipulate their currency. This has not worked. The domination of sellers may continue although probably not at the same rate.

Since December the price of oil has tanked to a 40-year low—briefly falling below $27 per barrel. A mixed blessing, the reduced cost of fuel may convince consumers they can afford to loosen the purse strings. Consumers remained positive according to December's polls but they have not increased spending notably. Massive layoffs and business spending pullbacks within the energy sector have tempered the gains that we might expect from reduced energy costs and a modestly growing economy. For example, during 2015 the economy added over 2.7 million jobs (the second-highest gain in 15 years—right behind 2014).Nearly ninety percent of those jobs gained were in the service sector.Job gains would have been even higher had it not been for a loss of 130,000 jobs in the energy and mining sector.

Where We Are Now

The markets are beginning to exhibit some stability as bargain-hunters have waded back into the water. As measured by the traditional ratio of price-compared-to-earnings, stocks are still overvalued. The season of quarterly corporate earnings reports is now upon us and this usually reduces the degree of overvaluation. Stocks have been the investment alternative of choice since interest rates remain so low as to provide little incentive to own bonds. Looking beyond our own borders, many economies across the globe are struggling. Countries that rely upon the extraction and export of natural resources have suffered due to severely reduced demand for their products. As a result, those countries have experienced reduced corporate, government, and personal spending and a decline in the value of their currency.

Looking Ahead

The Fed initially stated it expected to increase rates periodically this year, but given their recent hesitation to raise rates, negative investor reaction to the recent increase, the ever-strengthening of the U.S. dollar, and our anemic economic growth rate, this is very doubtful. The Fed's next meeting is in March and it's hard to conclude that our economy will be so strong by then as to merit another raise so soon. The U.S. dollar's strength has reduced the cost of imports, but the export of our goods and services to others has become more expensive. This is compounded by reduced demand from overseas due to the global economic slowdown.Our manufacturing sector remains quite weak, while the service sector remains strong.

The resilience of our economy is the shining exception to nearly all other global economies. Though we export less oil than many countries, the price of oil is having a direct impact on stocks. The global oil surplus is likely to be accentuated as Iran begins to export oil now that trade restrictions have been lifted. Our rate of economic growth may slow but most observers feel growth will likely continue. Though our markets are overvalued, the recent market downturn seems to be more dominated by emotional selling rather than justified by an economic downturn here in the States. It's hard to predict the future of the Chinese markets. We hope the selling ebbs and their markets stabilize—thereby alleviating this source of anxiety around the globe.As measured by production, China's economy is now second only to America's.

Although likely to remain somewhat overvalued, we expect the stock market to recover from the recent bout of selling. Though global economies could hold our back, we expect the U.S. economy to continue to grow modestly in a climate of low inflation and low interest rates.

As always, we will continue to follow the markets closely and take appropriate actions within client accounts to manage risk and return in accordance with each client's Investment Policy Statement.

Please feel free to call with any questions or comments.
Craig S. Limoges CFA, CFP, EA George Middleton CFA, CPA-PFS.
 

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Monday, 20 November 2017

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