Letter to Our Clients - January 2015
Dear Clients and Friends:
January has been full of bad news, and good news – in other words, perfectly normal.
There are four investment themes we would like to address in this letter.
1. While it is clear interest rates will rise from here, it also seems likely that they will not rise very much for the next few years. Why?
One reason is that while the US economy may not seem perfect, it is far and away the most vibrant economy in the developed world. Because the US is connected to the rest of the global economy, reduced demand overseas results in fewer buyers of US goods and services. This, then, reduces profits in the US, and limits the growth of the US economy. This may cause the Fed to be careful to not raise interest rates too much or too quickly.
Another reason is that interest rates in the US, although at historic lows, are also higher than interest rates in almost all countries throughout the world. This means foreign investors will be interested in buying US bonds. Increased demand in US bonds should help keep US interest rates low.
These two factors are likely to continue for several years. Generally, this environment can be predicted to be good for stocks. Until, of course, it isn’t.
2. Inflation is relatively tame in the US and is basically non-existent in the rest of the world.
One major cause for inflation is rising wages. While there is a push to increase the minimum wage in the US, the reality is that technology and improved productivity mean fewer workers are required for a unit of output. As a result, companies continue to lay off significant numbers of employees. Rampant wage pressure, as was last seen in the 70’s and 80’s, appears to be a last century phenomenon.
Another major driver of inflation is energy in particular and commodity prices in general. Oil prices have dropped by more than 50% since summer of 2014. In the past, oil prices have dropped because of too little demand. Supply itself was either constant or tight. Now it is reversed. Supply appears to be unlimited, and one reason for that is the dramatic increase in US oil production. However, demand has dropped because of poor international economies and changes in US driving patterns. The drop in oil prices has coincided with the drop in prices of metals as well. Thus, it is likely to be some time before commodity prices drive inflation up.
With inflation low, stock prices should continue to do well for profitable companies. Until, of course, things change.
3. The impact of lower oil prices cannot be predicted but should not be underestimated. There will likely be a strong negative impact on employment in oil-producing states, and on profits for oil companies. Overall, though, it should add spendable dollars to most consumers and increase profit margins for many corporations. Based upon information available to us now, it would seem lower prices will probably last for many years. This should be good for stock markets. Until it isn’t.
4. The US stock market is at or close to record high levels. One measure of whether the market is fairly-valued is the Price/Earnings ratio, also just called the P/E ratio. This is usually calculated by looking backward at the previous year’s earnings, or looking forward to the next year’s predicted earnings. The lower the number, the “cheaper” stock prices are, and vice versa.
By most measures the P/E in 1982 was historically low, which turned out to be a great predictor of future strong stock market returns. In 1999, the P/E ratio was historically high. This turned out to be a predictor of falling stock market returns.
Today, it appears the P/E ratio for the US stock market is somewhat above the average. By itself, this would not be a cause for great concern.
HOWEVER, there is another P/E measure, the Shiller Cyclically Adjusted P/E Ratio, known as the CAPE Ratio. It looks at average inflation-adjusted earnings for the last 10 years. According to Shiller, the CAPE ratio is currently higher than the normal P/E calculations described above would suggest. The only other times the CAPE ratio has been this high have been in 1929 and 1999, and both of those times directly preceded significant stock market declines.
Our recommendation is, as always, to develop an investment plan that is designed for your goals and concerns. Volatility may pick back up, month-end statements might show declines in account values, the media might create the impression that the economy and the markets will fall dramatically. None of this should be a reason to change your investment plan. It should be changed when your life changes, not when markets change.
At a recent investment conference the speaker said that statistically speaking, the US stock market has gained value in 78% of the years since World War II. How interesting, then, that so much market behavior is based on outcomes likely to occur only 22% of the time.
Please contact us if you have any questions, or if there is anything you would like to discuss. Thanks again for the opportunity to work with you. We hope 2015 will be a healthy, happy and prosperous year for you and your family.
Robert K. Haley, JD, CFP®, AIF®