As we approach the close of 2015, Cribstone Capital Management would like to wish all of our clients and friends a happy, healthy holiday season. We also want to take this opportunity to review the past twelve months, share with you our observations about the financial markets and our expectations for the coming year.
Good Bye 2015
As of this writing it looks like 2015 will go down as an unusual year for the broader stock market for a variety of reasons. Barring an extraordinarily strong rally between now and December 31, stock and bond market returns will be modest if at all positive. Results like this are to be expected from time to time, but not regularly. As we have noted in previous communications, stock market corrections of 10% or more, like the one we experienced in August, are a fairly common occurrence during the course of any given year. But more often than not, the pullback is reversed quickly and the year in which the correction occurs ends on a positive note. Indeed, in the 65 years since 1950, only 13 ended in the red and two had gains of 1% or less.
A Tale of Two Markets
But there’s much more to the story. The bottom line performance number for the stock market as measured by the S&P 500 is a misleading measure of what actually occurred to stocks—and investors– in 2015. The real narrative is a tale of “Haves and Have Nots,” and as it turned out, most stocks were “Have Nots,” or negative for the year. Additionally, over 40% of stocks in the S&P 500 were negative to the tune of 5% or more, and fully one third were down 10% or more. This latter category included many high quality, low volatility names that appropriately represent cornerstone long-term holdings for having demonstrated resiliency throughout many economic cycles: Procter & Gamble, Wal-Mart, Exxon, Oracle and Warren Buffet’s Berkshire Hathaway. But this year they were the biggest detractors from the market’s performance.
The “Haves,” on the other hand, were a select few NASDAQ listed stocks now commonly referred to as “FANG,” short for Facebook, Amazon, Netflix and Google. They are relatively young companies by comparison, extremely exciting with regards to technological innovation, but which typically exhibit higher volatility. They have experienced tremendous buying momentum behind them this year and carry high valuations, even for growth companies. But if it were not for just those four stocks, the market would have been down almost another 3% for the year.
In stock market parlance, the term used to describe how widely stocks are participating in the moves of the broad market index (like the S&P 500) is called “breadth.” In 2015, as demonstrated by the statistics we shared above where there was an enormous gap between the Haves and Have Nots, breadth was basically non-existent. Market watchers typically interpret this lack of breadth as an unhealthy sign. In other words, it raises concerns about the near term direction of the market overall.
Turning to overseas markets, while 2015 started out on very a promising note, the deterioration in the Greek economy and its potential exit from the European Union caused stocks in that region to reverse course. In addition, the slowdown in China has wreaked havoc on other emerging markets that have relied heavily on China’s growth. The dollar’s appreciation relative to the euro and emerging markets currencies made results look even worse. Indeed, in dollar terms, the Eurozone index fund (EZU) is down more than 3% so far, after having been up over 11% for the first six months of this year. Even worse is the performance of the emerging markets index fund (EEM), which in dollar terms is off more than 16%.
The U.S. economy still shows resilience. For instance, on Wednesday, December 16, the Federal Reserve finally (after having discussed it for months) boosted their target for the fed funds rate by 0.25%. This suggests that there is enough positive data on the U.S. economic front to warrant such a move. These include: an official unemployment rate that is near all-time lows, housing and auto sales that are strong and an acceleration in wage growth, albeit a modest one so far. We are more constructive on international equities, where, in contrast to the U.S., central banks are pursuing policies to stimulate economic growth rather than moderate it.
Even so, we are cautious about the overall environment and expect the market volatility we’ve experienced this year to continue in the near term. For one thing, while Fed was able to justify this most recent rate hike, the question remains as to whether and how much more rates will rise in 2016. At the same time, the valuation on the S&P 500-as measured by the price paid for each dollar of earnings (along with a variety of other measures)–leaves little room for expansion, based on data we’ve gathered from a variety of research sources. That means a further lift in the market averages will depend largely on earnings, for which the outlook is uncertain. We believe that we are in the late stage of an economic recovery that is also facing some headwinds from a variety of sources. China and other emerging markets present risks to global economic growth, as do sectors like commodities and energy. According to the investment team at our partner, Dynasty Financial Partners, most Wall Street predictions are calling for flat to single digit returns on the US stock market in 2016.
Stocks should still provide attractive returns over the long term, particularly when compared to other asset classes. Within the equity allocation of our clients’ portfolios, this longer term time horizon is our focus, but careful risk management needs to be applied over both the short- and long-term periods to meet the goals. Our approach is to balance growth with value and dividend paying stocks.
Slow and Steady Bonds
Turning to the fixed income markets, we have begun to build out our client’s bond portfolios with longer maturity dates. It has been a guessing game in determining the pace and magnitude of potential of Fed rate hikes. However, we do know that while the Federal Reserve can control the short-term rate structures, longer term rates are influenced by growth and inflation, each of which are likely to remain below average. Holding the bonds to maturity helps insulate us from interim fluctuations in bond prices and can provide better yields. Indeed, we are finding high quality bonds with attractive yields roughly five years out on the maturity curve while maintaining our view that the fixed income allocation provides the stability in the portfolio
2015 has been an interesting year for the markets, and we expect much of the same as we enter the New Year. As monetary policy diverges across different regions and as China’s slowing growth flows through to other economies we expect asset classes to remain volatile and long-term opportunities to continue to emerge. We have remained active throughout this challenging environment, including slightly increasing our allocation to cash, high quality and lower volatility securities, and will continue to make changes in order to manage risk and meet your long term goals. With that, we hope you have a wonderful holiday and rest of the year.
With warm regards,
Scott Upham, Managing Partner Odette S. Galli, Partner John D. Duffy, Partner
Cribstone Capital Management LLC. (“CCM”) is an SEC registered investment adviser located in the State of Maine. The firm and its representatives are in compliance with the current registration and notice filing requirements imposed upon SEC registered investment advisers. CCM may only transact business in those states in which it is notice filed, or qualifies for an exemption or exclusion from notice filing requirements. For information pertaining to the registration status of the firm, please contact the SEC on its website atwww.adviserinfo.sec.gov. A copy of the firm’s current written disclosure brochure discussing the firm’s business operations, services and fees is available from CCM upon request.