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A Bumpy Year for Stocks
In fact, while stock prices had been steadily advancing over the past few years, the profits of companies have been declining since the third quarter of 2014. This combination of falling company profits but rising stock prices suggested that if markets act in a rational way (which is not a trivial assumption to make), something would have to give: either companies would need to see earnings growth to justify their high prices or prices would have to fall to reflect economic reality. These diverging facts, plus the expectation of normalizing interest rates set up investors' expectations for the year. Since February, when oil prices 
dropped below $30/barrel, they have steadily recovered to current levels around $50. If this recovery continues, the earnings of energy companies should benefit, bringing the earnings metrics back towards 2014 levels.
Valuations Still Seem High In his best-selling book, A Random Walk Down Wall Street, Burton Malkiel, professor of economics at Princeton University, stated that "a blindfolded monkey throwing darts at a newspaper's financial pages could select a portfolio that would do just as well as one carefully selected by experts." For what it's worth, the Wall Street Journal later conducted a six month experiment to test this theory and the experts did slightly beat out the dartboard approach. Nevertheless, a healthy dose of skepticism should be taken with any forecasts for investment performance. With that in mind, the current P/E 10 ratio (lower right graph) is well above its historical average, suggesting that prices of stocks are currently overvalued relative to historical levels.
Before we panic, it is worth considering a few things. We have never been in a situation before now with global interests so low, and in some cases, actually negative. Short term government interest rates are typically used as a risk-free rate of return in many academic financial models to capture the time-value of money. Given that many of the commonly used models and theories of finance have not been tested before in a world of negative interest rates, there is some reason to believe that there may be nuances not taken into account. Low interest rates are designed to encourage banks to lend money so companies will expand business, people will buy homes, and the economy will grow. Therefore, if you believe the current all-time low interest rate levels around the world will stimulate a major expansion in the economy, you can accept a higher P/E multiple on the basis that you expect future earnings of companies to grow with the economy and justify current prices. So far, this has not happened. Finding Yield in a Zero Interest World When interest rates increase, the value of existing bonds decrease in value to compensate buyers for their lower interest relative to newly issued debt at the higher rate. Therefore, when the Federal Reserve Board released their expectation that they would raise interest rates multiple times during 2016, the reaction for investors was an expectation that bonds would perform poorly this year. The opposite has turned out to be true, with long term government treasury bonds being one of the strongest performing asset classes this year. While they only pay an interest rate under 2.5%, the price of the bonds has risen more than 10% this year as investors have used them as a safe haven for their money during times of uncertainty.
We selectively prefer credit risk to interest rate risk at this time. Moody's has said they expect a 30% increase in defaults on corporate debt during 2016 after default rates doubled in 2015 for non-investment grade debt. These defaults have not been widespread across different industries but concentrated within the energy sector as low oil and coal prices forced a number of major energy companies to default on their debt obligations. Energy and Mining companies are one of the larger concentrations within the high yield investment space, so rather than a passive index fund, we believe there is merit in this case for selecting managers who underweight energy within their non-investment grade portfolios. One related asset class which demonstrates this is Business Development Companies ("BDCs") which provide debt and equity financing to typically small and non investment grade companies, with the same higher exposure to energy companies. During the start of the year, the BDC index ("BDCS") fell sharply and did not start to recover until after oil prices bottomed. Within the BDC universe however, individual companies who had underweighted exposure to energy companies, outperformed their peers. Preparing for the Unexpected No one can predict with certainty if an investment will increase or decrease in value, but that does not mean there is nothing that can be done to plan your financial well being. Understanding your long term objectives is the first step in knowing what level of financial risk you must expose yourself to in order to achieve the required rate of return on your investments to meet those objectives. It would be nice if the only surprise left for us this year is the return of the Hokies' long-lost offense but the last six months have been bumpy for many investors though and there is little reason to think things will settle down. With a well thought out financial plan, you can keep your focus on achieving your long term goals instead of day-to-day fluctuations in the markets and the panic-de-jour on the news. In the meantime, enjoy the ride and remember that we are always here if you'd like to review your portfolio or plan. If you’d like to be notified of future blog updates, connect with us on LinkedIn!
Sources: Historical price data for S&P 500, TLT, VNQ, IVV, EFA, AGG, XLE from Yahoo! Finance. Historical WTI Crude Oil price from www.eia.gov. S&P 500 earnings data and P/E 10 data from http://www.econ.yale.edu/~shiller/data.htm. US Treasury Rate data from www.treasury.gov Securities and/or Advisory Services offered through Geneos Wealth Management, member SIPC/FINRA. Plott & French Financial Advisors is not affiliated with Geneos Wealth Management.
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If someone had woken up from a year-long coma on July 1st and glanced at a newspaper, seeing the S&P 500 up 2.7% for the first half of the year, with most other asset classes only slightly up or slightly down, they could be forgiven for thinking the world had been a quiet place. They would not know that during these six months, the world panicked about a potential collapse in the Chinese economy, the Federal Reserve increased interest rates for the first time in almost a decade at the end of 2015, and that oil would finally appear to stabilize after falling from over $100 per barrel in 2014 to below $30 in early 2016. They would be blissfully unaware of Hillary Clinton's emails and Donald Trump's wall. Without a doubt, they would think you are barking mad if you informed them that the United Kingdom had decided the EU wasn't really their cup of tea after all so they were taking their toys and going home. Yet here we are; let's take a look how it happened.
2016 was expected to be an interesting year for the markets. The economy had been steadily plodding along, unemployment was down to 5%, and the stock market was up over 200% from its recession low in 2009, and there were signs that interest rates were finally going to be headed higher, increasing rates on everything from mortgages to CDs. With cheap energy prices, a slow but steadily improving US economy, and a Greek bankruptcy averted in Europe, 2016 offered many reasons to feel optimistic. At the same time, a number of worrying signs were showing. Oil prices had been falling throughout the year and showed no signs of slowing. Concerns over a weakening Chinese economy lead to weaker demand for oil and other commodities, negatively impacting the earnings and share prices of global companies in the energy and mining sectors, which had already been beaten down badly in the second half of 2015.
The P/E 10 ratio was originally devised by Yale Professor Robert Shiller and looks at the current price of stocks within the S&P 500 compared to their average earnings over the past 10 years, conceptually capturing a company's earnings over a full economic cycle instead of a single point of time. Based in part on this ratio, Prof. Shiller called a tech bubble in 2000, a stock and housing bubble in 2005, and in 2013, he was awarded the Noble Prize in Economics for his research. Talking heads on CNBC and Bloomberg are a dime a dozen these days, but Prof. Shiller is one of the few to whom I listen. Therefore last year, when he stated there was a bubble in stock and bonds, pointing to the P/E 10 ratio being well above historical levels, many people wondered if the long bull run in stocks had come to an end. 
Despite the unrelenting decline in market yields, even in the face of rate hikes by the Fed, we continue to have a cautious position against investing heavily into longer dated government bonds. As a safe haven investment, we prefer shorter term government debt and would propose that with a flatter yield curve, investors are hardly being compensated for taking considerably more duration risk. 