As Chris Featherstone reported last week in his annual review, the S&P 500 got off to a rocky start in the New Year, falling 5.91% for the first full trading week of 2016. The results actually equated to the worst opening week in US market history. Investors grew increasingly concerned that China’s economy is slowing and commodity prices continued to falter. As of Friday’s close, the S&P 500 traded at 17.17 times earnings and had a dividend yield of 2.29%. The historically defensive utilities were the market leaders during the last week while information technology and basic materials were the laggards. Oil began the week selling for $37.04 per barrel, but fell 10.48% to close Friday at $33.16, reaching prices not seen since 2004. Copper prices also declined, falling 5.29%.
For US-oriented investors feeling the pain of this latest bout of market volatility, consider for a moment the plight of your counterparts in China. The Shanghai Composite fell more than 9% during the week despite tripping circuit breakers and closing early on Monday and Thursday. The dramatic drop in the value of the yuan was particularly disconcerting to China investors, and macro concerns about spillover effects continue to trouble markets around the world.
Attention will soon shift from the macro gloom to a more company-specific level as earnings season kicks off. Alcoa, Wells Fargo, JP Morgan, and Intel are among the notables reporting in the coming days, and perhaps the market will find relief from the specter of the macro in actual results on the ground from real companies. KB Home, one of the nation’s largest homebuilders, reported last week and managed to disappoint investors, but not for reasons you might expect. Shares in the company declined more than 24%, yet quarterly revenue for the company increased an impressive 23.84%. Due to a shortage of labor, the company wasn’t able to keep up with demand and deliver on their sales backlog, thus missing analyst expectations. Looking beyond the share price and instead at increasing revenues, full employment, and higher selling prices, you see evidence here of continued resilience in the US economy – a theme that is being reported by many of the leading economists that we follow.
The bond market saw yields fall throughout the week as increasing global economic concerns (looking at you, China) drove investors into safer assets. The non-manufacturing ISM report was below expectations on Monday, driven by a drop in supplier delivery times, which signaled fewer bottlenecks in the supply chain. On Tuesday, yields on the 10-year Treasury note fell to the lowest level in more than three weeks. On the bright side, the ADP employment report on Wednesday showed that December payrolls increased by the largest value in a year. The labor market continued to show its strength on Thursday as initial jobless claims fell with employers retaining workers due to sustained demand. Yields briefly rose on Friday, after encouraging employment reports showed a significant increase in nonfarm payrolls, but were quickly offset by investors’ concerns over global economic growth, sending the benchmark 10-year note to a two-month low. Nothing new there.
With respect to equities, investors should be prepared to endure higher levels of volatility in 2016, if for no other reason than the fact that the current bull market ranks as the third longest in history at 82 months (3/9/09-12/31/15) and counting. The VIX Index, which uses S&P 500 options activity to gauge investors' expectations of volatility, had an average reading of 16.68 in 2015, up from an average of 14.17 in 2014, according to Bloomberg (higher = greater expected volatility). The index stood at 18.21 on 12/31/15, closer to its 20.98 average for the 20-year period ended 12/31/15.
Here at MPCA, deterioration in many of our short- and intermediate-term market breadth indicators dictated some changes in our portfolios this past week. We removed our exposure to domestic midcap growth as represented by the passively-managed Vanguard exchange traded fund (“ETF”) (symbol VOT) across all risk tolerances. This decision raised approximately 7% for lower risk-tolerant accounts and up to 14% cash at the higher risk end of the spectrum. While we continue to retain midcap exposure in both active and passive vehicles, the defense is clearly on the field at the moment. We believe the risk of more significant downside has increased, according to our portfolio construction decision-making process. The cash raised will serve the dual purpose of softening portfolio volatility and keeping powder dry for more attractive risk/reward entry points. As always, we welcome your thoughts and comments.