Fourth Quarter 2015 Review/2016 Preview

The fourth quarter ended on a sour note, with a 178-point drop on the final trading day of the year. The first day of trading for 2016 was far worse, with the Dow Jones Industrial Average down almost 500 points during the trading session, before rebounding to close down 267. As we enter 2016 the Federal Reserve will take center stage, as their interest rate raising actions will drive economic and financial market performance to a large degree.

Fourth Quarter 2015 Financial Market Performance Summary

During the fourth quarter of 2015, stocks performed well following the steep declines experienced at the end of the third quarter. The “flash crash” that occurred in August pushed stocks down dramatically, but only for a very short time on that morning. Following the flash crash, stocks began to rebound and performed well during the fourth quarter, as stated above. However, the Federal Reserve raised rates in December, which was their first in many years. This rate increase signals the beginning of a multi-year rate increasing cycle by the Fed, which will significantly influence economic and financial market performance.

The Fed

As mentioned above, the Fed has begun its rate raising strategy, after holding rates at or near zero percent since the end of 2009, or for about 7 years. This period happens to coincide with the bull market for stocks, which began in March of 2009. Now that the Fed has started their rate raising strategy, we should expect to see rates move up slowly, but steadily, over several years. The Fed will attempt to balance economic growth and employment stability with fighting inflation. This is always trick; never easy.

Prior to the first rate hike, investors were very focused on the timing of the first rate hike, rather than the implications of an ongoing rate raising trend. Now that the first raise is on the books, investors will have to come to terms with the implications of a long-term rate raising cycle. We will discuss these implications below.

Bonds

Rates overall have bumped up accordingly, after the Fed action last month. We see the 10-year treasury yield at 2.25%, which is still very low historically speaking. The yield curve is still relatively flat from the 5-year to the 30-year, although the shape overall is fairly normal. It will be interesting to see if the yield curve flattens more, which is an early indicator of a possible recession (an inverted yield curve—one where long rates are lower than short rates—is indicative of a more severe recession). A flattening yield curve can serve as an early leading indicator of a recession on the horizon.

High-yield (junk) bonds have performed very poorly of late, which is yet another sign of a weakening economy and a result of the Fed raising rates to some degree as well. Many fixed income investors, hungry for current income, took increased risk by buying high-yield bonds, which typically have much higher yields than investment grade bonds, and have been punished for it. While government bonds were basically flat for 2015, high-yield bonds lost about 5% overall last year, while CCC-rated bonds lost about 15.5% in 2015.

Stocks

As stated above, stocks had a strong fourth quarter with all three major indexes performing very well. However, this good performance follows very poor third quarter performance. For the year, stocks provided lackluster performance, with the S&P 500 losing a bit less than 1%, while the NASDAQ Composite index gained almost 6% and the Dow Jones Industrial Average fell a bit more than 2% during 2015.

The Russell 2000 small-cap index performed about the same as the Dow during 2015, losing 5.7% for the year. Small-cap stocks are usually an early indicator for overall stock market performance as investors tend to increase or decrease the risk in their portfolios, depending on their outlook for stocks and small-caps are, in general, more risky than larger companies. Investors, if they are anticipating a slowing in the economy, will tend to want to reduce risk, and therefore will typically sell small-cap stocks.

With the exceptions of Energy and Utilities, all sectors performed well in the fourth quarter of 2015, mirroring what we experienced with the broader stock market indexes listed above. The best performers were Materials, Healthcare, and Technology, all of which were up more than 8% for the quarter. If we look at annual performance, however, we see a much more mixed picture of performance. Energy plummeted 23.8%, and was by far the worst performer. Since crude oil also fell hard during the year, it is no wonder that energy stocks also performed poorly. Interestingly, Materials, which were up nicely in the fourth quarter and were the best performing sector in the quarter, lost 10.62% for the year. Consumer Discretionary stocks performed best for the year, gaining more than 8%.

Looking Ahead

So what does all of this means for you and for your portfolio? It has been a long, painful road over this past year or so, with stocks showing highly volatile behavior, and portfolios, for the most part, remaining flat or losing value. To some it may have appeared that everyone else was making lots of money in stocks, while their investments were suffering. As we can see by the annual performance numbers for the Dow Jones and the S&P 500, those who raised cash and sat on the sidelines during 2015 likely avoided potential losses. Others with more of a technology focused may have fared better as the NASDAQ outperformed the other major indexes.

Now that the Fed has begun raising rates, and we see that the economy is slowing a bit, it will be that much more important to maintain a very strict buy discipline, including being very specific regarding pricing for any purchases. As I indicated above regarding the strong correlation between the Fed holding rates at zero percent since the end of 2008 until December of last year, and the bull market for stocks which started in March of 2009 (three months after the Fed placed rates at zero percent), and which continues today, we may very well see a shift in markets away from the steady growth witnessed in previous years. The fact that stocks actually ended the year down for 2015 (S&P 500 and Dow Jones) shows that the strong bull market trend is broken. Investors will now be forced to adjust their thinking regarding company/stock valuations. Without the Fed stimulating the economy and the market, and instead taking stimulus out of the economy and financial markets, stocks will no longer have the strong support that has been driving investors to buy stocks with little or no weight given to true valuations.

With the severe crash for stocks, which drove the S&P 500 down as low as 666 in March of 2009, and the massive stimulus from the Fed—zero percent rates and hundreds of billions of dollars pumped into the economy through quantitative easing—investors were able to ignore valuations for the most part. Now, seven years later, investors have grown so accustomed to the Fed supporting stocks that they have forgotten completely about the importance of valuations. Without Fed support, valuations—what a company is actually worth, based on revenue and earnings growth in relation to the stock’s price—must once again take center stage for investing.

It will take some time for investors to adjust their thinking regarding valuations and to accept that they can no longer depend on the Fed to support the stock market. With rates rising, companies will struggle to achieve strong revenue and earnings growth, so identifying those companies that can perform well will be of paramount importance, and will drive portfolio performance moving forward.

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