Commentary & Insights

New Year 2016: Looking Back, Moving Forward

Posted at January 13, 2016 » By : » Categories : Commentary & Insights » 0 Comment

January 2016, Mike Loewengart, VP of Investment Strategy, E*TRADE Capital Management

The Facts:

There were lots of ups and downs in the markets in 2015. Unfortunately, by the time December came to close, there were a few more downs than ups. Although the S&P 500 actually posted a slight gain, it was the index’s softest performance in seven years. We’ll show you what it all means.

The Impact:

U.S. large caps finished the year up 1.38% (including dividends), while small caps retreated.

International stocks fell, with emerging markets dropping almost 15%.

Fixed-income markets were relatively flat, though moves by the U.S. Fed triggered unusual volatility.

What It Means for Investors:

Where some see weakness, we see opportunity. With a well-diversified portfolio, a simple rebalancing strategy may help investors capture opportunities almost automatically. Read on for what this might mean for each of the major asset classes.

A Closer Look

As Shakespeare said, “All the world’s a stage,” and a dramatic year for both domestic and international markets may have once again proven him right. It was central banks that took center stage in 2015: The U.S. Federal Reserve (the Fed) made a small but significant step toward tighter interest rates, while looser monetary policy ruled the day in Europe, Japan, China, and elsewhere. The markets were unusually volatile, too, buffeted by several international flashpoints, including financial instability in Greece, a slowdown in China, and terrorist attacks in Paris that grabbed the world’s attention.

The end result? Most markets came under pressure in 2015. U.S. stocks ended the year mixed, international markets sagged (especially those in emerging economies), and U.S. bonds ticked slightly higher. Before we take a closer look, let’s quickly review the economic highlights for December.

Fed raises rates—finally: The odds makers finally got some rest. On Wednesday, December 16th, the Federal Open Market Committee voted to raise its benchmark interest rate, the federal funds rate, by 0.25%. This was the first interest rate increase in nearly a decade, and the first time in seven years the rate has exceeded the zero to 0.25% range. Projections by Fed governors also suggested that the Fed may increase rates by another 1% through the end of 2016.

U.S. economy keeps chugging along: The U.S. showed slow but steady growth throughout 2015. The unemployment rate dropped from 5.6% in December 2014 to 5.0% in November, the most recent month for which we have data, and the workforce expanded by 2.6 million employees. While gross domestic product grew by just 2% through the third quarter, the housing market and other indicators pointed to an economy that continues to expand.

 

Domestic Equities

There’s a lot to cover this month, so let’s go straight to the numbers.

The large-cap-oriented S&P 500 shed 1.58% in December, but finished the year up 1.38%, the smallest total return for the index since 2008. Without dividends, the S&P actually posted a modest annual decline. The tech-heavy Nasdaq Composite performed significantly better for the year, gaining 6.96% (also including dividends).

The month and year were much tougher for U.S. small caps. The small-cap-oriented Russell 2000 shed 5.02% in December—and finished 2015 with an annual decline of 4.41%.

Among the sectors that make up the U.S. equity markets (based on the S&P 500 sector indexes), consumer staples, utilities, and health care stocks were the biggest gainers in December, while the energy, materials, and consumer discretionary sectors lagged. The top performers for the year were consumer discretionary stocks, perhaps partially due to lower oil prices leaving more money in consumers’ pockets. Health care and consumer staples stocks also outperformed. On the downside, the energy sector was by far the weakest, falling by 21.12%, followed by materials and utilities.

It may be helpful to take a quick look at the energy markets, which struggled considerably in 2015. A glut in global oil supplies triggered a decline of 30.05% in the benchmark New York Mercantile Exchange in 2015—for a total loss of 64% over two years. The last time that crude dropped two years in a row was in 1997–1998. During the course of the year, oil plunged from a high of $61 a barrel to a low of $35, and more than 250,000 jobs in the energy sector were lost on a global basis.

For the equity styles, both growth and value stocks were lower in December, though growth slightly outperformed. (We track style performance using the Russell 3000 Growth and Value Indexes.) This theme played out through most of 2015, as growth led value by more than nine percentage points for the year.

What to Consider for 2016: In the spirit of New Year’s resolutions, the start of the year can be a great time to consider rebalancing one’s portfolio to its target allocations. Because U.S. small caps performed relatively poorly in 2015, this could mean adding exposure to small caps by redirecting funds from cash or other assets. (Of course, there’s no guarantee you’ll be reallocating assets at an advantageous time—and tax consequences could be triggered if the transactions are made in a taxable account.) As for U.S. sectors, it’s almost impossible to predict how things will play out. It might be tempting, for instance, to call a bottom in energy at these levels, but even more pain could be ahead, as U.S. crude inventories expand, Iran comes online, and Saudi Arabia fulfills its pledge to meet any increases in demand. Among other sectors, consumer stocks could continue to benefit from the spending power generated by oil price weakness, while higher interest rates could lift financials.

International Equities

Volatility ruled international stocks in 2015—to vastly different results. Developed markets ended the year just fractionally lower, while emerging markets dropped sharply.

The MSCI EAFE Index, a widely followed measure of developed market performance, fell 1.35% in December, finishing the year down 0.81%. Among the component regions that make up the index, Japan was the year’s star performer, while stocks in other Pacific countries and the UK fell sharply. Many Pacific economies were weighed down by the ripple effects of slowing growth in China and depressed commodity prices.

Emerging markets saw no reprieve in December. The MSCI Emerging Markets Index fell 2.23% for the month, and ended the year with a loss of 14.92%, the worst annual performance of any index we track. (This was also the index’s third consecutive yearly loss.) Latin America was the weakest region in the index, dropping sharply on lower pricing for some of the region’s biggest exports—oil and other natural commodities.

What to Consider for 2016: Given the underperformance of emerging markets over the past three years, many investors might find that their emerging market holdings have grown smaller relative to other asset classes. If this applies in your situation, now might be a good time to consider adding funds to the category to bring it back to desired target allocation. Investors might even want to reconsider the split in your international allocation—specifically, the amount you hold in emerging vs. developed markets. Valuations for emerging markets are now more attractive than they’ve been in quite some time, and emerging economies still offer the world’s highest (albeit declining) growth rates.

Fixed Income

The U.S. fixed income market had a relatively flat year, as the Fed finally put an end to the question of “when,” and voted to raise its benchmark interest rate. The Barclays U.S. Aggregate Index was down 0.32% in December, to end the year with a gain of just 0.55%.

In the U.S. Treasury arena, the yield on the benchmark 10-year note closed the year at 2.27%. This represented a gain of six and 10 basis points for the month and year, respectively. (A basis point is one one-hundredth of a percent.) For the full-year period, while rates increased across most maturities, the shape of the yield curve remained essentially unchanged.

Among the various U.S. fixed income sectors, Treasury bills were the strongest performers in December, while high-yield bonds (also known as “junk” bonds) were the weakest. For the full-year period, intermediate-term U.S. Treasuries led the pack, while high-yield bonds, TIPS, and long-term U.S. Treasuries lost the most. For both periods, high-yield bonds were hit by a number of factors, including the category’s overexposure to the energy sector, and new competition for income from bond sectors that are generally considered less risky.

What to Consider for 2016: While more rate increases are expected by the Fed this year, the bond market may have already priced in some of these moves. Short-tem rates may continue to rise, though this could be tempered by surging demand from yield-starved investors. Long-term rates, which are more influenced by inflation and economic growth than by rate policy, could stay at current levels or rise slightly. If this scenario plays out, the expectation would be for longer-term bonds to outperform their shorter-term counterparts.

The Bottom Line

Like every year before it, 2015 was full of surprises. But what will happen in 2016? Of course, we can’t predict the future, but there’s one thing we know for certain. Because 2016 is an election year (and there’s no incumbent on the ballot), a new American president will be elected.

Other themes that may play out in 2016 include: divergent monetary policy across developed economies (some countries loosening, others tightening); the consequences of higher domestic interest rates, whether intended or not; the effect of higher rates on corporations, particularly those that need to seek funding in the volatile high-yield market; and continued conflict in the Middle East. Plus, we’re sure there will be plenty of new surprises, which makes the financial markets so fascinating to watch and participate in.

So what can Investors do to prepare their portfolio for the changes ahead? As always, our best advice is fairly straightforward:

1.  Stay focused on the long term. Stick to a long-term investing plan by maintaining a risk-appropriate, well-diversified portfolio. This may help prepare one’s investments no matter which way the election goes, or whatever the news may bring.

2.  Consider rebalancing periodically to maintain target allocations. January can be a great time to review and refine one’s portfolio to stay in line with pre-set target allocations. This may mean selling some holdings that were relatively successful in 2015, and investing in sectors or regions that underperformed, while keeping in mind that there’s no guarantee of future performance. (If making transactions in a taxable account, it also helps to be mindful of any potential tax consequences.) While it may feel uncomfortable selling winners to buy losers, this strategy follows one of the basic tenets of investing for the long term.

Thank you for reading—and best wishes for a happy, healthy, and prosperous New Year.

Mike Loewengart

Vice President, Investment Strategy

E*TRADE Capital Management

Mike Loewengart is the Vice President of Investment Strategy for E*TRADE Capital Management, LLC. Prior to joining E*TRADE in 2007, Mike was the Director of Investment Management for a large multinational asset management company, where he oversaw corporate pension plan assets. Mike started his career as a research analyst and an investment manager due diligence analyst for the consulting divisions of several high-profile investment firms. He is a graduate of Middlebury College with a degree in economics.

PLEASE READ THE IMPORTANT DISCLOSURES BELOW.

This commentary provided by E*TRADE Capital Management is for educational purposes only. This information neither is, nor should be construed, as an offer, or a solicitation of an offer, to buy or sell securities by E*TRADE Capital Management or its affiliates. No information presented constitutes a recommendation by E*TRADE Financial or its affiliates to buy, sell or hold any security, financial product or instrument discussed therein or to engage in any specific investment strategy.

Upon request, we will send you a free copy of E*TRADE Capital Management’s Form ADV Part 2A, which describes, among other things, affiliations, services offered and fees charged.

Data and statistics contained in this commentary are obtained from what E*TRADE Capital Management considers to be reliable sources; however, its accuracy, completeness, or reliability cannot be guaranteed.

All investments involve risk, including the loss of principal amount invested.

Diversification, asset allocation strategies, automatic investing plans and dollar-cost averaging do not ensure a profit and does not protect against a loss in declining markets. Investors should consider their financial ability to continue their purchases through periods of low price levels.

Stocks fluctuate in response to the activities of individual companies and general market conditions, domestically and abroad. Investments in mid and small-cap stocks typically have higher risk characteristics than large cap stocks and may be subject to greater price fluctuations than large-cap stocks.

All bonds and fixed income products are subject to a number of risks, including the possibility of issuer default, credit risk, and market risk. All bonds and fixed income products are subject to a number of risks, including the possibility of issuer default, credit risk, interest rate risk, market risk and prepayment and extension risk. In general, bond prices rise when interest rates fall and vice versa. This effect is usually more pronounced for longer-term securities. Lower-quality fixed income securities generally offer higher yields, but also carry more risk of default or price changes due to potential changes in the credit quality of the issuer. Adverse conditions may affect the issuer’s ability to pay interest and principal on these securities and, as a result, they may have a higher probability of default.

Foreign investments involve greater risks than U.S. investments, including political and economic risks, concentration risks, liquidity risks, and the risk of currency fluctuations, all of which may be magnified in emerging markets. Emerging and frontier market investments are subsets of foreign investments. Emerging markets are rapidly developing politically and economically, but present a greater degree of these foreign investment risks because of the developing stage of the emerging market. Frontier markets are in early stages of economic and/or political development and are even less developed than emerging markets. As such, risks associated with foreign investments can be significantly greater in a frontier market compared to emerging markets and foreign investments generally.

Investing in commodities and international or global investments carries certain risks such as price volatility, currency risk, market risk, interest rate risk and credit risk. An investor should fully understand these risks before making an investment. The commodities industries can be very volatile and significantly affected by commodity prices, world events, import controls, worldwide competition, government regulations, and economic conditions.

Indexes used in this presentation are intended to provide a general measure of the market performance for a particular asset class or type. An Index is an unmanaged portfolio of predetermined securities and does not reflect any initial or ongoing expenses such as brokerage fees, commissions, principal mark-ups, management fees or taxes. The inclusion of any one of these items would reduce the performance shown. It is not possible to invest directly in an index.

The E*TRADE Financial family of companies provides financial services including trading, investing, investment advisory, and banking products and services to retail customers.

Investment advisory services are offered through E*TRADE Capital Management, LLC, a Registered Investment Adviser.

Index definitions:

Dow Jones Industrial Average: Computed by summing the prices of the stocks of 30 companies and then dividing that total by an adjusted value—one which has been adjusted over the years to account for the effects of stock splits on the prices of the 30 companies. Dividends are reinvested to reflect the actual performance of the underlying securities.

Barclays Capital U.S. Aggregate Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities.

Dow UBS Commodity Index: The DJ-UBSCI is composed of futures contracts on physical commodities. Unlike equities, which typically entitle the holder to a continuing stake in a corporation, commodity futures contracts normally specify a certain date for the delivery of the underlying physical commodity. In order to avoid the delivery process and maintain a long futures position, nearby contracts must be sold and contracts that have not yet reached the delivery period must be purchased. This process is known as “rolling” a futures position. The DJ-UBSCI is composed of commodities traded on U.S. exchanges, with the exception of aluminum, nickel and zinc, which trade on the London Metal Exchange (LME).

MSCI EAFE Index is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the US & Canada. The MSCI EAFE Index consists of the following 21 developed market country indexes: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, and the United Kingdom.

The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. The MSCI Emerging Markets Index consists of the following 23 emerging market country indexes: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Peru, Philippines, Poland, Qatar, Russia, South Africa, Taiwan, Thailand, Turkey and United Arab Emirates.

S&P 500 Index is a market capitalization-weighted index of 500 widely held stocks often used as a proxy for the US stock market.

All components of the S&P 500 are assigned to at least one of eleven S&P Select Sector Indexes, which track major economic segments and are highly liquid benchmarks. Stock classifications are based on the Global Industry Classification Standard. The Select Sector Indexes are: Consumer Discretionary Select Sector; Consumer Staples Select Sector; Energy Select Sector; Financials Select Sector; Health Care Select Sector; Industrials Select Sector; Technology Select Sector; Materials Select Sector; Telecommunication Services; and Utilities Select Sector.

The Russell 2000 Index measures the performance of the small-cap segment of the U.S. equity universe. The Russell 2000 Index is a subset of the Russell 3000® Index representing approximately 8% of the total market capitalization of that index. It includes approximately 2,000 of the smallest securities based on a combination of their market cap and current index membership.

The Russell 3000 Growth Index measures the performance of the broad growth segment of the U.S. equity universe. It includes those Russell 3000 companies with higher price-to-book ratios and higher forecasted growth values. The Russell 3000 Growth Index is constructed to provide a comprehensive, unbiased, and stable barometer of the broad growth market. The Index is completely reconstituted annually to ensure new and growing equities are included and that the represented companies continue to reflect growth characteristics.

The Russell 3000 Value Index measures the performance of the broad value segment of the U.S. equity universe. It includes those Russell 3000 companies with lower price-to-book ratios and lower forecasted growth values. The Russell 3000 Value Index is constructed to provide a comprehensive, unbiased, and stable barometer of the broad value market. The Index is completely reconstituted annually to ensure new and growing equities are included and that the represented companies continue to reflect value characteristics.

The Nasdaq Composite Index is a broad-based index that includes all domestic and international-based common stocks listed on the Nasdaq Stock Market.

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