October 2016

A Summer Reprieve

The 3rd Quarter and Year

The third quarter of 2016 continued the positive momentum that we saw in the second quarter. The third quarter began with the S&P500 at 2099 and ended at 2168. This is an increase of 69 points, or an increase of 3.2%. This is the most robust quarter we have had in over a year and a half.  Since the beginning of the year, when the S&P 500 was at 2044, we have had an overall gain of over 6%.  

A great deal of the increase in stock values occurred because investors held a general belief that the second half of the year would see accelerated growth and earnings. As we came closer to the end of the 3rd quarter, however, this optimism weakened as some large corporations indicated that they would not meet earnings projections.

The interest rate on the 10-year Treasury dropped below 1.4% on July 5th, and then rose as the quarter progressed. It currently stands at 1.79%, which is an increase of almost 28%. Because this is a bench mark for many other interest rates, it means that mortgage interest rates have risen; interest on business loans is increasing; and interest rates tied to this bench mark will also climb.  

Price Earnings Multiple

In a recent blog, I discussed the price earning multiple. This is a metric used by many investors to determine the long-term direction of the stock market. The actual earnings of a company for the past year are used to see how many times the earnings go into the current price of the stock. To obtain a rate that would be similar to an overall portfolio an investor can use either the trailing price earnings multiple of the S&P 500 or the Russell 1000.  The difference between the two is that the S&P 500 has 505 stocks, while the Russell 1000 has 1000 large stocks. There are about 25 stocks in the S&P 500 that make up the bulk of the average. Recently, there has been a sharp trend of individual investors, using passive investing, buying S&P 500 index funds and ETFs. This rush to buy the stocks in the S&P 500 has driven up the prices of these stocks unrealistically. For example, the trailing price earnings multiple of the S&P 500 is now 24.  A multiple larger than 20 is very unusual, by historic standards.  On the other hand, the trailing price earnings multiple of the Russell 1000 is a more reasonable 19.

In the 1970’s investors thought that if they owned a select group of stocks, known as the “Nifty Fifty,” then they did not have to own anything else in the market.  The price earnings multiples of these stocks grew to a point which made no sense.  Finally, the prices on these stocks came tumbling down resulting in significant losses to investors. The current S&P 500 stocks, I’m afraid, have become the nifty fifty of our era.  When the stocks representing the S&P 500 come down, the result could be dramatic.  A comparison of the S&P 500 to the Russel 1000 indicates that the stocks of the S&P 500 are over-priced by 25%.

Dividends

Many investors have concluded that, with interest rates on bonds being very low, it was an easy move to earn more money by buying dividend-paying stocks. Investors must always remember that stocks are more risky than bonds. Therefore, such a change from bonds to dividend-paying stocks requires the investor to take on substantially more risk.

A year ago the dividend rate on the S&P 500 was 2.26%. At the end of the third quarter the dividend rate was 2.13%. This is a drop of almost 6% from a year ago. A number of factors are driving dividends downward. The most important factor is that corporations are not earning as much money. For the past 5 quarters (and potentially the third quarter of 2016) the overall earnings of the stocks in the S&P 500 has dropped. As earnings decline, less money is available to pay dividends. Dividends should be paid from earnings, but sometimes a corporation will borrow to keep the dividend stable. Such a policy cannot be sustained.

Investors who believed, incorrectly, that dividends would continue to move upward are now selling their dividend-paying stocks. If enough investors follow this approach we will see stock prices move downward.

The FED

Once again the FED did not raise the discount rate in September. I believed that the lack of a rate hike last September, followed by a raise in rates in December, led to turmoil in the stock markets. This could again be the case. The next time the FED meets is on November 1st and 2nd, a week before the election.  From a political and tactical standpoint, it seems unlikely that they will make any changes to the rate at that time.

Following the November meeting, the FED will meet again on December 13th and 14th, just before the end of the year. It is a time when we would like to see some optimism in the markets as corporations begin to give year-end results. There is nothing like the uncertainty of the impact of an interest rate increase to give the market something to get worried about. I think the FED will raise rates in December, and unless there is a clear indication that corporate earnings are going to be up in the final quarter of the year, this may push the market lower.

Bonds

Bonds have done well this year. As low as interest rates were coming into the year, they have decreased even more during the year.  As an investor, this means you are earning interest on your bonds while the value of the bonds appreciates. As interest rates drop, the value of bonds rises. Investors in investment grade bonds have seen the overall rate of return rise rather nicely this year.

The corollary to this is that, when interest rates rise, the market value of bonds drops. You continue to get interest on the bonds, but the market value of the bonds goes down.  If we do continue to see a rise in interest rates, we will likely see an erosion of the investment return on bonds.

Conclusion

During the third quarter, we saw the stock market have a significant gain. This is good news because we had about 18 months during which the market seemed to go nowhere. Unfortunately, the third quarter earnings results may not be up to expectations. We have also seen a reduction in dividends rates over the third quarter. It appears likely that interest rates are increasing in the fourth quarter.  All of these points need to be monitored to allow for appropriate investment decisions to mitigate loss. Such decisions might include: a lowering of stock exposure, underweighting of dividend-paying stocks and shorter term bonds, which can adjust more quickly to changes in interest rates. The first thing to watch is reported earnings of major corporations for the third quarter.

Ed Mallon

Posted Thursday, October 27, 2016