Letter to Clients: 1st Quarter 2016

“The stock market is the story of cycles and of the human behavior that is responsible for overreactions in both directions” – Seth Klarman

“In the old legend wise men finally boiled down the history of mortal affairs into a single phrase: ‘This too shall pass'” – Benjamin Graham

Dear Clients and Friends:

A new year is upon us. We hope you enjoyed your holiday season and celebrated the birth of 2016 with excitement and enthusiasm. This is always a great time to clean out old records and papers. Don’t forget that you can drop off all your sensitive papers into our secure shredding box and we will make certain your documents are properly destroyed.

There are a few changes coming to DV Financial this quarter. After working in the same office together for over seven years, Matt Kacer has decided to open his own insurance office in Altoona and Sue Cowden will join him in the new location. We will continue to rely on Matt to provide expertise with property and casualty insurance as well as health insurance, and Matt will continue to work with us on securities and financial planning.

We are currently looking for a new administrative manager for the Urbandale office. If you or someone you know is interested in a part-time position with consistent hours which can work well in a “mom” schedule, please let me know. And if you know a college student studying financial planning who is looking to graduate in 2017, we are planning to begin an intern to full-time position this summer.

So don’t be surprised if you hear a new voice or two over the phone as we transition to some staff changes. We continue to consider how we can best support you and your financial services needs.

A volatile year ends with a whimper

The Dow Jones Industrial Average is made up of 30 large, well-known companies. It is the best known and oldest of the many yardsticks that measure stock market performance. While not necessarily a household name, the S&P 500 Index—as its name implies—is made up of 500 larger U.S. companies so it represents about 80% of the entire market capitalization and is the most often quoted measure of market performance among analysts.

While the S&P 500 made significant advances in 2013 and 2014, this past year action in stocks felt more like 2011 when overseas tremors reached our shores. Although 2015’s ride was not as volatile as that of 2011, the S&P 500 did experience its first 10%+ decline in four years and in both years the benchmark index ended the year pretty much where it started.

Even though the market ended relatively flat, that doesn’t mean that there weren’t winners and losers. Technology, health care, and consumer-driven issues posted modest gains, the relentless drop in commodity prices hit the mining and energy sectors hard, large companies beat smaller companies, and U.S. stocks generally topped international.

The poor performance from international equities was a surprise to us. We anticipated economic expansion outside of the United States to exceed growth domestically. Even where we were correct our gains were eliminated by the strong U.S. dollar. More on the dollar later, but we believe the underperformance in international equities will self-correct so we continue to hold those positions.

Meanwhile, longer-term Treasuries yields continue to hold near historic lows, which signaled there’s still plenty of interest in the most creditworthy bonds. Expectations of an eventual Fed rate hike probably influenced yields in investment grade issues, but the sharp increase in high yield bonds, especially those with the lowest credit ratings, were tied mostly to problems in the energy and mining sectors.

Table 1: Key Index Returns

MTD %

2015 %

3-year* %

Dow Jones Industrial Average

-1.66

-2.23

+9.97

NASDAQ Composite

-1.98

+5.73

+18.37

S&P 500 Index

-1.75

-0.73

+12.74

Russell 2000 Index

-5.19

-5.71

+10.18

MSCI World ex-USA**

-1.88

-5.44

+1.27

MSCI Emerging Markets**

-2.48

-16.96

-9.04

Source: Wall Street Journal, MSCI.com
MTD returns: Nov. 30, 2015–Dec. 31, 2015
2015 returns: Dec. 31, 2014–Dec. 31, 2015
*Annualized **USD

Emotional vs. disciplined investing

Last year’s lackluster performance in key stock and fixed income sectors is a perfect segue into why long-term goals and sticking with a carefully crafted investment plan have historically been the best way of managing risk and reaching your financial goals.

Your personal situation, goals, and risk tolerance dictate your asset allocation (which is another way of saying your investment plan). If your personal situation has changed, we may want to make a mid-course adjustment to your investment portfolio. But for most clients, the plan that was designed specifically for you remains the best long-term roadmap.

To highlight let’s examine a study published last year by DALBAR, who has a 40 year track record and is one of the nation’s leading financial research firms. The study found that over a 20-year period ending December 31, 2014, the average equity stock fund investor posted an average annual return of 5.19%, which compares unfavorably to the average annual return for the S&P 500 Index of 9.85%.

Going back 30-years, DALBAR paints an even gloomier picture, with the average equity stock fund investor earning 3.79% annually versus the S&P 500’s average annual gain of 11.06%. As the study underscores, “Investor underperformance is present in all investment classes, therefore proving [the word used in the study] that the failure is not primarily one of poor asset allocation.

Our goal has never been to match or outperform the S&P 500 or any fixed index. Our goal is to maximize your return within a given appetite for risk. An all-stock portfolio, even one that is fully diversified, is too risky for most investors. We typically recommend a percentage allocation into an income producing component that not only reduces overall volatility but also creates a steady stream of income.

So what may be the causes of such woeful underperformance? Some simply has to do with everyday cash needs and unplanned expenses. But the study concluded that the largest contributor came under what it called “voluntary investor behavior,” which generally represents “panic selling, excessively exuberant buying, and attempts at market timing.

Prudential took the study one step further and analyzed equity cash inflows and outflows over the last 20 years ending December 31, 2014. Not surprisingly, investor interest was the highest when shares peaked in 2000 and outflows were largest when prices approached the bottoms in 2002 and 2009.

This is what happens when emotions get in the way of a disciplined approach.

It is simply human. There is temptation to sell when stocks are in downdraft as we briefly saw last year. However, your financial plan takes into account those hard-to-time downturns which keeps us well positioned to recover when shares inevitably move higher.

Around the globe

Last year international events played a role in hampering sentiment at home. A slowing economy in China provided just the right excuse for late summer’s correction. China’s rocky transformation from an industrial-based, infrastructure-driven economy to one that is more balanced remains a headwind to sentiment. Keep in mind that U.S. exports to China account for less than 1% of the total U.S. economy which makes it hard to imagine a scenario where weakness in China pulls the U.S. into a recession.

Then there is Greece. The troubled nation created headlines and short-term volatility in 2015. While last year’s ‘solution’ is tenuous at best and we may not have heard the last from Greece, eurozone leaders appear to have created a financial firewall that is strong enough to contain the fallout if we see the outside possibility and Greece defaults this year.

Political uncertainty on the continent and a wave of immigrants from the Middle East are creating challenges that must be addressed in 2016.

Manufacturing woes and oil

Closer to home, the U.S. service sector has continued to expand at a moderate pace but manufacturing remains in the doldrums. Manufacturing accounts for a just a small segment of the U.S. economy, however, it is more volatile and can exacerbate a downturn and accentuate an upturn.
More importantly for investors, S&P 500 performance and industrial production in the U.S. have a fairly close correlation. Simply put, a healthier industrial economy would likely create a favorable tailwind for stocks.

As we enter the New Year, two stiff headwinds remain–oil and a stronger dollar that is contributing to weakness in exports. We, as consumers, are being treated to the lowest gasoline prices in years. But we are benefiting at the expense of producers, and not just the big oil companies. Sharp cutbacks in capital spending in the energy sector, coupled with layoffs, are hampering manufacturing. Low oil and commodity prices help keep inflation in check, but again, that’s creating big problems in the energy and mining sectors.

The high yield oil spill

These well-documented problems in energy and mining have spilled over into high-yield bonds which have seen a significant jump in yields. Always keep the price-to-yield (interest) relationship in mind when discussing bonds; they move in opposite directions. Yields increased when the prices of high yield bonds fell significantly because many of these issues are from the currently out of favor energy and mining sectors. In less than a year, yields with a ‘CCC’ rating have more than doubled, and the difference in yield between higher quality high yield debt (BB) and lower quality high yield debt (CCC) has widened considerably.

Rattle the bond market and you can rattle the stock market. Yet, measures of credit conditions used by the Federal Reserve indicate financial stresses in the economy remain muted as the New Year begins.

If oil and the commodity sector begin to bottom and the economy continues to expand at a modest pace, historical analysis suggests that much of the damage in high yield bonds is probably behind us. However, a lack of liquidity in the sector, the outside potential for a broader economic slowdown, and continued problems in mining and energy may generate additional uncertainty.

Seeking clarity in earnings

Let’s end on a more upbeat note. Corporate earnings are probably the most important variable in determining the direction of stocks over the medium and long term. Yes, other factors can create volatility shorter term, but profits are the lifeblood of stocks.

According to Thomson Reuters, earnings for S&P 500 firms collectively fell by 0.8% in Q3 and are forecast to decline 3.7% in Q4. Much of the weakness can be pinned on a steep drop in earnings among energy companies. Pull out the energy sector and Q3 profits would have been about seven percentage points higher, according to FactSet Research. The rise in the dollar has also weighed on profits of multinationals, as they translate sales abroad back into the stronger greenback.

Thomson Reuters is projecting that earnings will begin rising again in the first quarter of 2016 and accelerate in Q2 and Q3. Of course, what happens to energy, the dollar, and the economy will ultimately determine the path of corporate earnings. But the forecast for an improving profit outlook, which we don’t believe is currently priced into the markets, gives rise to cautious optimism as 2016 begins to unfold.

Bottom line

It is all about being comfortable with your portfolio. Again, our goal is to help you accumulate and manage wealth without taking on undue risk. While markets rise and markets fall, unless there have been changes in your circumstances or you’ve hit milestones in your life such as retirement, it is important to stick with your plan.

You must be comfortable with the level of risk you’re taking. If you are not, let’s talk and recalibrate. Changes in various asset classes may have knocked you out of alignment with your target allocations. We will continue to adjust your portfolio to maintain balance.

Let me end with this comment from Warren Buffett. “Someone is sitting in the shade today because someone planted a tree a long time ago.” You have already planted that tree. So we encourage you to stay with the plan that nurtures and grows your tree.

As always we hope you’ve found this review to be educational and helpful. DV Financial is here to serve you! If you have any questions or would like to discuss any matters, please feel free to give us a call.

As we enter 2016, I want to say once again that I’m honored and humbled that you have given me the opportunity to serve as your financial confidant and advisor.

Sincerely,

Art Dinkin, CFP®