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1st Quarter 2016

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Fears of a global slowdown and new lows in crude oil prices triggered an 11% selloff in stocks during the first six weeks of 2016.

However, a stream of data showing that the six-year U.S. economic expansion was still intact put the bulls back in control during the last six weeks of the quarter.

It was a see-saw ride, but by the end of the three-month period, the Standard & Poor’s 500 stock index eked out a total return of 1.4%.

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When January began, evidence had been mounting for months of weakening in the Chinese economy.

This set off widespread fears that a slowdown in the world’s second-largest economic engine would drag down growth of the global economy.

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Meanwhile, in January, oil prices plunged to lows not seen in more than a decade.

Investors became so spooked at the prospect of a global slowdown that they focused on the negative effect that lower oil and commodities prices would have on nations whose wealth is tied to exporting commodities.

The positive effect of lower oil prices on the consumer-driven U.S. economy was totally ignored.

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Stock prices were more vulnerable to emotional swings because investors had bid prices up.

In an amazing three-year bull run, the price-to-earnings multiple expanded from deeply undervalued, at 12, to somewhat overvalued, at 18.2.

The higher valuation helped fuel the bull market, but it also made share prices more susceptible to emotional price drops.

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The turning point in the quarter came in mid-February.

A string of positive economic news and corporate earnings announcements confirmed that the U.S. economic expansion that began in 2009 — one of the longest expansions of the past century — was still very much intact.

And just like that, stocks recovered from the worst start to a new year in Wall Street history and the S&P 500 returned 1.4%, with dividends included.

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Personal income and spending were strong, and so were retail sales.

The index of leading economic indicators (LEIs) haltingly advanced, while jobs openings hovered near an all-time high. The unemployment rate fell to 5% and the Fed clearly and repeatedly said it intended to maintain an accommodative monetary policy.

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As the second quarter got underway in April, the price of stocks in America’s blue-chip companies was neither expensive nor cheap.

Trading at a price-to-earnings multiple of 17.4, stocks in the Standard & Poor’s 500 index were priced in line with the historical norm.

Click image to enlargeThe index closed the quarter not too far off from all-time highs reached in mid-2015.

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Last quarter, we mentioned that growth stocks had dramatically outperformed value-style stocks, not just for the quarter but for all of 2015, and we warned that the pendulum can swing from one extreme to another. 

That is precisely what happened in the first quarter of 2016.

Value stocks beat growth within each of the market capitalization bands.

It was a total reversal from investor preferences in 2015.

Small- and mid-cap value stocks trounced the gains on the four other styles and market-cap categories.

While fast-growing companies were preferred by investors just a quarter earlier and throughout 2015, investors moved in the exact opposite direction in the first quarter of 2016.

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Investors are fickle and their preferences almost seem whimsical at times.

That’s why strategic asset allocation makes so much sense, especially to a long-term investor focused on creating an income stream whose goal is to outlive you.

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In the first quarter, which ended March 31, 2016, the three sectors in the S&P 500 commonly considered to be the most defensive outperformed.

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Telecom services and utilities shares respectively gained 15.1% and 14.5%, while the consumer staples sector gained 4.8%.

Illustrating the volatility of the period, the energy sector, which posted a 24% loss in 2015, gained 3.1% in the quarter.

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Comparing the U.S. stock market to major foreign indexes, emerging markets came out on top with a 4% gain for the first quarter of 2016.

It marked a total turnaround from the fourth quarter of 2015, when emerging market stocks were last among this group.

Conversely, the Eurozone stock index went from first place during 2015 to last place in the first quarter of this year.

U.S. indexes, small-, mid-, and large-cap, generally outperformed rest-of-world in the first quarter.

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Looking across a wide range of 12 asset classes, the laggards were crude oil, master limited partnerships, and commodities.

This was a continuation of the losses they experienced in 2015.

Gold, on the other hand, surged 17%, which represented a significant reversal of its multi-year decline.

Real estate investment trusts, having been one of the few asset classes to have posted positive returns in 2015, posted gains once again in the first quarter.

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Stocks have gone approximately sideways for the past 12 months.

Including dividends, the S&P 500 returned 1.8%.

Despite U.S. economic data remaining positive for the entire period two stunning double-digit plunges rattled investors.

It was an abrupt change from the five previous five years of rising stock prices amid low volatility.

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The first big dip came after China devalued its currency slightly on August 11, 2015.

This signal of weakness from the world’s second-largest economy combined with heightened worries over weakening commodities.

Fears of a global slowdown triggered a “flash crash” on the morning of August 24, 2015, when the Dow Jones Industrial Average plunged 1,000 points in the first six minutes of trading.

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Stocks rallied into the Federal Reserve’s September 17 meeting, when it was widely believed the Federal Reserve would raise its target rate for the first time in seven years.

The Fed’s postponement of that long-anticipated rate hike set off another stock market selloff that ran through the end of the third quarter of 2015.

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The fourth quarter brought a steady stream of positive economic data.

Data showing new job formation in October and November had helped the stock market right itself from the late-summer correction.

Then came another stock price plunge, again on news about China’s weakening economy and new lows in crude oil prices.

Those fears abated by the end of the first quarter of 2016, however.

Global economic data firmed up, and U.S. economic data continued to come in strong, led by a string of healthy monthly new-jobs reports and a rising index of leading economic indicators.

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The 12 months ended March 31, 2016, show just how weak U.S. stocks were during the period.

If you break the U.S. stock universe into six categories by style, only one of the six styles did not sustain a loss.

Large growth companies managed a 1.8% total return.

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For the 12 months ended March 31, 2016, the three S&P 500 sectors usually considered to be the most defensive – telecom, utilities, and consumer staples – were the leaders as the broad market went sideways.

This came as a big surprise to most Wall Street strategists.

According to research from independent economist Fritz Meyer, these three sectors have been among the most “panned” in both 2015 and 2016.

Wall Street so-called experts are often totally wrong in their tactical asset allocation advice.

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For the 12 months ended March 31, 2016, U.S. stocks outperformed the four major regional equity markets across the globe.

Foreign stocks have been much more susceptible to news of slower growth in the Chinese economy than has the U.S. stock market.

China’s tiny stock market lost 16.2% of its value, and much larger Eurozone stock markets fell almost as much.

Stocks in emerging economies and Asia lost 13.5% and 8.4%, respectively.

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This chart shows why broad diversification is important.

Can you imagine how an investor in stocks tied to oil and commodities was feeling seeing the heavy losses deepen in this 12-month period?

The crude oil index shown lost 41%. Master limited partnerships, which are tied to the fortunes of energy companies, lost 37.2%% and the commodities index we track quarterly lost 28.7%.

While the 1.8% total return in this 12-month period may seem paltry, and the returns of about 4% on indexes tracking real estate investment trusts, gold, and bonds may not look very spectacular, a prudently managed portfolio, diversified broadly among these 12 asset classes, would not have been crushed.

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In 2015 and the first quarter of 2016, the stock market leveled out following the extraordinary recovery run and tripling in value from the March 2009 bear-market bottom seven years ago.

In 2015 and 2016-to-date the stock market experienced two long-anticipated “10% corrections” following four years of unusually low downside market volatility.

Over the last five years, including reinvestment of dividends, the Standard & Poor’s 500 total return index has returned 73%.

Without  dividends, in the same period, the S&P 500 gained 55% — 18 percentage points less.

Since 1900, only three of 23 bull markets have lasted six years or longer.

The likelihood of a bear market — a pullback of at least 20% — increases as the bull market grows older.

But fundamental economic conditions that have accompanied bear markets in the past were not present as of the end of 2015.

Restrictive Fed policy, the likelihood of slowing economic growth, stock market overvaluation, and irrational exuberance — traditional important precursors of a serious market downturn — were not yet evident as the second quarter got under way in April 2016.

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For the five years ended March 31, 2016, what particularly stands out is how large-cap growth stocks in the S&P 500 growth index returned 69%, compared to a 42% gain in large-cap value stocks.

From time to time, investors prefer large-caps over small companies or growth over value.

Rebalancing a portfolio periodically prevents a portfolio from becoming too heavily skewed toward a hot asset class or style growing faster than others.

That’s because investors are fickle and their preferences for certain styles often abruptly change.

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For the five years ended March 31, 2016, the three best performing sectors – health care, consumer discretionary, and technology – consist predominately of growth stocks.

Conversely, the lagging sectors – energy, materials, and telecom services – consist mainly of value stocks.

The energy and material sectors were slammed by the collapse in the price of crude oil and other commodities.

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Look at the wide disparity in returns between the best and worst asset classes.

U.S. real estate investment trusts and large U.S companies gained more than 70% in the five years ended March 31, 2016.

Meanwhile, during this same period, the Goldman Sachs index tracking West Texas Intermediate crude oil prices, plunged 76%.

An investor who bet on oil stocks and rising commodities prices sustained heavy losses that will take years to recover from.

For an investor who is trying to build a secure retirement income, making big bets risks too much.

No one can reliably predict the next move in asset class prices, which is why diversifying across a broad spectrum of asset classes, along with periodic rebalancing, is so important.

There is nothing magical or complicated about it. It’s investment math.

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For the five years ended March 31, 2016, U.S. stock indexes – small-, mid-, and large-cap – outperformed indexes for these four major regional bourses across the globe.

While the largest publicly held U.S. companies represented by the S&P 500 gained 55.4% in price, S&P’s European stock index lagged with 13.7% price appreciation over the same five-year period.

Of course, this does not mean the same thing will happen over the next five years.

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European society, culture, institutions, and economies are adjusting to the European Union.

Growth is slowly returning to the Eurozone.

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In February, the Organization of Economic Cooperation and Development’s chief economist, Catherine Mann, urged European leaders to act urgently to adopt growth-enhancing reforms.

Mann projected global GDP growth in 2016 would be no higher than in 2015 and revised her global growth forecast downward.

She expected the Euro area will grow at a rate of just 1.4% rate in 2016 and 1.7% in 2017.

While growth in Europe is anemic, it is nonetheless growth.

Europe’s recovery from the credit bubble of 2008 has lagged the U.S but it is slowly recovering.

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Growth prospects on the U.S. remain quite good.

For months, U.S. economic data releases have all been positive, and this chart from the Institute of Supply Management’s Manufacturing Purchasing Managers Index in March was another good sign.

This index historically has slumped to under 50% as the economy slides into recession, the areas shaded in gray.

A reading above 50% indicates that the manufacturing economy is generally expanding, A reading below 50% indicates that the economy is contracting.

ISI reported on April 1 that the index in March was at 51.8%.

New orders, which is a sub-component of the index, took a big jump from 51.5% in February to 58.3% in March.

New orders is a forward-looking component of ISM Manufacturing's PMI index, and it is a good sign of growing manufacturing activity to be done in the weeks immediately ahead.

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While the ISM’s manufacturing index gets more coverage in the press, the ISM’s index of non-manufacturing purchasing managers is actually much more important in judging the strength of the U.S. economy.

Manufacturing accounts for only about 10% of jobs in the U.S. economy, according to U.S. government statistics, while non-manufacturing jobs account for the other 90%.

While this index has only limited history, it’s calculated the same way as the manufacturing index from ISM.

The non-manufacturing PMI is expected to substantially slump to less than 50% before the onset of a recession.

The March non-manufacturing PMI, at 54.5%, was a point higher than a month earlier, and that reading is quite strong.

As with the manufacturing PMI index, new orders reported for the non-manufacturing sector of the economy in March were up, and that is a good sign for the weeks immediately ahead.

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The number of positions waiting to be filled fell to 5.45 million in March from 5.6 million February, according to the Labor Department in early April 2016.

U.S. employers were taking on more workers, further evidence of a firming U.S. labor market.

With job openings in February remaining near a record-high, it’s hard to argue that the economy is in trouble.

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Meanwhile, real disposable personal income and spending have been growing at a healthy clip.

In fact, real DPI is growing faster than during the boom before to the last recession in began in January 2008.

How many times have you heard pundits and politicians tell us that Americans’ income has been stagnant for many years, and that average American is going backwards?

The data belie these claims.

Real purchasing power has been growing steadily.

In fact, the average American’s disposable income after inflation is growing faster than in the credit-financed boom before the 2008 recession.

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According to Standard & Poor’s forecasts, earnings at the nation’s largest publicly-held companies will grow 14% through the end of 2016.

Even if this is overly optimistic, a growth rate half of that would be good news for investors in stocks.

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What matters most, however, to a long-term investor is corporate profits.

Earnings ultimately is what drives stock prices.

In this chart, stock prices, the black line, are determined by the red line, corporate earnings.

Plotted in the upper right corner in the two red dots are the latest consensus 2016 and 2017 earnings forecasts by Wall Street analysts.

Barring some unexpected bad news – and bad news is bound to happen now and then – the black line will be pulled toward the red dots, which represent the consensus forecast of Wall Street analysts.

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Despite the stream of positive economic news, continued volatility should be expected.


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1st Quarter 2018
4th Quarter 2017
3rd Quarter 2017
2nd Quarter 2017
1st Quarter 2017

This article was written by a professional financial journalist for Legend Financial Advisors, Inc.® and is not intended as legal or investment advice.
@2018 Advisor Products Inc. All Rights Reserved.


©2018 Legend Financial Advisors, Inc.®. All rights reserved.