2016 has made quite an entrance so far with the S&P 500 experiencing the worst beginning to a calendar year (through the first 10 trading days of the year) in history. The financial press has attributed the recent volatility to a variety of suspects, including concerns about Chinese economic growth, falling oil prices, fears of a U.S. recession, and the possibility of a policy mistake by the U.S. Federal Reserve. The risk of recurring bouts of market volatility has been a topic we have addressed many times in recent years, most recently in this month’s feature article: “Focusing on Long-Term Return Objectives in a Low Return World.” It is important to focus now on the potential investment opportunities created by this jarring start to the year. We believe that the recent market turbulence presents an opportunity to consider a modest tactical addition to stocks.
The recent decline in global equity markets has yet to produce compelling long-term “buy” signals from our indicators, but these indicators are also not in high-risk territory today. This lack of high-risk indictors is an important component of our constructive view on the recent pullback. For example, consider Exhibit 1, which shows six-month forward S&P 5001 returns in environments where our domestic economic indicators are not signaling a high-risk environment. The returns are segmented into two regimes based on the level of the VIX2: low volatility (VIX < 30) and high volatility (VIX ≥ 30). Historically, elevated market volatility in the absence of economic excesses has been associated with strong market returns over the following six to 12 months. In mid-January, the VIX crossed 30 on an intraday basis, putting the combination of indicators into the favorable regime (i.e., high volatility and lack of economic excesses).
We targeted three areas for modest increases in January (see the Recommended Asset Allocation section for details on positioning): U.S. large caps, U.S. small caps, and European stocks. The recent market environment has been unpleasant for most large-cap stocks, helping to justify a modest increase. Between the end of November 2015 and January 21 of this year, the median stock in the large-cap focused S&P 500 returned -11.4%. However, the environment has been even more painful for small-cap stocks. During the same period, the median return for stocks in the Russell 20003 small-cap index was -17.4%. Ongoing underperformance of small caps versus large caps has corrected much of the relative overvaluation of the former versus the latter (Exhibit 2, top and middle panels). Nevertheless, our modest addition to small caps only brings the recommended allocation to neutral, as this is not the point in the economic cycle that warrants an overweight to small caps. Furthermore, while absolute small-cap valuations have become more reasonable in recent months, they are not particularly cheap by historical standards (Exhibit 2, bottom panel). We consider the recommended increases to both large caps and small caps to be tactical in nature, and will likely move to decrease these allocations if valuations increase again or sentiment becomes more bullish.
The recent market volatility also provided us with an opportunity to add to our recommended European equity exposure. Europe continues to look attractive in our indicator framework and is an area we believe warrants an overweight exposure. Major European indexes are essentially unchanged over the past two years, yet contrary to many other areas of the world, economic data reports for Europe have been improving during this time. Unemployment rates have started to decline, GDP is growing at the fastest pace year-over-year since 2011, private consumption growth is the strongest it has been year-over-year since before the Great Recession (Exhibit 3), and the purchasing managers’ indexes (PMI) for the services and manufacturing sectors are both in expansion territory.
The lack of willingness to lend and borrow has been a substantial challenge to European economic growth, but recently lending activity has turned positive. Non-financial corporate loans outstanding made by eurozone commercial banks turned positive at the end of 2015 for the first time since 2011 (Exhibit 4). We will continue to monitor the economic backdrop in Europe for further signs of strength, as well as the risk of renewed weaknesses, and adjust our recommendations accordingly.
The current lack of true table-pounding buy signals tempers our enthusiasm, hence the recommendation for just a modest tactical addition to equities. Furthermore, there are a number of risks present around the world today that warrant close monitoring. One in particular that we are tracking is the possibility that the United States could enter a recession driven by a slowdown in manufacturing activity, which could result from the decline in energy prices and the strength of the dollar. Many have pointed to the decline in the Institute for Supply Management’s manufacturing PMI as evidence that this scenario is unfolding today (Exhibit 5). This survey of manufacturing activity in the United States recently slipped below 50, moving into contraction territory. The non-manufacturing PMI is still well into expansion territory, however, which mitigates the fact that the manufacturing PMI has been declining. In 1998, and to a lesser extent in 2005 and 2012, the manufacturing PMI fell while the non-manufacturing PMI stayed in expansion mode, and the manufacturing PMI eventually picked up. A weakening of the dollar, a grandfathering-in of dollar weakness, or a pickup in global growth could relieve some of the pressure on manufacturing today. Nevertheless, we will be monitoring both PMIs closely.
We strongly believe that an active approach to investment management is the best way to capitalize on opportunities and manage risk in volatile markets. The concerns among many investors today are legitimate and need to be monitored, but the market tends to overreact in both directions. The ability to respond to these overreactions and swings in investor emotion can be a valuable tool for adding value over the course of a market cycle.