Back to Where We Started
The performance of the S&P 5001 in the first quarter of 2016 was ordinary and rather extraordinary at the same time. This proxy for U.S. large-cap stocks closed the quarter up 0.77% (excludes dividends), which is a little light in terms of the historical average return but well within historical norms. This is only part of the story, however. As even the most casual student of the markets is keenly aware, the opening three months of 2016 were far from tranquil. The S&P 500 experienced a drawdown of over 10% before rallying strongly to close the quarter in positive territory. To put this feat into proper context, the first quarter of 2016 ranks as the greatest intra-quarter drawdown recovery dating back to the start of 1980.
We believe fears of weak economic activity leading to outright recession have driven a lot of the volatility experienced in the stock market this year. These fears were fed by a downturn in economic indicators such as the Institute for Supply Management’s manufacturing purchasing managers’ index (PMI). The market rally in March was due in part to the emergence of evidence suggesting that the economy was not in freefall. For example, a number of the regional Federal Reserve manufacturing activity surveys showed noteworthy improvements during the month. These improvements were recently confirmed in the manufacturing PMI itself, which moved back into expansion territory (i.e., a reading greater than 50) in March.
It is important not to put too much weight on any individual data point, but the weight of the evidence at the moment suggests that our slow growth base case has again weathered a minor crisis of confidence.
Investors are, in many ways, back to where they started 2016. Valuations for U.S. stocks have rallied toward their highs for the current market cycle. At the same time, our overall expectation for slow, below trend economic growth remains unchanged. This combination of relatively full valuations and modest growth expectations continues to present a challenge for equity investors.
The lack of strong tailwinds—such as compelling valuations or prospects for robust top-line growth—should not be confused with a stock market facing outright headwinds of unsustainably high valuations, rampant speculation, or an overheating economy. We continue to believe that the current environment is one that requires an active approach to asset allocation that seeks to benefit from episodes of market volatility. Consistent with this perspective, we increased our recommended allocation to equities in January as market fears continued to build. The recent rally in equities returned many of our indicators to readings similar to those present at the start of the year. Furthermore, measures of investor sentiment such as the VIX index and the Investors Intelligence bull/bear ratio have become less pessimistic in recent weeks as the S&P 500 has moved back up.
In light of these developments, we have opted to reduce our recommended allocation to stocks, effectively removing the tactical additions from earlier in 2016. Our indicator framework suggests a modest overweight allocation to stocks is appropriate today, with the most attractive opportunities coming outside of the United States. We believe valuations in many of these markets are more attractive. This is particularly true for measures such as price-to-five year average earnings, which seeks to show valuations under a normalized earnings environment. Although there are legitimate concerns regarding growth internationally, many of our indicators suggest a more attractive risk/reward profile for equity markets outside of the United States.
Investors are likely hoping for calmer waters for the rest of the year after the turbulent first three months of 2016. While anything is possible, we believe that further volatility over the course of the year cannot be ruled out. The exact timing and cause of volatility will be difficult (if not impossible) to predict, making it essential to be prepared in advance to act. We are closely monitoring the economic, valuation, and sentiment landscape so that when volatility inevitably returns, we are armed with an understanding of where opportunities may exist.