2016 Stock Market Review & Analysis
Former Wall Street Journal personal finance columnist and frequent guest Jonathan Clements visits with Steve to talk about the past year in stocks and the importance of asset valuations, a diversified portfolio, and the long view for investors.
Jumping right into a discussion of markets in 2016, Jonathan notes that the year started with losses in US stocks of more than 10% and much speculation about the end of the bull market that started in 2009. Of course, the year ended with a far different mood and double-digit gains for large-cap stocks in the S&P 500, a story shared albeit to a lesser extent by small cap stocks, emerging markets, and even gold. Two major shocks to the financial world—Brexit and the election of Donald Trump—initially looked like they would derail markets, but quickly proved to be a wash, in the first case, and a galvanizing shot in the arm in the latter.
Jonathan points out another variable that ought to have generated headwinds for markets, namely the decline of US corporate earnings since September 2015, which has evidently been discounted and seemingly forgotten. Steve invites a deeper discussion of the various ways of valuing stocks and what role valuations ought to play in deciding whether a stock is fairly priced or not. The consensus Steve and Jonathan reach is that US stocks are expensive by historic measures, trading as they do at 28 times 10-year earnings versus a 50-year average of 19 times earnings. While this insight justifiably evokes a cautionary note which investors ought to take heed of, in and of itself it’s not a reliable bellwether of what direction stocks will take in the upcoming months or years.
There is a counter argument that can be made which states that the market prices stocks according to a forward outlook some 6 to 18 months in the future. In other words, stocks are priced more reasonably in terms of PE ratios based on expectations of earnings a year or year and a half from now. In the final analysis, however, neither of these approaches can simply be “taken to the bank.”
The Importance of Valuation and a Globally Diversified Portfolio
Steve worries that many investors have grown complacent during the last several years of a healthy bull market and believe that all they need to do is imitate the success of these bull years by buying and holding S&P 500 stocks or index funds. He wonders whether it might be smarter to consider investing in (or emphasizing in one’s portfolio) asset classes that have underperformed and consequently been neglected in recent years. Jonathan agrees that the S&P has been the “star performer of the global market” which all other assets have lagged behind. This may drive many to invest, as Steve phrases it, while “looking in the rearview mirror,” expecting the S&P to continue to post double-digit gains every year or two. Such expectations can’t be met indefinitely. Based on inflation adjusted 10-year PE ratios, European and emerging market stocks are significantly cheaper than US stocks at the moment, according to Jonathan. Despite their attractive prices, returns on foreign stocks in the past five or so years have been miserable.
At some point, markets will catch up with this pricing disparity and non-US stocks will break out of the middling- price ranges they’ve languished in. Again, the question of timing becomes preeminent and can only be answered in very approximate terms. Jonathan points out that foreign stocks have outpaced US stocks in five of the past eight decades, a fact which may provide cold comfort for some investors, but should nevertheless underpin a globally diversified portfolio. On his website humbledollar.com, Jonathan advises readers to include foreign stocks as 33-40% of their overall equities holdings.
While there are many ways of identifying market opportunities, in Jonathan’s point of view, all of these fail to perform as well as valuations of individual stocks when it comes to predicting future earnings and returns. He cites a study by Vanguard which confirmed this advantage and estimates that current valuations explain around 40% of equity earnings for the next decade. He concedes that this longer span is necessary for valuations to prove out and that guidance for a 1-2 year timeline is unreliable.
In the end, Steve and Jonathan concur that a globally diversified portfolio, regardless of specific allocations and weighting among asset classes, offers the best balance of risk and reward for most investors.
Steve Pomeranz: Jonathan Clements has been a frequent guest on this show, and the reason is a good one. Jonathan is the author of numerous personal finance books, including How to Think About Money. He’s also Founder and Editor of Humble Dollar, which is a new website he’s created, and we’ll talk a little bit about that later on in the segment.
Jonathan’s got some cred; he’s not just a guy who wrote a book. He spent almost 20 years as the personal finance columnist at the Wall Street Journal. That’s how I’ve known his work, and he’s written over 1,000 columns, and he joins me today. Jonathan, welcome back to the show.
Jonathan Clements: It’s great to be with you, Steve.
Steve Pomeranz: Where are you right now? What part of the country are you in?
Jonathan Clements: I am just north of New York City in Westchester …
Steve Pomeranz: Okay.
Jonathan Clements:…in our home looking over the Hudson.
Steve Pomeranz: Very nice.
Jonathan Clements: On a rather frosty day, I should add.
Steve Pomeranz: Yes, very nice. Very nice. We, in fact, are in Boca Raton, Florida, and the weather is absolutely glorious. We get about 10 days of this kind of weather per year, so I’m trying to figure out how to bottle it and make some money. Let’s talk about 2016 and what went on in the markets worldwide. It’s been really a remarkable year. What’s your take on 2016?
Jonathan Clements: 2016 was a year that surprised a lot of people, partly because it started so badly. It’s easy to forget, but you go back to January of 2016 and people were talking about us having a market correction. I think the DOW and the S&P 500 were down about 6% the first week of January and everybody was saying, “This is going to be the end of the Bull market.” The great bull market that we’ve seen since the market bottom of March 2009 is over.
Guess what? These particular stocks, it isn’t. We ended up with double-digit gains for large cap US stocks, the S&P 500. Small cap US stocks had a really big year as well, and there were also some surprises. We saw a comeback by gold, and we also saw something of a recovery by emerging stock markets.
Steve Pomeranz: Yeah, you know for the last few years … I mean in 2015 the markets really didn’t do much of anything and it happened with a lot of volatility. You know, volatility is this risk and uncertainty and wondering whether this is the beginning of a bear market and all this stuff, and you hope that for this kind of pain, psychological pain that you’re going through, and some monetary pain, that you’re going to get rewarded with some return, and 2015 didn’t give that to us.
Now 2016, I think at one point in February, the S&P 500 was down something like 10 or 11%; pretty painful, for the first couple of months. Then it kind of bounced around for the rest of the year until, little surprise in Brexit, where everybody thought, run for the hills because this is bad news. The market went up and then Trump got elected—that was unexpected—actually on the night of his election, I think the market did go down 800 points, but by the time the market opened things had stabilized and we’ve seen a Bull market since then. A lot of this return has really been in the last two months, right?
Jonathan Clements: It’s absolutely correct and what you see when you look at the story of the last couple of years in the US is that we’ve actually seen corporate earnings decline. This is actually a story that people don’t seem to be that aware of, but the earnings of the S&P 500 peaked in September 2015, and today those earnings are about 15 or 16% lower. That would normally be really bad for stocks, but the reality is the alternative investment, the main alternative investment, which is bonds, had been extremely unattractive because we had such low-interest rates.
Trump gets elected and there’s a lot of talk about big infrastructure spending, about tax cuts, and traders are looking at that and saying, “Hey, we’re going to get a lot of economic stimulus thanks to increased spending and reduced taxes; that’s going to make the economy grow faster and that’s going to mean higher corporate earnings.” That’s why the stock market has rallied.
Steve Pomeranz: Yeah, so the stock market rallies in advance of expectations some six months, some say 18 months, out. Right now, the market looks really, really expensive because, if you look back on these declined corporate earnings and you look at the stock prices looking forward, you have this discrepancy so you hear a lot about markets that are very, very high price to earnings ratio. Well, when you’re coming out of a situation like that, it actually should be at a high price to earnings ratio, if you think about it because it’s anticipating higher future earnings. The question is, Jonathan, will those earnings actually come to bear? I don’t know if you want to make a forecast on that. Probably not.
Jonathan Clements: Only if you put a gun to my head, Steve. They say, you know, economists have forecasted five of the past three recessions. The forecasting game is awfully tough, but you are indeed right. The stock market looks expensive, and I would argue, in terms of US stocks, it is expensive. We are at a very high-price earnings ratio, even if you normalize those earnings utilizing what’s called the Shiller PE ratio and what you do with that is you take corporate earnings for the past 10 years, you increase the earnings from earlier years to reflect inflation, and then you look at how expensive the market is. If you use that measure, currently we have US stocks trading at something like 28 times 10-year earnings versus a 50-year average of 19-times earnings.
Steve Pomeranz: That’s expensive.
Jonathan Clements: We’re expensive. No one should delude themselves otherwise.
Steve Pomeranz: Looking at the charts of returns, if you look at the S&P 500 over the last three or four years, it’s had some stellar returns. It’s been double-digits numerous times and people tend to invest looking in the rearview mirror. Clients come in to me and they say, “Hey, why don’t we just invest in the S&P 500 and be done with it? Why are we diversified into foreign markets, emerging markets, why do we have some bonds? Why do we have some of these asset classes?” That, to me, is a signal that we may be kind of near the end of that cycle, when the average person is saying, “Hey, you know, throw in the towel. Let’s just invest in what’s popular and what’s done well in the past few years.” I guess the reverse of that is, if you want to be smart you’d be investing in what hasn’t done well in the last few years. What is that, Jonathan?
Jonathan Clements: If you look around the world and you say “what is the most unpopular investment,” it would have to be foreign stocks. Foreign stocks have really been a wretched investment over the past six years, whether you look at emerging markets or you look at developed foreign markets. In fact, if you look at the valuations abroad and you compare them to the US, they are significantly more attractive because we’ve had this period of lousy returns.
I mentioned earlier the so-called Shiller PE, that 10-year earnings number where you adjust for inflation. If the US is at 20 times those Shiller earnings, European markets today are in the teens; and if you look at emerging markets, they’re at about 11 times 10-year earnings. Emerging markets are trading at less than half what US stock market’s trading at. Yet, if anything, we should expect higher growth from emerging markets in the years ahead, simply because these are much more vibrant economies with faster growing populations.
Steve Pomeranz: Yeah, this is not prediction stuff, this is just basic common sense thinking, but here’s the rub—people are impatient. The one psychological aspect I think most people experience is that when the market’s rising, and we’re talking about, let’s say, the US market, and your money is not rising with it because you’ve decided that “Hey, US stocks are expensive, foreign markets are cheap. I’m going to overweight my money into foreign markets. Oh, there’s another year that they just haven’t kept up.” It’s very hard to stay the course. How do you do it?
Jonathan Clements: You’re absolutely right, Steve. If you want to feel short, stand next to tall people. If you want your portfolio to look inadequate over the last six years, compare it to the S&P 500. The S&P 500 has been the star performer of the global market and anybody who’s been diversified in the global fashion, which is what every sensible investment expert will tell them to do, anybody who owns that globally diversified portfolio is going to have lagged behind the S&P 500.
What you’re looking at here is comparing apples and oranges. You should not be comparing a globally diversified portfolio to the S&P 500 because you’re comparing your global portfolio to just one part of the market. If you look back historically, over the past eight full decades, foreign stocks have outpaced US stocks in five of those eight decades. Most of the time, it turns out, you would have actually been better off holding foreign stock, but the fact is the last six years that hasn’t been the case. People are much more comfortable owning the S&P 500 company than they are owning foreign stocks, and that’s why the advisors like you, Steve, are getting a lot of grief.
Steve Pomeranz: Yeah, well, we don’t really get too much grief because at least we’ve got a good portion of our money in US stocks, but when you look at the detractors of performance in any given year, and you know there’s always going to be something. One year we were surprised—for example, this year—that emerging market stocks did so well, but last year they were a terrible performer. It’s always going to be something that’s not working. I always use the analogy of a six-cylinder car. There’s three cylinders that are working really well and really efficiently, two are just kind of getting by not so great, and one’s really not operating at all, but your car is moving forward, you’re not careening off the side of the road, off the rails. It’s steady as she goes. Since you can never tell which asset class is going to be the next best performer, it’s just a good idea to stay diversified and try to tilt in certain directions using valuations, like you do.
Jonathan Clements: Mentioning valuations is important because if you look historically and you say, “what’s the best strategy for earning healthy returns?”, if you say to yourself the best strategy is to invest in the economies with the highest growth, which among developed markets would be the US economy today, that strategy of investing in the economies that have had the fastest growth of the past five years would have actually produced the worst returns. Investing in high-growth economies tends to produce poor returns and the reason is this: investors see the high growth and they bid up stock prices. When you invest in those high growth economies, what you’re tending to do is invest in very expensive stocks.
In fact, the best indicator of future returns is not the level of economic growth, instead, it’s the level of valuations. Vanguard did a study and they found the best determinate of future returns was current valuations. Current valuations explain about 40% of returns over the next 10 years.
Steve Pomeranz: Price is everything. I think that’s the point. It’s what you pay that really matters. There’s this old saying that people know the price of everything but the value of nothing, a somewhat cynical look at some people’s view of assets and things they purchase. The bottom line is if you’re buying things that are lower in price, the future return, on average, is going to be higher than if you pay a higher price because trees don’t grow to the sky.
Jonathan Clements: The caveat to all this—and it’s a caveat you would no doubt add, Steve, if I didn’t add it—we don’t know. Even though valuations tell us that developed foreign markets, emerging markets look more attractive than US stock, you still want to have that globally diversified portfolio because you simply do not know what’s going to happen this month or next.
Steve Pomeranz: So true.
Jonathan Clements: Valuation may be the determining factor over 10 years. That doesn’t tell you anything about what’s going to happen over the next 12 or 24 months.
Steve Pomeranz: Emotionally, people have very short time horizons especially when they’re thinking about their money. They want their money to rise, they want it to rise quickly, they want it to rise now. Ten years is just too long for most people to hang on. My guest is Jonathan Clements. He’s a frequent guest on the show and you can see why I like to have him on here. He’s really intelligent, very filled with common sense. He’s the author of How to Think About Money, and he’s the Founder and Editor of Humble Dollar, which is kind of a new website that he’s just created, and I want to ask him about that. Tell us about that, please.
Jonathan Clements: HumbleDollar.com grew out of the annual financial guide that I’ve been putting out the past couple of years as a book. The goal of the book was to put it out every year on January 1st with completely up to date information as of the previous day. The problem was, the logistics of putting out that book was adding or subtracting years and years from my life. What I did to make my life somewhat easier and also to make the information truly accessible to readers was to take all the information from the book, put it on the web, and now I can update the information every day with a few clicks of my mouse. It makes my life much easier, and, I hope, for people who are interested in learning about not just investing but broader personal finance, it’ll be a great resource they can turn to whenever they want, at no cost, to get the latest information.
Steve Pomeranz: I took a look at the site. It explains very simply investment terms; it explains the economy very simply. It takes a somewhat humble approach. Where did you come up with Humble Dollar?
Jonathan Clements: The real story, Steve, is that I spent almost 11 months on GoDaddy.com banging in every potential name for the site that I could think of and, as everybody who’s ever been through this exercise quickly discovers, all the good names have been taken.
Steve Pomeranz: Yeah. Of course.
Jonathan Clements: For instance, I wanted to get the name Enough.com. It would only have cost me 1.2 million dollars.
Steve Pomeranz: Enough, enough.
Jonathan Clements: Enough!
Steve Pomeranz: Okay, enough.
Jonathan Clements: I woke up in the middle of the night and this name, Humble Dollar, popped into my head. I got out of bed, opened up my laptop, tapped it into GoDaddy.com and there it was. I bought it for 9.99.
Steve Pomeranz: Good for you. You know, that’s why we …that’s not really why, but one of the driving factors of us changing the name of the show was there were some other shows called On The Money, but there’s no other show called the Steve Pomeranz Show. We got StevePomeranz.com no problem. I guess you got the same thing.
HumbleDollar.com, it’s a site I absolutely recommend. I also recommend Jonathan’s books which are listed on the site. Again, the site is HumbleDollar.com. My guest has been Jonathan Clements. Thank you so much for joining me once again.
Jonathan Clements: It’s been my pleasure, Steve.