SUMMARY: 2016 IS OFF TO AN UGLY START. FORTUNATELY, WE ARE POSITIONED FOR UGLY WITH ABUNDANT CASH. WE SEE OPPORTUNITIES.
Clients and Friends of our Firm:
Gloom, Uncertainty, and Despair
Just 18 days into 2016 and the Dow Jones Industrial Average is already down more than 8 percent. The Russell 2000 small-cap index is in worse shape. It’s down 11% for the year and on the verge of an outright bear market having lost more than 20% from its highs of last summer. Rising interest rates, a precipitous decline in crude oil, volatility in China, and Mideast tensions have all conspired to set a tone of general pessimism.
With that pervasive pessimism as the backdrop for the start of 2016, do we expect to have a profitable 2016? We do indeed. In fact, with the current market anxiety and the resulting discounted pricing that we’re now seeing in the stock market, we’re more confident making new investments now than we were in Spring of 2015 when markets were sailing along relatively smoothly. In the markets, where there is fear there is opportunity. The opportunity is beginning to present itself in the form of distressed equity pricing.
2015 in Review – What We Got Right
Our views on the overall direction of the market were pretty much spot-on in 2015. We published three significant market updates last year (see below). In March we said, “It’s Time to Take Profits”. Two months later on May 21st the market peaked. From that high point, the S&P 500 is down 10%. In our July blog we said, “It would certainly not surprise us to see the market finish in the red for the year” (it did). Finally, in August our “It’s Hurricane Season” blog warned that we believed a significant market correction was imminent. Within days of that warning the market plummeted with the Dow at one point trading lower by an unprecedented 1,000 points.
Our cautious stance in 2015 proved to be accurate. We protected clients by increasing our target cash levels, particularly for our Cypress small cap strategy. That proved prudent as small cap stocks were hit hard last year. Further, we took selected short positions for eligible accounts. Short positions serve two purposes: 1) they serve as a hedge, reducing overall risk for investors making us less dependent on a rising market, and 2) can be a source of significant profits. We work hard to find good investments in companies that will rise in value over time. Meanwhile, in the course of our research we often come across some terrifically stinky investments. It’s usually a matter of when (not if) a grossly overvalued stock will decline in value. If feasible to short the stock, we can capitalize on these overvaluations. By holding our noses and taking a short position in the equity we are able to profit from the stock’s decline. Notably, our short position in Workday (WDAY) has declined from its February peak above $100 to $67.87. Workday makes useful software for the human resources management space. But we found the company’s stock to be grossly overvalued. Lastly, shares of MobilEye (MBLY) have declined 39% since we shorted the stock for eligible clients (3) on September 9th. MobilEye makes an interesting and much-hyped technology marketed to the hot driver-less car space. The stock is way ahead of itself resulting in an unsustainable valuation in our view.
2015 in Review – What We Got Wrong
- We were caught flat-footed on energy. The benchmark price of oil in the U.S. (1) fell 35% during the year ending at $37.04 per barrel. While not a major area of focus for us, the sharp energy price decline hurt our investments in Chevron, Suburban Propane, and various energy master limited partnerships (MLPs). The sharp losses in energy-related shares tempered our overall results.
- In direct sympathy with energy, commodities in general had an abysmal year. This affected our limited investments in ocean shipping firms (SB and ISH most notably) and Harsco.
Positives for 2016
- Unemployment is at 5% and falling.
- US large cap stocks now trade at approximately 15x P/E. This is a slight discount to the 25-year average of 15.8x. While not cheap on an absolute basis, stocks are reasonably priced. When compared to cash and fixed income investments, stocks are inexpensive. Thus we believe any talk of a “bubble” is not based in fact.
- Although still sluggish, the American economy and corporate profits continue to grow.
- We believe the recent plunge in U.S. stock markets to be largely an emotional response.
- We respect the views of Abby Joseph Cohen, of Goldman Sachs. According to Cohen, the fair value for Standard & Poor’s 500 Index is 2,100 (3). To reach that level by year-end, stocks would need to rise more than 10% from here.
- The Irony of Oil- Lower oil prices are usually a tailwind for most developed economies that are net importers of oil, and a break for consumers at the gas pump. As the U.S. is the world’s largest oil consumer and its second-largest oil importer, low prices are a net positive for the domestic economy overall. However, near-term the precipitous decline in the price of oil has the market rattled. When oil stabilizes (and we believe it will in the first half of 2016), the benefits of lower oil prices will be clearer as a net positive to the market.
- The S&P 500 closed nearly flat last year. The historical precedent for years immediately following a flat return are quite good (see chart below) ranging from +11% at the low end to +34%.
In 2015 we raised cash to levels that were significantly elevated above our historical targets (generally less than 5%). This tactic proved correct as almost every major asset class (other than cash) finished in the red for the year. Cash was indeed king in 2015, and we entered 2016 with a significant portion of our holdings in cash. We have found that markets provide opportunities at the extremes, but only those with available cash are able to take advantage of the opportunity. We will maintain our disciplined approach of buying quality securities at pre-determined pricing. Sellers, yielding to anxiety, are becoming more accommodative. With ample available cash, we believe we are well-positioned to take advantage of discounted pricing.
In sum, this is not 2007 / ’08. We are not in a bubble or standing on the precipice of a financial disaster as we were then. Stocks are rationally priced and are undergoing a healthy correction. We see the major risk to 2016 not as economic, but geopolitical. A major act of terrorism which undercuts the ability for worldwide commerce to flow could derail the financial markets in a meaningful way. In fairness, we recognize this statement can now be applied to essentially every year from this point forward. The specter of terrorism at home or abroad is our reality. Nevertheless, our reminder to ourselves and counsel to our clients is to remain focused on extended value rather than near-term anxiety. It is still wise to make prudent investments with an extended time horizon. This current environment is unsettling, but with uncertainty comes opportunity. We plan to continue to make prudent investments that will prepare our clients for retirements, college educations, and financial independence.
– Jonathan Boyd
(1) Refers to the price of West Texas Intermediate.
(2) In general, IRAs and other tax-deferred accounts cannot take short positions.
(3) Quoted in MarketWatch, 1/14/16 (http://www.marketwatch.com/story/sell-everything-goldmans-abby-joseph-cohen-says-stocks-are-best-place-to-be-2016-01-14)
(4) These materials have been independently produced by Blackwell Boyd. Blackwell Boyd is independent of, and has no affiliation with, Charles Schwab & Co., Inc. or any of its affiliates (“Schwab”). Schwab is a registered broker-dealer and member SIPC. Schwab has not created, supplied, licensed, endorsed, or otherwise sanctioned these materials nor has Schwab independently verified any of the information in them. Blackwell Boyd provides you with investment advice, while Schwab maintains custody of your assets in a brokerage account and will effect transactions for your account on our instruction.