The S&P 500 index which is representative of US large capitalization stocks started 2015 at a level of 2058.20 and completed its annual journey at 2043.94. It was a relatively smooth ride with a 6.4% descend during the third quarter and followed by a swift ascend of 7% in the final quarter. It was only thanks to the dividend that the large cap index managed a positive return of 1.38%. Meanwhile the small cap index of Russell 2000 began the year at 1204.7 and ended at 1135.89. It was all so promising as the index climbed to 1295.80 in June and far outpacing the returns of its beefier brethrens. Alas, as the risk off third quarter began, it would lose all its advantage and did not entirely recover during the final quarter. For the year, it showed a negative total return of 4.6%. Thus for the second year in a row, small cap stocks far under-performed large cap ones.
It has certainly been a difficult year for stocks; yet the credit sensitive high yield bond market experienced even greater tremor. The price of the SPDR Barclay High Yield ETF was off by 12%. Given the nature of high yield bond’s limited upside and complete downside, it is the sector of the financial universe most sensitive to economy downturn. It is this warning signal that we are currently taking our cue with our more conservative investment stands.
Soon the fourth quarter 2015 earnings reporting season will be underway. Given current expectation, 2015 S&P 500 earnings may very well be down from 2014 levels. Much of this earnings recession stemmed from the weak energy sector; however, other parts of the economy simply failed to show any consistent momentum. After earnings decline of slightly over 2% for each of the past two quarters, Q4 earnings are expected to decline by more than 5%. The earnings recession is yet another reason for us to start 2016 more conservatively.
Finally, the United States Federal Reserve has initiated its long anticipated normalization of interest rate. The risk to the economy had been on the side of weakness even before this action was underway. It has now become the single greatest concern that we have. The path and amount of interest tightening will go a long of determining financial returns for 2016. If the Federal Reserve is able to achieve a more normal interest rate and the US economy stays within the mode of growth, a great deal of risk would then be removed from the financial market. With this optimistic scenario, we may very well have a reasonable return for stocks especially given the anticipated earnings growth over the second half of 2016.
Yet as the Fed embarked on its initial tightening, a record $475billion Treasury securities were sold to Banks, Brokers and certain money market mutual funds. Such robust demand for securities with zero risk certainly underscores the risk-averse nature of the current financial environment and also raises questions about the hidden dangers associated with such a long period of extremely easy money policy. So it presents another strong incentive for us to stay conservative.
Dong Hao Zhang
President & Chief Investment Officer Evla Hills Investment Management