With the New Year, a Refreshed Perspective

The 2016 new year: a time to refresh one’s perspective on the financial markets, both past and future. The global financial crisis of 2007 and 2008 seems like ancient history now.

The Federal Reserve lowered interest rates to near 0% to stimulate the economy, and eight years later we are still waiting for stronger economic growth.

The U.S. gross domestic product (GDP), a measure of broad economic growth, grew only 2.0% in the third quarter of 2015. The U.S. is the largest economy in the world, followed by China and Japan. Given our size, 3% or 4% is good growth, but we are at half of that level. China’s GDP has been in the 6% to 7% range and slipping, but still substantially higher than the United States. Japan’s economy has been flat for years.

Since 2008’s drop of 42% in the MSCI All Country World Index, the global stock market has had positive returns in five of the seven years. Modest losses of -7.89% and -2.19% were posted in 2011 and 2015, respectively.

U.S. large-company stock market returns have been positive in all seven of those years, although 2011 and 2015 were modest at +1.97% and +1.25%, respectively.

We have not had a calendar-year major stock market decline of over 10% in seven years. Stock market declines of 10% to 20% can happen at any time without warning, and like the law of gravity, stock market losses have not been repealed.

Risk and return are related, so on the positive, rewarding side, the MSCI ACWI index of global stocks was up 16% and 24% in 2012 and 2013, rewarding disciplined, long-term investors and providing above-average historical three- and five-year stock market returns.

Dividend growth has also rewarded stock market investors in 2015. Companies increase their cash dividends as revenue and profits increase, and this rewards investors separately from share price changes. Stock dividend income has also proven to be a pretty reliable source of income and offers income growth better than bonds.

Here are the annual dividend growth percentage increases for 2015 vs. 2014 for commonly held mutual funds:

  • Vanguard Total Stock Market Admiral Shares: +11%
  • Vanguard 500 Index Fund Admiral Shares: +12.5%
  • Vanguard Dividend Appreciation Fund: +15%

Turning to the future, what is our outlook? Our crystal ball is no clearer than yours, and we do not make future forecasts. Nonetheless, some basic data serve as indicators.

Inflation is low, measuring 0.7% for the 12 months ending 11/30/15, compared with 3% to 4% long-term historical averages. Inflation is projected to be 1.5% to 2.5% annually over the next five years. Low inflation is good, but it can result in low interest rates for investors.

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The S&P 500 P/E ratio is 23, which is high and indicates below-average future returns.

The S&P 500 dividend yield is 2.1%, which is low, but higher than safe U.S. Treasuries.

International stocks, both developed and emerging markets, provide better stock market valuations than U.S. stocks and therefore better future growth potential. Time will tell when the pendulum will swing back in favor of international stocks, and patience may be required over the next few years. The strength of the U.S. dollar versus foreign currencies continues to weigh down international profits converted back to U.S. dollars.

Emerging markets are particularly affected by low commodity prices in oil and metals. Commodity prices have dropped dramatically, including oil, natural gas and precious metals like gold. This has had an unprecedented impact on many countries, industries and companies. This may be a long-term trend with long-term impact as adjustments are made throughout the global economy.

Interest rates remain low, and any future increases are expected to be slow and modest.

The key benchmark for any investment portfolio should be inflation and maintaining and increasing purchasing power through price appreciation and increased dividend income.

With low inflation and a slow-growing economy, investment returns are likely to be lower in the years ahead. While historically inflation was 4% and investment returns of 6% to 8% were targeted, with an expected 2% inflation rate, portfolio investment returns of 4% to 6% will achieve the same result.

Our motto for 2016: Investors should adjust investment return expectations to be more modest, but be confident that long-term goals are still achievable given low inflation.

Remember a few key lessons for 2016:

  • Successful investing is a contrarian process. Sell high, buy low and be willing to do what your gut tells you not to do. Don’t follow the crowd.
  • Successful investing requires a tolerance for volatility and a long-term focus.
  • A strategic asset allocation in a broadly diversified, multi-asset portfolio emphasizing passively managed funds is a sound investment strategy.

As always, please contact us with any questions, news or comments.