Second Quarter Review

The second quarter of 2016 wrapped up with some excitement. After the “Brexit” selloff a few days before the end of the quarter, the market rallied strongly. Unfortunately, stocks markets have shown little progress during the past two years. On the other hand, bonds have rallied strongly and are up more than 5 percent for the year. Stocks have struggled because earnings have been declining, as the following chart shows:

We hope the estimates come to fruition, but regardless of if they do or not, stocks are not going to advance while earnings are declining.

Not all of our strategies suffered during the Brexit event. We own several managed futures funds and came across this comment in the July 5, 2016, Wall Street Journal Wealth Adviser Daily Briefing by Anna Prior:

“One post-Brexit bright spot: managed-futures funds. As the S&P 500 Index tumbled 5.3 percent in the two days following Britain’s decision to exit the European Union, investors in many mutual funds saw steep losses. But according to a report from WSJ.com’s Wealth Adviser, there was one bright spot: managed-futures funds. During that same period, the average managed-futures mutual fund gained about 3.1 percent, according to Morningstar data.

“Part of a class of hedge-fund-like ‘alternative’ investments, managed-futures funds bet on futures contracts in a variety of markets, including currencies, fixed income, stocks and commodities. While alternative funds in general can be volatile and aren’t for everyone, managed-futures funds have a track record of holding up during times of market stress and experts say they’re worth considering as part of a well-diversified portfolio.”

Basically, this is why we own managed futures funds and why we added to the position earlier this year.

The chart above includes some analyst forecasts of future earnings. We recently read a great article by Adam Butler that perfectly expresses our views about most forecasts, especially short-term forecasts. To put it bluntly, they are worthless. You can read the article here.

We do use forecasting in our investment process, but they are long-term forecasts supported by numerous studies showing their validity. A recent article in the Wall Street Journal by John Coumarinos discussed three forecasting techniques that we actually use in our investment management process. A few quotes from the article follow:

Yet small investors can make forecasts about long-term investment returns in stocks and bonds that at least are based on decades of market data. Such forecasts aren’t infallible, but they can help investors estimate whether they’re saving enough to retire or send children to college.

Here are three ways investors can get an understanding of what markets are likely to deliver—maybe not precisely, but closer than many investors might think.

A longer-view P/E

One method for forecasting long-term returns comes from Nobel laureate and Yale University professor Robert Shiller. It’s based on price/earnings ratios, but it uses more data than the one year of profits that many forecasts rely on.

Because profits have a pronounced cycle, making one year’s earnings potentially misleading, Prof. Shiller compares current stock prices to 10-year average earnings, after adjusting them for inflation, to get an idea of where stocks are headed.

The so-called Shiller P/E has averaged about 17 since 1870. It’s above 25 now, implying below-average future returns, assuming the ratio tends back toward the historical average.

Three steps

Vanguard founder Jack Bogle outlined a three-step process for forecasting share prices over the next decade in an interview with fund tracker Morningstar Inc. last year. It starts with dividend yields, which have accounted for a significant part of historical stock returns. The S&P 500 index currently gives an investor about 2 percent in dividend yield.

Second, Mr. Bogle factors in the historic earnings growth rate, which is close to 5 percent annually for the 100 years through 2014. That plus the dividend yield pushes the prospective return for an investment today in a fund that tracks the S&P 500 to nearly 7 percent annualized over 10 years.

Last, Mr. Bogle incorporates an estimate of what multiple of earnings investors will pay to own stocks in the future. He figures the current multiple of 20 for the S&P 500 (based on one year of earnings) will decline over the next few years to its historical norm in the mid-teens, that leads him to reduce the prospective 7 percent annualized return from dividends and earnings growth to 4 percent—much lower than the 10 percent stocks have delivered over the past century.


Bond forecasting is simple, according to Mr. Bogle. He says bonds’ current yield to maturity has been a good predictor of their returns for nearly every 10-year-period since 1906.

We use these methods along with numerous others to evaluate the risk-return tradeoff currently offered by the market. As we’ve discussed in the past, when the tradeoff is poor we become more defensive, as we are today.

We enjoy discussing our process with clients. Please let us know if you would like more details or have questions about the above information, just don’t ask what the market is going to do tomorrow!

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