After the recent correction, many investors are asking how to respond in their portfolios. I’m recommending clients hold on to equity exposure, even consider increasing it. Below, I run through my case.
Reason 1: Valuations
For the first time since 1956, the dividend yield on the S&P 500 is above the 10-year US Treasury interest rate. The chart below is long-term Shiller data of the dividend yield of the S&P 500 and 10-year US Treasury bonds. The data is monthly data, and since the beginning of the month, due to the recent correction, the series have inverted. As of 8/25/2015, the dividend yield was 2.15% and 10-year bonds was yielding 2.07%.
What makes this comparison especially compelling is: 1) the payout ratio is still 50% below very long-term average, and 2) dividends are growing at an 11.6% rate currently, which is well above the long-term average. In the first chart, I show the S&P 500 payout ratio using Shiller data going back to 1871. In the second chart, I show the long-term growth rate of dividends.
Reason 2: Energy Production
The US is now producing more oil than at the peak of production in 1986. Historically rising commodity prices are one reason the economy goes into recession. In 2008, oil prices hit $140/barrel, and this was a significant contribution to the recession that followed. Soaring domestic production is likely to lead to a longer-term contained oil price.
Reason 3: Banks
The banking system has never been this liquid. With reserves hovering around 17.6% of bank assets, US banks have never been more liquid. US banks could almost meet the ridiculously high reserve ratio standards of China!
Reason 4: Monetary Cycle
Historically, stocks are not impacted by rising interest rates until the end of the Fed rate hiking cycle. In the chart below, I show the S&P 500 compared to the Federal Funds rate. The Fed’s final rate hike was in July of 2000, and stocks didn’t ultimately roll over until September 2000. In the more recent rate hiking cycle, Fed funds peaked in August 2006, and stocks didn’t peak until October 2007. So, history suggests that rates don’t provide a headwind to stocks until the end of the hiking cycle, not at the beginning.
Reason 5: Comparison to 2011 Correction
In the table below, we map out the progression of the 2011 correction and then the 2015 correction so far.
There are several interesting observations here:
- From the cycle high on April 29, 2011, the S&P took 63 days to break the 200-day moving average. From the cycle high on May 21, 2015, it took 62 days to break the 200-day moving average.
- The initial low on August 8, 2011 was -17.9% from the cycle high and occurred 69 days from the cycle high. The initial low in the current sell-off was Wednesday, August 25, and was 12.4% from the cycle high and occurred 66 days after the high.
- In 2011, the initial low (August 8, 2011) was -17.9% from the cycle high. We spent another 39 days after the August 8 initial low going back and forth before making a new low on October 3, 2011. This was the ultimate low for the cycle and was down -19.4% from the cycle high price. This low occurred 108 days after the cycle high. Importantly, the initial low (down -17.9% by 8/8/11) was the majority of the decline experienced in the whole cycle (down -19.4% by 10/3/11).
- If the 2011 template holds, we have seen the majority of the declines in this cycle already. History would suggest we spend the next few weeks going back and forth, making an ultimate low in the next 6 weeks maybe 1-2% lower than on 8/26/2015. Then we will spend another seven weeks going back and forth, eventually successfully testing the low.
None of these factors in isolation are perfect predictors of any subsequent move in stocks, but taken together they present a persuasive case that most of the decline in the cycle has already passed as of Tuesday. And, given low commodity price and low interest rates, plus healthy banks that are lending, it is hard to see a case that recession is anywhere near.
For all these reasons, I think there is a case to make that now is the time to hold equity allocation steady, and focus on risk management. In the Knowledge Leaders Strategy, our goal is exceed the performance of our benchmark indexes while sidestepping much of the declines.
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