Investment Update

The year ended for stocks and bonds, not far om where they began. Seems fitting to come full circle like this, if only fitting were part of the plan.

Not for Nothing

Here were very few winners in 2015 – save a handful of U.S. growth stocks that performed spectacularly well. e average stock lost ground, conventional high-grade bonds were slightly positive, junk bonds sold o sharply, the average hedge fund was negative, gold declined, REITs were generally at to down, non-U.S. stocks dri ed lower, and stocks across the energy and commodity sectors su ered severe declines. e equity market started the year slowly, then rallied to new highs in May, followed by a sharp summer correction, mitigated by a fourth quarter recovery that got tripped up (again) by falling oil prices.

Returns for the year show the S&P with a 1.4% gain, the Dow Industrials at, the S&P Dividend Index o 3.2%, and the tech- oriented NASDAQ up 5.7%, the best of the bunch. Divergence by equity styles and cap-sizes were large for the year as Growth strategies outperformed Value investing by almost 10%, and large stocks outpaced small stocks by approximately 5%.

Consensus expectations coming into 2015 turned out to be wishful thinking in regard to the economy gaining strength, a second half pick-up in earnings growth and oil prices stabilizing around $50. In contrast, the more restrained projections now being o ered for 2016 re ect the lackluster year just completed and the understanding that (1) Fed policy is becoming less accommodative, (2) there are more negative ripple e ects to cheap oil prices throughout our economy than previously understood, (3) a little disruption in China’s growth plan can go a long way in spooking global markets, (4) continued acts of terrorism may have a more tangible impact on markets, and (5) the economy and the stock market are still disconnected.

Anatomy of Higher Stock Prices

To this last point, we have periodically observed that in the recovery from the Great Recession, stocks have fared better than the overall economy. We thought it would be helpful to take a simple look at the key components that drive stock prices and what has to fall into place to support higher stock prices from here. At a basic level, stock prices can be seen as driven by (1) earnings growth, (2) a valuation multiple on that stream of earnings (or cash ow) and, (3) shareholder distributions, such as dividends.

Stock prices can move higher when there is positive earnings growth, when investors place a higher valuation on earnings or cash ow, and when dividends increase.

A recent study by Alliance Bernstein, a large investment management and research rm, looked at the strong recovery in stocks a er the nancial crisis (chart included below). In the three years from June 2009 through June 2012, the S&P 500 compounded at approximately 16%/yr. at gain was comprised of an 18% earnings growth impact, 2% from dividends and a negative valuation component of 4% since valuation multiples on earnings actually declined.
Over the next two and a half years, July 2012 through December 2014, the S&P compounded at 22%/yr. During this period, the earnings growth contribution was 5%, dividends were 3% and signi cant multiple expansion added 14%. e moderation in earnings growth was o set by the willingness of investors to place a meaningfully higher valuation on earnings (from 12 times to 16 times). is period of extraordinary returns coincided with investors regaining con dence in stocks, helped by the end of the Fiscal Cli overhang, peak central bank monetary accommodation and the capitulation of investors who were slow to return to stocks due to lingering fears of another nancial contagion.

This brings the discussion to how these three components interact to support higher stock prices from here. e year-over- year earnings growth for 2015 is expected to be at to down. e current valuation multiple on 2016 earnings is about 16.5 times, and dividends remain somewhere around 2%.

We know earnings growth has stagnated because energy sector earnings have collapsed, the 20% increase in the dollar over the past 18 months has translated to reduced earnings for U.S. multinationals, and top-line revenue growth has slowed as the economy muddles along. ere are multiple ways that earnings growth could reaccelerate, the most direct coming from a stronger economy creating organic revenue growth. is, however, has been elusive since the Great Recession and would run counter to global trends with China slowing and Europe and Japan struggling with their own anemic growth rates. It is also hampered by historically high debt loads in the U.S. 2015 is the 10th consecutive year the economy has expanded at less than 3%, the longest streak on record.

Past performance and current forecasts do not guarantee future results. Numbers may not sum due to rounding.

As of September 30, 2015.
An investor cannot invest directly in an index, and its performance does not reflect the performance of any AB portfolio. e unamanged index does not reflect fees and expenses associated with the active management of a portfolio.
*Five-year annualized expected return for US equities uses proprietary AB forecasts. Display reflects composition of expected US equity returns.
Source: S&P Dow Jones and AB

The expansion of profit margins would boost earnings, but the upside here is limited as margins are already near record levels.

Risk of wage pressures and increases in health care costs will pose a challenge to maintain margins at current levels. Productivity growth rates could increase from further technological advances, but the growth trends over the past several years have been negative. Lastly, corporations buying back their own shares have been an e ective way to boost earnings, but given the current record buyback activity in 2015, earnings are already too dependent on this form of nancial engineering.
Valuation multiples are currently in the upper end of a normal range for earnings and are expensive when measured against cash ow and sales. ey could certainly go higher as they have done in more speculative periods, but this would be a riskier case to make on its own in supporting higher stock prices, especially given the level of uncertainty around Fed policy, oil prices, and geopolitical con icts. Low interest rates are supportive of higher multiples, but with Fed policy intent on normalizing interest rates, the bene ts of low rates on higher multiples have probably run their course.
With all this as a backdrop, Alliance Bernstein’s 5-year projections show a 5.9% annualized return from stocks, with 4.4% from earnings growth, 2.1% from dividends and (0.6%) from valuation as multiples contract slightly from today’s relatively high levels. is seems like a conservative outlook on the surface, but it underscores the challenge of being able to support a more optimistic outcome. Clearly, stronger economic growth is the prescription to justify more normal return expectations from stocks, but as the Fed has learned from unprecedented monetary stimulus and asset price in ation (higher stock prices), the real solutions lie beyond the powers of central bankers and policy makers.

Closing thoughts

In our Investment Update from last year, we o ered a few thoughts about the year ahead (since we don’t fancy predictions) and a few of those are still standing. More relevant is what we did not anticipate. As a value shop, the dominance of momentum investing over value became more visible, as much of the year’s outperformance was concentrated in a narrow group of large- cap growth stocks. We also did not anticipate that the speci c challenges of the energy and commodity sectors would spill over to broader value and dividend-related parts of the market. ese style-driven trends are cyclical and while they typically become overdone before they reverse, they will reverse.

Lastly, we have also consistently commented that our macro intuition counts for little, while stock selection counts for a lot. is will continue to drive us to improve our process and the tools we use to help us make the best decisions at the individual security level, regardless of where we are in a cycle, leaving us with a positive, less “ tting” outcome in 2016.