2016 began with a vicious, energy-led selloff in the global equity markets and ended with a dramatic rally in the same markets.  For investors who like to see “V” shaped recovery patterns, the first three months in the stock market had to be very fulfilling.  The Standard and Poor’s 500 Stock Index (S&P 500) fell 10.27% from January 1st to February 11th.  Then on February 11th both the oil markets and stock markets developed “traction.”  During the remainder of the quarter (February 11th to March 31st) the S&P 500 gained 12.95% (All returns include reinvested dividends – Bloomberg, LP).  By the end-of-the-quarter the S&P 500 had managed to post a positive return of 1.35%.  The Dow Jones Industrial Average (The Dow) finished even better with a three-month return of 2.20%.  Small cap stocks and international stocks fell short of a total recovery with the Russell 2000 Small Cap Index losing 1.53% and the MSCI EAFE Index dropping 2.87% during the quarter.

Index Chart Q1 2016

In other markets oil regained its viscosity and ended the first quarter nearly where it had started.  It opened January 4th at $40.71 per barrel and closed on March 31st at $39.75 per barrel (West Texas Intermediate Crude – Bloomberg, LP).  However, between these two dates oil touched an intra-quarter low of $31.77 on January 20th.  Interest rates retreated (bond prices rose) as the yield of the U.S. Treasury 10-Year Government bond began the quarter yielding 2.27% and finished the quarter yielding 1.77%.  Prospectors struck it rich as gold quietly gained 16% during the first quarter as investors attempted to escape the volatility of equity markets by buying coins and bars.This is a text block. You can use it to add text to your template.

The first three months of 2016 were stressful for investors who wondered if a larger global sell-off was imminent.  However, it was clear early in the downturn that the price declines were more technical than fundamental.  The biggest give-away was that stocks were selling because oil was declining in price.  This is unsustainable and a counter-economic phenomena.  Oil is a fundamental expense for nearly every business and household in the United States.  A lower cost of oil is good for corporate profits and increasing discretionary spending for individuals.  The decline in oil prices that began in 2015 did have a primary effect on one industry (energy) and a secondary effect on a secondary industry (financials).  The more aggressive and highly leveraged companies in the energy field could not survive the decline in oil prices.  Additionally, many energy firms cut operations back significantly and eliminated many high-paying jobs.  The failure of energy firms that were capitalized with bank debt impacted financial firms.  The stabilization of oil prices by the end of the quarter halted the contraction in the energy sector and had a limited impact on financial firms.

Looking Ahead

D’Arcy Capital does not expect the volatility to end any time soon.  However, the type of volatility that is currently occurring is “friendly” volatility.  It is friendly because for the last fifteen months all the drops in stock indices have been temporary as stocks returned to previous values.  D’Arcy Capital has used this friendly volatility to reinvest interest and dividends, make allocation changes with lower tax effects, and bank tax-loss assets for future benefits.  Often the term volatility is used as a euphemism for a declining stock market.  However, volatility is the changes (both higher and lower) around an average.  Real volatility is a requirement to achieve higher rates of return over time.  Volatility (aka risk) is accepted by long-term investors in exchange for higher returns over time.  If the markets lose volatility, investors will lose the ability to earn higher average rates of return.

Chart Q1 2016

D’Arcy Capital expects friendly volatility to continue through 2016.  The firm also anticipates stock prices will move higher as corporate profits rebound in the second half of 2016.  The best stocks in 2016 will not be the same stocks that had a great year in 2015.  More specifically, active managers and “stock pickers” will likely outperform index and passive strategies.  This is a reversal of a pattern that has existed since the end of the Great Recession.  However, with index heavyweights Apple, Facebook, and Alphabet experiencing slower growth, the most popular indices will lag.  This will eventually lead to a mass redemption of passive (index) investments and additional poor relative returns.  With the continued expansion of interest income spreads in banks, the financial sector should continue to perform well.  Emerging markets have also sprung to life early in 2016 and should remain a source of performance the remainder of the year.  Utility companies, energy companies and precious metals remain underweight sectors at D’Arcy Capital.

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