Back to Zero: Market’s Flat Return Masks Underlying Pressures

Key Points

  • S&P 500 had a nearly flat year in 2015.
  • Returns bucked historical tendencies; and were heavily biased by the FANG stocks.
  • Flat years historically have been followed by strong year, but …

It was indeed a “running to stand still” market this year (a U2 song title I used for one of my reports last spring to describe the market). The S&P finished 2015 nearly flat at -0.7%, but only Rip Van Winkle would have thought it was a calm year. The return, or lack thereof, belied the angst investors were feeling for much of the year. There are precedents for flat years, and in this short update, we’ll look at what it meant in the past for the future.

But the conclusion first: As you’ll see highlighted in our soon-to-be-published 2016 outlook report, we believe 2016 is likely to bring similar action as in 2015—with bouts of extreme volatility and a greater frequency of pullbacks or corrections. 2015 just ended with a whimper and 2016 is beginning with a bang. We continue to believe risk is elevated and investors should maintain no more than a neutral allocation to US equities.

The past year was “supposed” to be a good one given the history of calendar and election cycles. Not only has the third year in the four-year election cycle been the best for stocks historically; years ending in “5” have nearly all been strong … until 2015. But we entered last year with a more cautious stance on equities; and for now, we are maintaining that stance.

What drove performance … or lack thereof?

Remember, the S&P 500 is a cap-weighted index; and although it was about flat on the year, the average stock in the index did considerably worse—returning -3.8% according to Bespoke Investment Group (BIG), who took a look at what drove performance in 2015.

Market cap: bigger was better. The 50 largest stocks at the beginning of 2015 were up an average of 1.5% by year-end; while the 50 smallest stocks were down 11.9%.

P/E: growth was better. Price/earnings ratios were a factor, too; although perhaps not as you might think. The four deciles of stocks with the lowest P/E ratios (i.e., the cheapest stocks) were all down at least 5%; while the four deciles of stocks with thehighest (or no) P/Es (i.e., the most expensive stocks) were all at least flat or up on the year.

Dividends: none or lower was better. For income-oriented investors, note that the decile of stocks which started the year with the highest dividend yields were down 14.6%, while the stocks which pay no dividends at all were up 3.9%.

Momentum: 2014’s winners won again. The top six deciles of stocks which did the best in 2014 all averaged gains in 2015. The 50 stocks which did the worst in 2014 were down another 28% in 2015. Buying the losers of 2014 was about as painful as it gets.

FANG stocks ruled. The “fab four” stocks, now nicknamed FANG—for Facebook, Amazon, Netflix and Google (now called Alphabet)—were up over 60% on a cap-weighted basis. Excluding those four stocks, the S&P 500 was down 4.8% last year.

What’s happened following flat years?

Defining “flat” as the S&P 500 having a price-only (not dividend-adjusted) return between -2% and +2%, on a calendar year basis, the market has been flat in six years since the end of World War II. As you can see below, in each case, the market’s return the following year was positive by double-digits.

Whats happened following flat years?

Source: FactSet.

The rub this year is that corporate earnings growth has been weak. In the highlighted “flat” years historically, each was followed by a strong earnings year. S&P 500 earnings are expected to lift out of negative territory this year; but if commodity price declines and dollar strength persist (the culprits to negative earnings), I would not place high bets on a strong year for US stocks.

In with a bang

One final thought given that as I write this, stocks are under significant pressure to start the year. If the decline persists into the close, it would mark the worst opening day to start a year for the S&P 500 since 2001—and only the 15th time in the S&P’s history when it opened a year down more than 1%. BIG data shows that a weak opening day of a year was historically met with buying in the remainder of January. Nearly 80% of the 14 prior incidents saw positive January returns, with a median gain of 5%. As for the remainder of the year, the percentage of time with positive returns dropped to 57%, with a median gain of 7.2%.

Important Disclosures

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