State of the Markets
Happy New Year, indeed. 2013 turned out to be a banner year for the U.S. stock market which finished the year at an all-time high, up over 32%. Developed international markets also turned in very good numbers for the fourth quarter and the year. The U.S. bond market and emerging market stocks struggled throughout the year and had slightly negative returns.
The total returns for major asset classes are below.
The Wind at Our Backs
The stock market moves in cycles. Some are long and some are short. Some work against us and some work in our favor.
Cycles not only affect the overall direction of the market, but also the movements of industry sectors and investment styles (value versus growth and small versus large) within the market itself. These internal trends are not always apparent from the headline numbers like the S&P 500, but they are very important to how we manage money. The cycle over the past year has been very much in our favor. Small company stocks in the U.S. and around the world have outperformed large company stocks. This is a market environment in which our overall investment strategies (and DFA Funds in particular) shine.
The Balance in a Balanced Portfolio
As we celebrate the returns that equity markets delivered in 2013, we must keep in mind that equities are just one component of a diversified investment portfolio. Ultimately, the return of an overall portfolio is a blend of the performance of each major asset class, and while equity markets generally had a stellar year, the environment for bonds was challenging.
We have been very cognizant of the fact that interest rates had been driven to artificially low levels as a result of the Federal Reserve’s monetary policy and that a rise in interest rates was inevitable. Since bond prices move in the opposite direction of interest rates, the potential for losses in bond allocations was of great concern. In anticipation of an eventual rise in rates, we began making changes to our bond allocation in late 2012. The changes helped, but did not shield us completely from the decline in bond prices that accompanied May’s dramatic shift in interest rates as the yield on 10-Year Treasuries quickly rose from 1.66% to 2.73%.
Bonds – The Math Still Works
When all is said and done, we have to look at our bond holdings in perspective. Bonds have unique qualities that play vital roles in the construction of diversified portfolios. They provide:
- Stability to offset the volatility of stock prices
- Income and return potential that generally exceeds cash and inflation
- Liquidity as they can be easily converted into cash
That said, bonds can lose money, especially in rising interest rate environments. This begs the question: Should we be doing more to get out of the way of this proverbial oncoming train? The answer is somewhat counter-intuitive.
First, a bad year for bonds (-2%) is nothing compared to a bear market in stocks. Second, while bonds lose value initially when rates rise, the decline is immediately offset by higher yields. This serves to backfill the loss over time and results in a positive performance over a full cycle of rising rates, as evidenced by the chart below.
For those inclined, Vanguard has produced a somewhat technical, but well written research piece that goes into more detail on bond returns in a rising interest rate environment. It can be found here.
We recognize that the current environment of extraordinarily low yields and significant macroeconomic risks may produce unique challenges, so we are not standing by idly. We are monitoring the situation in real time, considering alternatives to our current strategies, and will make changes as warranted. In the meantime, we are more comfortable owning bonds going forward with a 3% yield than we were when the yield was 1.5%.