2014 Q4 Market Update

 

State of the Markets

The fourth quarter of 2014 saw continued volatility in equity markets around the world. After suffering a steep correction at the beginning of the fourth quarter, equity markets at home and abroad staged an equally steep recovery in November. December, however, was a mixed bag for stock prices, resulting in a flat quarter for the S&P 500, and a modest decline for International stocks. The difference between U.S. and international markets is even more pronounced for the full year with the S&P up a strong 13.7% while foreign developed and emerging markets are in slightly negative territory for the year. The U.S. bond market saw a surprising drop in yields and strong performance for the quarter and the full year. The big winner for the year was real estate. The Dow Jones US Select REIT Index was up 32% for 2014, and the S&P Global REIT Index rose 21.5%. The total returns for major asset classes are below.

Big Headlines, Little Impact

In retrospect, 2014 was a year of big news with little impact. Below are some of the potentially market moving events over the last twelve months:

  • Janet Yellen replaces Ben Bernanke as chair of the Federal Reserve
  • U.S. first quarter GDP goes negative for 1st time since recession
  • Russia annexes Crimea and continues its standoff with Ukraine
  • The Federal Reserve ends its bond buying activity
  • Ebola outbreak in Africa reaches epidemic proportions
  • Bill Gross abruptly departs PIMCO and Investors flee the world’s largest bond fund
  • U.S. Interest rates defy expectations and decline back towards 2%
  • U.S. real estate securities on a bull run – up 32%
  • Bestselling author, Michael Lewis. declares the stock market “rigged”
  • U.S. Dollar surges in value while the Russian Ruble collapses
  • Oil prices plummet from $100 per barrel to roughly $50 by year end
  • U.S. third quarter GDP up 5% – the biggest gain since 2003
  • U.S. federal deficit falls to 2.8% of GDP – the lowest level since 2007

Despite these seemingly significant events, a globally diversified portfolio of stocks and bonds delivered surprisingly steady but sedate returns and ended the year with mid-single digit gains.

A Year of Divergence

These tepid results are in stark contrast to the S&P 500 index which delivered a total return on 13.7% and continued to make new highs throughout the year – 25 in total. There is no question that 2014 was a year of divergence. Divergence of economies as the U.S. finally reached escape velocity from the systemic problems left over from the Great Recession. In contrast, Europe is still stagnating under its forced austerity, Japan still struggles with deflation, and China’s growth is decelerating with consequences for the rest of Asia. Divergence of returns as some asset classes performed exceptionally well (bonds, real estate, and large U.S stocks), while others did not. On the negative side, U.S. small cap stocks took a not unexpected pause after 2013’s exceptional performance. International and emerging market equities suffered due to the economic concerns stated above, but were also impacted by the strength of the U.S. dollar, which turned moderately positive local currency gains into small losses for U.S. investors.

Is Diversification Still our Friend?

In market environments such as this, the value of diversification looks suspect. When I googled “diversification is dead” I found an article from 1999 with the following quote by Anne Smith writing for TheStreet.com: “Remind me again why I own small-stock, value and international funds? Oh, right, so I can be diversified. OK. Remind me again why I want to be diversified?”  This was written at a time, similar to today, when the seemingly invincible S&P 500 forged ahead of other asset classes and seemed like the only investment anyone needed to own. However, just as trees don’t grow to the sky, assets classes don’t outperform forever. Reversion to the mean is inevitable. As proof, the table below illustrates various investable asset classes and their total returns (grouped into three year segments) from 1994 through 2014. We used three year ranges because it easily demonstrates the cycles individual asset classes go through as they swap places from best to worse or somewhere in between.

As expected, a portfolio which owned all these assets classes in rational proportion (which ours do) was never a top performer, but over the entire period delivered the best risk adjusted return with much lower volatility than any individual asset class. In addition, divergences in performance are usually accompanied by divergences in valuation, and today is no expectation. As U.S. stocks have continued their advance, they have gotten more expensive. However, the opposite is for emerging markets and international stocks. They have maintained valuations which are quite attractive relative to the U.S. While no guarantee, this likely sets the stage for outperformance in the future. We can’t predict with accuracy how the boxes in the table will be arranged three years hence, but we can say with confidence that the order from top to bottom will be different than it is today.

Conclusion

What lessons should we take away from this? The following are four simple rules for managing diversified portfolios.

  • Own every investable asset class in rational proportion. You never know which one will be in the lead at any given time, or when shifts in performance will occur.
  • Build your allocation to fund long-term goals with the highest probability of success, not to shoot the lights out.
  • Once an allocation is established, stick with it. Discipline is a key ingredient for a successful investment experience.
  • Rebalance systematically. Sell today’s winners – the expensive outperformers, and buy the losers – the cheap underperformers which are likely to be the winners in the next cycle.

Our investment process is built on these time-tested ideas. They may seem counterintuitive and unproductive at times, but we have confidence they will deliver in the long run.

Posted by Jay Healy at 11:34 AM
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