Quarterly Perspective for 4Q14

Summary

It is hard to overstate the impact that weakness in the global economy had last year.  Because the United States was the only major economy to have clearly strengthened in 2014, capital poured into dollar-denominated securities.  This boosted the highest quality U.S. stocks and bonds disproportionally, partially because these are the easiest for foreigners to buy.  Economic weakness overseas also contributed to the collapse in oil prices, as demand fell below supply and suppliers were either unable or unwilling to cut back on production.

 

U.S. stocks finished the year with a gain of 13.7% according to the S&P 500 stock index, but the year was not as good if you look at it from any other perspective.  The gain drops to 12.1%^[1] if you include the rest of the U.S. market (the 5000+ companies too small to make it into the S&P 500) because by themselves, U.S. small companies only rose 4.89%^[2].  The biggest sector winners were those that appeared to be immune from the business cycle – utilities, health care, and real estate.  Losing industries were those most affected by slowing world demand – energy, mining, and materials.

 

With the message of the markets worldwide being a lack of confidence in global growth, high quality bonds had a very good year.  The Barclay’s Aggregate Bond Index rose almost 6% in 2014.  Again, the major benchmark doesn’t tell the whole story.  If you weren’t willing to take interest rate risk, your return wouldn’t have been nearly as good.  Intermediate term bonds gained just 2.8% and short term bonds only 0.8%^[3].  Municipal bonds had an even better year (9.0%)^[4] as investors were attracted to their long maturities and low default rates.

 

While 2014 was a very good year for “plain vanilla” securities like blue chip stocks and Treasury bonds, it was a fairly dismal year for risk takers.  On the equity side, foreign stocks delivered negative returns whether large cap or small cap, developed market or emerging market.  Asian stocks managed a modest gain ex-Japan, but that was more than offset by double-digit negative returns in Latin America as currencies in that part of the world performed especially poorly versus the dollar.  On the bond side, high yield corporate and emerging market debt lost much of their first half of 2014 gains in the last three months as the combination of credit concerns and a soaring dollar were too much to overcome.

 

Activity

Most portfolio changes last quarter had one of two primary objectives: improving the credit quality and lengthening duration in the bond portfolio, or reducing the foreign currency exposure in both the bond and equity portfolios.  To achieve the former, we sold out of the shorter, more opportunistic Thompson Bond fund and put the proceeds in a more interest rate sensitive government or municipal bond fund (depending on the tax status of the portfolio).  To reduce dollar sensitivity, we exchanged many foreign bond positions into PIMCO Foreign (Hedged) which as its name implies hedges currency exposure.  In some portfolios we bought a dollar bullish ETF.  For other risk tolerances we exchanged a foreign stock fund for a competitor (say FMI International) that hedges currency exposure.  As always there were some trades we made because a former “flower” had become a “weed”.  This was especially true last quarter since many fund managers got caught overweighting the U.S. energy renaissance theme.

 

Outlook

Volatility has picked up lately.  We had a correction of close to 10% in October and two five percent pullbacks in the last six weeks.  This doesn’t necessarily mean the bull market is over, but it reminds us that we are closer to the end.  Just as stocks almost always start their cyclical ascent before there is evidence that the economy is recovering, the bear market usually begins before the economy has peaked.  Increased volatility is often the leading indicator.  We often see volatility pick up when the Federal Reserve contemplates raising interest rates, as they are now.  We need to see economically sensitive stocks perform better in order to believe we can have another leg up, because market gains have largely been confined to high dividend and blue chip stocks so far, and valuations in those areas are stretched.  Furthermore, dividend-oriented stocks typically don’t respond well to rising rates.

 

Probably more important than anything else, we need economic growth to accelerate somewhere else in the world.  If the current trend continues, the dollar will rise to a level where U.S. products are not competitive, causing our balance of trade to deteriorate and eventually our economy to suffer as well.  A strong dollar also draws money out of emerging markets causing those economies to contract.  More economic balance in the world is in every investor’s best interest.  This is what we will watch most closely in 2015.

 

Commentary – This Too Shall Pass

I have been working in the investment field since 1986, so for me it is a given that investment returns are cyclical.  By now I have seen every asset class, every sector, and every geographical region go in and out of favor at least twice.  Because of this, I have a hard time placing a strong overweight on any particular asset class.  I know every asset class’ good fortune is temporary and furthermore, I know they won’t ring a bell at the top. 

 

Let me give you an example.  Figure 1 below is a table showing year by year returns for twelve asset classes from 2000 through 2009.  The cells are shaded green to red (left to right) to help highlight relative performance for a given year.  Best performers are shaded green and worst performers are shaded red.  Only one asset class failed to achieve a positive 10-year average annualized return – large cap U.S. stocks.  Everything else made at least a small amount of money.  The best – commodities – posted a sizzling 14.49% average annual return for the decade.  Of course we know what happened thereafter – U.S. stocks have been a star performer over the subsequent five years to 2014 (trailing only Real Estate Investment Trusts).  Commodities, on the other hand, have been the very worst performing asset class by far over the last five years.

 

The lesson here is that every asset class goes through periods of stronger and weaker performance, and often extreme highs are followed by extreme lows (and vice versa).  We don’t know in advance when a particular asset class is going to bottom out or top out, so we can’t risk putting all our assets in one “basket”.  Figure 2 shows nine assets and one “asset allocation” portfolio, which is a diversified mix of the representative asset classes.  Notice that while the diversified portfolio doesn’t ever make it into the top three in a given year, it never falls into the bottom four either.  Asset diversification does not guarantee you a positive return, but it does tend to keep the losses manageable.

  

Figure 1

Source: Trademark Financial Management.  Selected Asset Class Indexes: (1) S&P 500 Index (2) S&P Midcap 400 Index (3) Russell 2000 Index (4) MSCI EAFE Index (5) MSCI Emerging Markets Index (6) Dow Jones U.S. Select  REIT Index (7) Goldman Sachs Natural Resources Index (8) Deutsche Bank Liquid Commodity Index (9) Barclay’s Capital Aggregate Bond Index (10) Barclay’s Capital Aggregate Bond Index(11) Citibank WGBI Non-US Dollar Index (12) 3-Month Treasury Bill

 

Figure 2

Source: JP Morgan 1Q15 Guide to the Markets

 

As you can see, 2014 was dominated by REITs and large cap stocks, but most asset classes were either mediocre or downright crummy.  While this may appear to suggest that investors should flock to REITs and U.S. stocks right now, the performance history of buying the leading asset class on a ten year basis is not good (see the returns of commodities and emerging markets post 2009).  If we ran a chart showing 1990 through 1999, it would show sizzling performance for U.S. large cap stocks, and it would have been similarly prophetic in terms of calling the top.

 

We diversify because we believe this is the best way to help investors realize their financial goals.  We believe it is more significant to our clients’ long term financial success to avoid significant losses than it is to make significant gains.  Why?  Because the 5.2% return generated by the diversified portfolio in Figure 2 last year and the 6.7% return over the last ten years would have kept almost anybody’s investment plan on track.  On the other hand, if one had gotten too bullish (or bearish) at the wrong time, they could have put a meaningful dent in that plan.  In the end success becomes less about beating the market and more about not letting the market (through its periodic appeals to either your fear or your greed) beat you.