Quarterly Perspective for 4Q15
In a way, 2015 was a lot like 2011. Markets muddled through the first half of the year, then plummeted in the third quarter before staging a modest recovery in the fourth quarter. Like four years ago, large stocks rallied enough to close the year with a gain while mid and small cap stocks had a much smaller bounce and finished with losses. The difference was that in 2011 the dividend paying blue chips were the winners, while this time around it was a handful of technology and consumer names that led the market. And handful really is the correct word. Factoring out just Amazon.com, Netflix, Facebook, and Alphabet (Google), the S&P 500 would have been negative on the year.
With the S&P 500 stock index gaining 1.28% in 2015 and the Barclays US Aggregate Bond Index up 0.48%, simple diversification would’ve resulted in a return somewhere around 1%. If, however, you diversified by size, geography, credit quality, and asset class, your returns in 2015 would have been quite a bit worse. Small cap U.S. stocks lost -1.84%. International developed market stocks as measured by the MSCI EAFE (think Europe and Japan) fell -0.99%. Emerging market stocks plunged -16.20% as measured by the MSCI Emerging Markets index. Commodities crashed -27.6%. Gold dropped -10.7%. High yield U.S. bonds were down -5.02%. See Figure 1. As you can see, last year was very difficult, even if you were underweight all of those diversifiers. In fact, economist Zachary Karabell noted that 2015 was the hardest year to generate returns since 1937, since it was the first time in 78 years that no asset class gained 10% or more.
Figure 1: 2015 Annual Returns by Asset Class
There was just one way to make money last year in foreign markets, and that was to own European or Japanese stocks on a currency hedged basis. Every region declined in U.S. dollar terms, but as noted above, one was a lot better off in developed markets than emerging markets. China continues to be the biggest driver of the global economy, and unfortunately they are not currently driving in a helpful way as their economy slows.
On the bonds side there were basically two ways to come out ahead – municipal bonds and mortgage securities. To be sure, returns were modest – muni bonds were up 3.30% and mortgages 1.13%. Taking any kind of risk to try to earn a higher yield was in most cases punished last year, as investors become nervous about a slowing economy and rising defaults.
We were more active than usual in the fourth quarter of 2015. We made use of new exchange traded funds (ETFs) that sorted the universe of stocks for factors that were currently in favor. The three that we used most frequently were low volatility (choosing stocks with lower than average daily fluctuation), momentum (stocks whose prices had been showing relative strength when compared to the market as a whole) and quality (stocks of companies whose financial strength was superior when measured in several different ways). As investors grew more defensive, it was the low volatility strategies that performed the best relative to their respective categories. We used them both domestically and internationally. Also, given the tough sledding the market encountered in the second half of the year, we had a larger amount of capital losses to harvest for tax purposes in taxable portfolios.
Three months ago, amidst a rebound in October after a very rough third quarter, we wrote that we didn’t expect that rally to lead to new highs. The first quarter of 2016 is obviously off to a poor start, perhaps confirming that the May 2015 all-time high was the peak for this cycle. Oaktree’s Howard Marks likes to talk about asset prices being more a function of psychology than any kind of hard science. Investors tend to overlook negatives for a long time, then suddenly over-react to them. We have expressed our concerns about high stock valuations relative to modest economic growth for quite some time, but only recently have those concerns been borne out. Market leadership has been narrowing – health care is clearly no longer a leading sector, and there just aren’t enough consumer growth stocks to carry the market by themselves. Even some of those companies – Apple and Disney, for example – are now 15% or more off their 2015 highs.
The combination of a weak global economy and a Federal Reserve in credit tightening mode is probably too great a headwind to allow the market do much more than tread water at best over the next few months. As a result, we expect to maintain higher than normal cash positions and to continue to rebalance portfolios so as to reduce volatility.
Commentary – And Again…
“Wait a minute, Mark. If you are concerned about the stock market, why don’t you just sell everything and go to cash?” I hear this every time the market declines, and I have answered it before, but since it is topical I want go over it again. There are three reasons we don’t sell everything when the stock market starts to fall:
One: Because we don’t know if the current decline is temporary or whether it will last for a long time.
There is certainly fear out there, but nobody knows how long it will last and what the magnitude of the current decline will ultimately be. I do know that the stock market decline in 2016 has been pretty much in lock step with the price of oil. Falling oil prices hurt certain entities – oil producing firms and countries and the companies that supply them and anybody invested in them – in a very real way. It does not, however, hurt everybody. The average U.S. consumer is getting a dividend in the form of a lower gasoline bill and lower heating bills. At some point the market may focus on this. Right now, however, we are doing the equivalent of seeing the house across the street on fire and worrying that our house is going to be next. At some point, oi prices will bottom. That may or may not coincide with an overall market bottom.
Worry is something, unlike cash flow or return on equity, for example, that we as investment analysts can’t forecast. It grips the market for a time and then it goes away, sometimes gradually and sometime not. Historically, most 10% declines in the market do not turn into 20% declines and most 20% declines don’t turn into 40% declines. And yet some do. It is the lack of certainty about markets that creates volatility, but it is volatility that creates opportunity.
Two: Because there are many assets that do not necessarily decline when stocks do.
The first two weeks of 2016 have certainly been rough on stocks all over the world. Would it surprise you to know that most bonds are up this year? Government and municipal bonds more often than not rise in value when stock prices fall sharply. This is what is called negative correlation. There are other asset classes that often have negative correlations with stocks. Gold, for instance. Gold is up a little over 2% year-to-date. There are also certain type of funds that that will invest on trends in asset classes or commodities. These are called managed futures funds. They have the ability to profit from a decline in stocks, or oil, or copper, etc. As a whole, these types of funds are ahead in 2016 as well. The point is, one should not assume that just because stocks are down that everything in one’s portfolio is also declining.
Three: Because moving in and out of the stock market has a poor track record.
We know that psychologically the most comfortable place to be when the market is going down is out of stocks. That said, from an investing standpoint what is psychologically easy is seldom profitable. The herd does not get rich. It is often said that stock climb a wall of worry, because while there are always reasons to fear that stock prices will fall, most of the time they don’t. Just looking back over the past several years – a time period in which the S&P 500 more than doubled – there were plenty of reasons to have bailed out of stocks. The Federal Reserve embarked on an unprecedented expansion of its balance sheet (2009). The U.S. credit rating was downgraded from AAA to AA+ by Standard and Poors (2011). Greece has a credit crisis (2011) and ultimately defaulted (2015). Commodity prices began a sharp fall as China began to re-orient its economy away from massive capital spending (2012 to the present). Syria disintegrated into a war zone, throwing the Middle East into chaos (2013 to the present) and creating a refugee crisis in Europe (2015). The list goes on. And yet, General Mills still sells cereal and yogurt and Amazon still sends you nearly any material thing you could want in a day or two. Profits are still being earned all over the world.
More often than not, selling stocks on the basis of fear leads to buying them back later at higher prices. Vanguard, Morningstar, Dalbar and JP Morgan have all done studies showing that people’s actual returns are much worse than that of the mutual funds in which they invest because investors have a strong tendency to buy into rising markets and sell into falling markets. Wall Street even has a saying “bear markets are when stocks return to their rightful owners” that refers to the fact that any idiot can buy a rising market but only the savvy investor buys when prices are low. See Figure 2; the yellow bar represents the average investor return between 1995 and 2014 as calculated by J.P. Morgan Asset Management.
Figure 2: 20 Years Annualized Return by Asset Class (1995-2014)
Source: JP Morgan 1Q16 Guide to the Market
If we thought we could be more effective jumping in and out of the market we would. We’ve been doing this long enough that we remember the names of those who got one major market call right and never did it again. We don’t know of anybody that has consistently made that work.
The point is, we believe that all market conditions require intelligent, experienced management. Nobody rings a bell at the top or at the bottom. Market movements constantly confound expectations. One has to continuously evaluate one’s holdings in light of the current circumstances and be ready to make changes if necessary. The investment world is fortunately very diverse, so alternatives exist for just about any type of market condition. Going to 100% cash is not the only way to protect a portfolio; in fact it tends to reduce one’s returns over time due to the difficulty of timing one’s re-entry. All we really care about is being effective on your behalf; that is why we spend a considerable amount of time on research, analysis, and portfolio monitoring.
Thanks for your continued trust in our management program.
-Mark Carlton, CFA
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 Source: YCharts.com. As measured by the total return of the ETFs tracking those indices from 12/31/2014 – 12/31/15: S&P 500: IVV, Barclay’s US Agg: AGG, S&P 600: SLY, MSCI EAFE: EFA, MSCI Emerging Markets: EEM, DB Commodity Index: DBC, Gold: GLD, High Yield Bonds: HYG. We’ve listed ETF returns because they represent an investible way to access the referenced index.
 Source: A Most Challenging Year, Zachary Karabell, Investpmc.com
 As measured by the Barclay’s Municipal Bond Index and the Barclay’s U.S. Mortgage Backed Securities Index. Source: Morningstar Adviser Workstation
 Latest memo from Howard Marks: On the Couch, January 2016, oaktreecapital.com