Quarterly Market Review - Jan 13, 2015

Did you stay the course in 2014? As so often happens, the financial markets defied expectations and expert prognostications. When the market plunged in October, those who hung on were rewarded at year-end. Proving once that the best antidote for financial fear is a sound strategy, disciplined approach, and broad diversification. And 2015 is likely to be no different

 A Look Back

2014 was another great year for the S&P 500 as it posted a third consecutive year of double-digit gains, ending at near-record highs and a 13.69% total return including dividends. With credit to Weston Wellington (Patience Pays Off, DFA Jan 2015), achieving that return required a level of patience that eluded many investors. Stock prices fell sharply in January 2014 with the S&P 500 Index sliding 3.56%. They then soared to new heights before the Dow Jones Industrial Average plunged as much as 460 points on October 15^th. At that point, the Dow was down 2.6% for the year while the S&P 500 was holding on to a modest gain of 0.76%. Amidst the volatility, American stocks had just lost over $2 trillion in value, and investors were bracing themselves for a continuing slide. Despite the turbulence and contrary to many expert predictions, stock prices shrugged off declining oil prices and Eurozone fears, recovering quickly and rising through December as the bull-run endured.

In the bond market, professional investors were overwhelmingly confident that interest rates would rise in 2014, but the yield on 10-year US Treasury notes instead fell sharply from 3.03% at year-end 2013 to 2.19%. Lo and behold, bonds confounded the so-called experts with better than expected returns in 2014.

Stock returns in non-US markets were generally positive in 2014 but with a wide range of dispersion. Among 45 developed and emerging markets tracked by MSCI, total return expressed in local currency ranged from 38.66% in Israel to -31.59% in Greece. Thirty-five non-US markets had positive returns, including 17 with higher returns than the US. With so many pessimistic discussions about the European economy in recent months, many investors might be surprised to learn that stocks in Belgium, Denmark, Finland, and Ireland outperformed US stocks when expressed in local currency. Appreciation of the US dollar relative to every major currency significantly penalized net results for US investors.

Exchange rates fluctuate in unpredictable ways, and the recent strength of the US dollar stands in stark contrast to the gloomy predictions heard from many commentators just a few years ago. Many investors have followed the crowd, herding into the dollar and out of the euro, yen and emerging markets. This leaves them vulnerable. The risk is that off-shore economies may be a little better than expected, and any news to support that possibility could lead to a sharp reversal in the dollar. But there’s no way to predict. As the late John Kenneth Galbraith remarked, “the only function of economic predictions is to make astrologers look good.” Fewer than 10 percent of active managers beat their benchmarks in 2014 (and those who did are unlikely to do it again). Trying to outsmart the market with expert predictions and guesswork is a loser’s game.

In US dollar terms, New Zealand was the best performer in developed markets during the fourth quarter. The fall in commodity prices, in particular the decline in the price of oil, contributed to the lower performance of commodity-dominated countries such as Norway and Russia. Turkey and China recorded the highest performance among emerging markets.

Commodities were broadly negative during the fourth quarter. The Bloomberg Commodity Index fell 12.10%. Energy led the decline with WTI crude oil and natural gas returning -40.65% and -32.49%, respectively. Wheat was the best performer with a gain of 21.82%. After experiencing negative returns in the third quarter, corn and soybeans gained a respective 19.70% and 10.44% in the fourth quarter.

In the words of Weston, 2014 was a challenging year in many respects, but perhaps the biggest challenge was to resist the urge to dip and dart in response to the cascade of news, events and opinions that suggested action of some sort was imperative for financial success.

Central bank missteps, oil shocks and herding into the dollar are among a long list of concerns in the coming year. No one knows what the implications will be of an interest rate rise from such historically low levels. And there is no guarantee of a magic stimulus to the global economy affected by tumbling oil prices. It could be a decade away or days away, but at some point there will be another crisis that makes the financial markets stumble. The question is, what can one do today to mitigate risk triggered by a future downturn? As I have said before (and you will hear from me over and over), the answer lies in a sound investment philosophy, a disciplined approach, broad diversification, and suitable asset allocation based on one’s unique needs and preferences.

Are you prepared for a stock market correction? Do you feel confident in your strategy? Do you have questions about your asset allocation? Contact me. I am here to help.

Living with Volatility Again

Feeling uneasy? Here are six simple truths adapted from Outside the Flags by Jim Parker (Dimensional Fund Advisors, October 2014):

Don’t make presumptions | Remember that markets are unpredictable and do not always react the way the experts predict they will. When central banks relaxed monetary policy during the crisis of 2008-09, many analysts warned of an inflation breakout. If anything, the reverse has been the case with central banks fretting about deflation.

Someone is buying | Quitting the equity market when prices are falling is like running away from a sale. While prices have been discounted to reflect higher risk, that’s another way of saying expected returns are higher. And while media headlines proclaim “investors are dumping stocks,” remember that someone is buying them. Those people are often the long-term investors.

Market timing is hard | Recoveries can come just as quickly and just as violently as the prior correction. For instance, in March 2009—when market sentiment was at its worst—the S&P 500 turned and put in seven consecutive months of gains totaling almost 80%. This is a reminder of the dangers for long-term investors of turning paper losses into real ones and paying for the risk without waiting around for the recovery.

Proper portfolio diversification is crucial to managing risk | While equity markets have turned rocky again, highly rated government bonds have flourished. This helps limit the damage to balanced fund investors. So diversification spreads risk and can lessen the bumps in the road.

Nothing lasts forever | Just as loading up on risk when prices are high can leave you exposed to a correction, dumping risk altogether when prices are low means you can miss the turn when it comes. As always in life, moderation is a good policy.

Discipline is rewarded | Market volatility is worrisome, no doubt. But through discipline, diversification, and understanding how markets work, the ride can be made bearable. At some point, value re-emerges, risk appetites reawaken, and for those who acknowledged their emotions without acting on them, relief replaces anxiety.

Fourth Quarter 2014 Index Returns

World Asset Classes

REITs, particularly in the US, had higher returns than most asset classes in the fourth quarter, outperforming equity indices. US equities performed better than non-US developed and emerging markets. Many equity markets outside the US declined in US dollar terms. Currency movements played a role; the dollar appreciated against most currencies. Small caps outperformed large caps in the US. In developed markets outside the US, small caps slightly outperformed large caps but underperformed in emerging markets. Broad market value indices outperformed growth indices in the US, but underperformed in developed markets outside the US and in emerging markets. The results were mixed across size ranges in the various markets.

US Stocks

The US equity market performed better than most other markets for the quarter. Small cap indices outperformed large cap indices. Marketwide value indices outperformed growth indices, and large and mid-cap value indices outperformed their growth counterparts. However, value underperformed growth among both small and micro-cap stocks.  REITs, which are included to varying degrees in many benchmarks, boosted index returns. In spite of strong 4th quarter performance, small and mid-cap stocks lagged behind large cap stocks on the year.

International Developed Stocks

International developed broad market indices measured in US dollars underperformed the US indices but outperformed emerging markets as a group. Small caps slightly outperformed large caps. Value underperformed growth across all size segments. The US dollar strengthened against most currencies during the quarter. For the year, international developed stocks underperformed the emerging markets.

Emerging Markets Stocks

Broad market emerging markets indices underperformed developed markets, including the US. Small cap indices underperformed large cap indices for the quarter. Value indices underperformed growth indices in large caps and mid-caps but outperformed in small caps. The US dollar strengthened against most currencies during the quarter. 

Real Estate Investment Trusts

REITs outperformed the broad equity market for the quarter. REIT indices in developed markets outside the US outperformed broad market equity indices.

Fixed Income

Interest rates across US fixed income markets generally declined during the quarter. The yield on the 10-year Treasury note ended at 2.17%, a dip of 34 basis points (bps). (One basis point equals one-hundredth of a percentage point.) Long-term US Treasury bonds gained 27% in 2014.

While intermediate- and long-term rates declined, short-term rates increased. The 2-year Treasury note was up 10 bps to 0.68%.   

Long-term corporate bonds returned 3.98% for the quarter and 15.73% for the year. Intermediate-term corporate bonds gained 85 bps for the quarter and 4.35% for the year.

Municipal revenue bonds (+1.54%) again slightly outpaced municipal general obligation bonds (+1.11%) for the quarter. Long-term munis continued to outperform all other areas of the curve.