By: Matt Garrott
What Happened in 2015
2015 was a year for the markets to catch their breath. While the US Dollar was strong for another year, stocks and bonds were largely flat. In fact, the S&P 500 ended the year with one foot in negative territory and one foot in positive. The price index was down 0.74%, but including dividends the index was up 1.38%. The S&P 500’s 3 and 5 year returns took a step closer to their historical average of 10%. Last year, permabears could point to the market’s recent returns as unsustainably high. Now we are merely above average. Of course there is also a case to be made that there is still room to run as 10 year returns are only about 7%. Whichever way you look at it, last year’s performance takes the air out of the argument that we are in a stock market bubble. We often harp on how difficult (impossible) it is to predict how the markets will behave, but experts also had a hard time explaining the market’s movements as they were happening. Because it ended the year flat, some are saying that the market traded sideways. It did not. The S&P 500 gained about 4.5% through July then dropped with much of the downward action occurring during the market dislocation at the end of August. This was the long-awaited correction, a 12% fall. It was expected eventually and is a normal turn of events. Much less heralded is the fact that the S&P 500 climbed back up the wall of worry (gaining about 10%) to end the year about even. Every S&P 500 sector had a correction of at least 10% during the year. Energy ended the year down 21.12% while the Consumer Discretionary (stocks like Amazon, Disney, and Starbucks) sector was up 10.11%.
Just like every year, 2015 was supposed to be a stock picker’s market. Like most years, however, the S&P 500 beat the majority of active managers, this time outperforming 80% of the competition.
The US Dollar played a major role in global investing again as the US Federal Reserve raised rates in December and the European Central Bank and Bank of Japan sent signals of continued easing. The strong Dollar applied downward pressure to commodities as a whole as energy and materials sectors were hammered. Emerging markets, which were beneficiaries of a commodities boom just a few years ago, are struggling to get back on their feet. Foreign returns were dampened by the strong dollar as the MSCI EAFE was down 0.81% in US Dollar terms, but actually up 5.33% in local currency. Likewise, the MSCI Emerging Markets index was down 14.92% in US Dollars, but down “only” 5.76% in local currency.
What worked in 2015? Municipal bonds and Real Estate. Real Estate has been on an extended run and its volatility makes it unsurprising to see it either lead the pack or finish last. Municipal bonds, however, are less exciting. With the Federal Reserve raising interest rates it’s even more surprising to see a fixed income asset class being one of the year’s top performers. The only asset offering sweeter returns was Cocoa, up 9.57%, but you would have been cuckoo to put a big slug of your portfolio into such a thinly traded soft commodity.
2015’s Buzzwords: ISIS, Trump, Unicorns, Oil, Millenials, Star Wars, Shkreli, Valeant
Outlook for 2016
Instead of the polar vortex we had in 2014 and 2015, we’re getting an El Nino now. It will be interesting to see how first quarter GDP looks as cold weather and accounting weirdness (skewed seasonality) were blamed for low numbers in the past. The accounting issue was fixed, leaving no easy scapegoat if GDP comes in low
The US Federal Reserve is expected to continue to slowly raise rates (by a quarter of a percent every other meeting or slower) while the rest of the world’s banks continue to ease. One of the things investors should have learned over the last 7 years is to not overreact to widely-held macroeconomic expectations such as this. Logically, as rates rise, bond prices go down. When rates rise in slow-motion, though, investors have been paid to hold on to their bonds. The change in rates is happening so slowly that the interest payments can more than make up for the slight change in price. From an equity standpoint, does it make sense to hedge foreign stocks back to the Dollar? Over the long-run, no. Research shows that buying and holding either hedged or un-hedged foreign stock leaves investors with nearly the same returns. Over the short-term, it’s a coin flip. No one knows whether hedging will pay off in the next twelve months or not (what happens if Mario Draghi, Shinzo Abe, or Christine Lagarde makes a hawkish speech?). What we do know is that trading back and forth is a loser’s game and not recommended.
Low oil prices seem to be with us a while longer as OPEC isn’t backing off on production and Saudi Arabia is shockingly adjusting its own budget in response. We are not making a call on oil – as far as we know, it could fall to $20/barrel or double in price tomorrow – however, the price of oil can be felt in unexpected areas of a portfolio. The energy sector is strongly represented in the high yield bond space, for example. In recent years, experts have said they see opportunities in various flavors of high yield from plain vanilla junk to floating rate to distressed debt. Here’s the pitch for junk bonds: yields are attractive given the low yields in the rest of the bond world, stocks are doing nothing, and there’s plenty of liquidity right now. The implication is that you are an idiot for not already holding this stuff. The truth is that high yield also means high risk and many of these high yield bonds were issued by energy companies impacted by the price of oil. There’s a reason these companies couldn’t issue their bonds with low 3-4% yields. The scariest part of the pitch is the liquidity. A Third Avenue distressed debt fund closed recently because their bond holdings weren’t liquid enough to handle rising redemption orders and fund holders suffered major losses. This asset class is highly liquid… until it isn’t.
The popular prediction for 2016 is that it will be a ‘difficult’ year for the markets. When was the last ‘easy’ year? Prognosticators see the market ending anywhere from flat (it’s always popular to predict exactly what happened the previous year) to up 15% or so. Needless to say, someone is wrong here. It’s interesting that using the same information, people can come to such wildly different conclusions. What’s even funnier is that these experts will revise their predictions halfway through the year (likely predicting the second half of 2016 to be exactly like the first half) and still miss the mark. I have to agree that 2016 may be difficult if you are a money manager charging 2&20. It will not be difficult for those investing with a long-term perspective.
As is consistent with our philosophy, we continue to focus on controlling what we can control, embrace an open architecture approach, and create customized, elegant portfolios for our clients. Portfolio rebalancing and tax loss harvesting will continue to add value without having to be “right” about any predictions. A portfolio diversified across asset classes continues to be the most prudent way to protect against risks in the market. Money that is invested in stocks is money we know our clients don’t need to touch for at least the next 5-10 years. While much of our attention is on risk, we are also looking for opportunities and believe that equity investors will be rewarded as the markets return to fundamentals instead of day-trading the macro news cycle.
Our investment committee met recently to review our base allocation models and benchmarking. We’ll be discussing those updates with you during our next set of meetings. In general, we expect the following guidance for 2015:
- Allow Bonds weighting to return to policy weight
- Allow Stocks weighting to return to policy weight, particularly focusing on foreign equities as their valuations are favorable relative to domestic stocks
