By: Matt Garrott
The US Dollar reigned supreme in 2014, driving commodities down (-17.01%) and dampening returns for foreign denominated asset classes such as foreign bonds (-2.77%), developed market stocks (-4.90%), and emerging markets stocks (-2.19%). Domestic large cap stocks had another strong year, up 13.69%. Small and mid-cap US stocks had a bumpy year, but ended up 8.54%. Although the Federal Reserve halted its policy of Quantitative Easing, interest rates generally fell during the year and the Barclays Aggregate Bond Index was up 5.97%. TIPS were held in check by lowered inflation expectations, returning 3.64%. Real estate went through the roof, up 31.53%.
There were plenty of scary headlines this year. After 2013’s huge returns, experts warned that we were due for a correction. The year began with a 5.66% drop in the S&P 500. The “January Effect” (as goes the month of January, so goes the rest of the year for the stock market) dictated that we were in for a bad year, but market timers that fell for this mumbo jumbo got hurt as the market rallied hard in the following months. October provided another chance for emotions to dictate behavior as the S&P dropped 7.28%, but then bounced back with a vengeance. It is interesting to note that the nearly-unanimous call for a market correction never happened, at least for large cap US stocks, as the S&P 500 never did lose the 10% required to earn that title. It was a strong 2014 despite fears of Ebola, continuing unrest in Ukraine and the Middle East, and the dreaded polar vortex.
Investors who didn’t panic during the year found solace in several positive news stories as well as their investment statements. The Federal Reserve finally ended its Quantitative Easing policy. US GDP rose by 5.0% in the third quarter. Innovations in the American oil industry, a strong US dollar, and a shrug of the shoulders by OPEC led to a dramatic drop in the price of oil.
2014 was a year to be skeptical of consensus opinion. After a monster year for stocks in 2013, everyone KNEW that there HAD TO BE a correction. There was NO WAY oil would fall below $80/barrel. Interest rates had NOWHERE TO GO BUT UP. With individual stock correlations dropping, this HAD TO BE a stock-picker’s market. There was no correction. Oil plummeted. Interest rates dropped. Money managers got punished as the S&P 500 beat 82% of active managers.
2014’s Buzz words: ISIS, Ebola, Ukraine, Ice Bucket Challenge, Ferguson, Mid-Term Elections, Data Breach
Oil prices will be interesting to watch this year. For the last few years, experts have pegged oil’s fair value at $90-$100/barrel and only saw this increasing due to growth in the emerging markets and decreasing oil supplies. The American shale revolution has disrupted this narrative and OPEC is on board with allowing the market to re-price oil, potentially shaking out some of the higher-cost producers. This may take six or twelve months to develop as many firms hedged against a fall in prices. Whether oil is on sale for half-off or if this price point is here for a while, American consumers (68% of GDP) are getting a boost.
As they did last year, prognosticators see a 10-20% correction at some point in 2015. This is actually a very conservative prediction as despite the market historically averaging 10% per year, it also experiences a 14% drawdown each year on average. So as we’d say every year, we won’t be surprised nor panic if we see a double digit drop sometime in 2015.
The Federal Reserve is expected to raise rates at some point in 2015. Because no one knows the exact timing or how the market will react to this, we continue to lean on active managers in the bond space to manage interest rate risk and credit risk. We have largely avoided reaching for yield as many asset classes with high yields in this environment harbor outsized risk as well. Low interest rates have allowed many companies who perhaps should have gone out of business to issue high yielding debt and survive. We do not want to be holding junk paper when this unwinds. Lower oil prices may actually be a catalyst for this as the energy sector has become a large chunk of the junk bond market. We favor passive exposure to equity markets as the indexes continue to consistently beat active managers, especially over long periods of time. High quality US businesses look fairly valued to us. Rather than cutting back now, we expect to underweight this area when valuations become irrational, which may take some time. Developed and emerging international stocks are still untangling themselves from the financial crisis and the strengthening dollar hasn’t helped returns for US investors in foreign stocks. However, they are trading at lower price/earnings multiples than domestic stocks and after trailing their US counterparts by a wide margin over the last five years, somewhere along the way we are due to see some reversion to the mean.
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. While much of our attention is on risk, we are also looking for opportunities and believe that equity investors are being rewarded as the markets return to fundamentals instead of day-trading the macro news cycle.
