4th Quarter Client Note

By Steven Smith | Newsletters

Jan 16

Unquestionably the biggest economic story of 2014 was the price of a barrel of oil dropping over 50% since June –from over $100/barrel to $50/barrel. This was the result of three phenomena: 1) the enormous increase in US production over the last few years, 2) falling demand due to the increased use of alternatives and to continued weak economies overseas and 3) the failure of the Saudis to cut production in the Middle East. Almost nobody predicted such a precipitous drop.

And good luck to anyone trying to forecast the eventual equilibrium price and the various economic and investment consequences of a persistently low price. Obviously, lower prices are bad for oil producers and all the other businesses in the supply chain; including those entities supplying financing to the sector. (In Colorado, the average petroleum company lost between 30% and 50% of its market value in the second half of the year.)

On the other hand, lower energy prices act as a tax cut for consumers and is a boon to the airline and automobile industries. And the value of the dollar against the currencies of most other countries has surged. Of course, as demand increases and supply decreases due to production cutbacks in the oil patch the equilibrium price will tend to rise.

US Stocks Shrug.

And yet, despite the plummeting price of oil the S & P 500 Index (including dividends) advanced 4.93% for the quarter and 13.7% for the year. As of October 15, the S & P 500 Index was up only .76%. Almost all of the gain occurred during the last 10 weeks. The average active US Large Blend mutual fund returned 10.96%, trailing the benchmark by 2.7%.

With a gain of 32%, Real Estate Investment Trusts (REIT’s) achieved their highest total return since 2006 (prior to the real estate recession) when the REIT index returned 35%.

Just about every other asset class underperformed to a significant degree.

Diversification Works. Except for When it Doesn’t. And Then it Works Again.

Take international stocks; which from 1970 to the present have a long term average annual return of approximately 10%, similar to the S&P 500; but with a correlation of only .67%.

The MCSI EAFE (developed markets) Index was down 4.90% in 2014. Some of which resulted – for US investors – from the rising value of the dollar. The EAFE trailed the S&P 500 Index by 18.59%. From 2010 through 2013 the return of international developed markets stocks trailed the S&P 500 Index by 7.3% per year. But the EAFE outperformed the S & P 500 substantially in 2004, 2005, 2006, 2007 and 2009. A blended portfolio of the two asset classes would have outperformed either, standing alone, over the entire ten year period.

Further, take Emerging Markets (EM), many of which rely on extractive industries. EM’s have performed miserably in the last two years; with negative absolute returns.  In 2013, EM (represented by the MSCI Emerging Markets Index) underperformed the Russell 3000 index by 35.82%. This year the underperformance was 14.75%.  But for the entire period from 1988 to 2013, EM outperformed the US market by 5.30% (17.59% vs. 12.29%); but with twice the risk as measured by volatility. In that same period, EM had twice as many negative years as the US market. So clearly,  if an investor wants to capture the risk premium emerging markets have to offer over an investing lifetime we have to put up with the frequent drag on returns entailed by investing in that asset class.

The Dog that Didn’t Bark. Yet.

Speaking of poor predictions; contrary to the forecasts of most prognosticators interest rates did not rise in 2014, rather they fell. The yield on the 10-year US Treasury note started the year at 3.03% and ended at 2.17% – resulting in a total return for Barclays US Aggregate Bond Index of 5.97%. Yes, it is likely that interest rates will eventually rise. The Fed has signaled an end to QE3. But other forces are at work. Making outsized bets against bonds has hurt rather than helped investors.

Mistakes Will be Made. Make Sure They’re Not Fatal.

Formulating an investment strategy is always an exercise in decision making in the face of uncertainty. Whether today’s environment is any more uncertain than others is – well – uncertain. What is in store for interest rates, the Fed and the US economy? What about China, Europe and Japan? We’ve already discussed the price of oil.

US stock valuations – especially large cap growth companies – are probably somewhat stretched. But research shows that that none of these measures is useful in making short term predictions. While it is tempting and virtually human nature to inform one’s investment strategy with forecasts in these macroeconomic realms, it is best to limit such activity – if at all – to the very margins of your portfolio. Bobbing and weaving to try to be in just the right place at the right time remains an unlikely undertaking toward successful wealth management.

On the other hand, one of the few things we can believe with some confidence is that asset classes that have outperformed over recent years are likely to underperform at some time going forward. By the same token, asset classes which have underperformed over the last six years likely have higher expected returns than when their prices were elevated. Which suggests the maintenance of your individually tailored asset allocation with disciplined rebalancing. Or, at the very least, not panicking out of the poor performing asset classes only to load up on the relatively overvalued ones.

This market is a little reminiscent of the late 1990’s as the technology bubble was inflating. Large cap (especially growth) stocks fueled an unprecedented multi-year rise in the S & P 500 Index. Clients with broadly and globally diversified portfolios were calling their advisors in droves, begging to be set free. Unfortunately, those that escaped were soon filled with regret. When the bubble burst, the S & P 500 Index suffered an average annual loss of 14.6% between 2000 and 2002. Many investors then bailed and never recovered. Meanwhile, globally diversified balanced strategies managed a small gain over the same time period as US Large Cap Value and US Small Cap Value (which had been performing relatively poorly from 1998-2000) both experienced positive returns during the tech meltdown.

Volatility simply comes with the territory. Our friends at Dimensional Fund Advisors present a very nice six point plan for “Living With Volatility” at the end of their Quarterly Market Review. It might be worth printing and posting next to your computer.