4th Quarter Client Note

The stock market actually achieved a sizable gain in the fourth quarter. But it sure didn’t feel like it. Going in to the quarter the S & P 500 (Total Return) Index had been down 5.29% for the year. So the 7.04% fourth quarter gain resulted in a small 1.38% increase for the year; almost entirely attributable to dividends. And then the New Year’s tumult began. The S & P 500 Index is down 6.83% year-to-date as of this writing.

For 2015, nearly all other equity asset classes turned in negative performances. The MSCI EAFE (Developed Markets) Index was down 3.30%. The Emerging Markets Index lost 16.96%. Commodities were down 24.66%. One bright spot was the US REIT Index which returned a positive 4.48%

US Growth stocks – led by the FANG’s (Facebook, Amazon, Netflix and Google) – continue to outperform Value stocks; a phenomenon which has persisted for the last decade; an unusually long (but not unprecedented) period.

In December, the Federal Reserve took its first baby step in raising the federal funds rate by a quarter percent from a 0 – .25% target to a .25% – .50% target. Interest rates also increased across the upper end of the yield curve as well. Accordingly, the Barclays Aggregate Bond Index fell .57% for the quarter and was up a modest .55% for the year.

High Yield (or junk) bonds were down 4% for the year, their first annual loss since 2008.

For a complete picture of the quarter’s data you can peruse the Quarterly Market Review from our friends at Dimensional Funds Advisors.

Asian Flu

A good deal of the turmoil is a result, at least in part, of events in China. China is a developing economy undergoing vast economic transformation and has been growing at a rate of 10% annually for two decades. China and the rest of the world’s economies are now linked in ways making them considerably more interdependent than in the past. And the Chinese economy is undoubtedly slowing as it tries to transform from just production to consumption as well. The Chinese stock market has incurred strong selloffs twice in the past six months. And the Chinese central bank continues to take steps to devalue the Yuan to protect Chinese exports. Chinese regulators in general are struggling to find policies to make their economy and markets work better.

However, Chinese stocks represent just a small fraction of a broadly diversified portfolio; representing just 2% of the market capitalization of the Total World Stock Index. While China will continue to grow in importance, much of the US market reaction to events in China appears to be somewhat emotional and is not directly driven by fundamentals.

Cold Commodities

Among the worst performers over the last few years have been commodities – such as oil and other natural resources – and the stocks of companies that extract and distribute them. The price of a barrel of crude oil has dropped from over $100 to around $30 for the first time in over a decade; and could go lower still.  (A strengthening dollar has contributed substantially to the fall in commodity prices.)

Worldwide demand, led by the slowdown in China has been falling. Nevertheless, for whatever geopolitical and strategic reasons, Saudi Arabia has continued to produce, even in the face of falling prices. The US shale industry has invested billions and is struggling with when and how to cut production. But, as one of my economics professors used to say, you can’t repeal the law of supply and demand.

Producers can’t survive in an environment in which the price is lower than the cost of production. Some will go bust. The strong will survive. And eventually, equilibrium will take hold, prices will stabilize and likely rebound in what has historically been one of the most cyclical industries. Of course nobody knows when that will happen.

Asset Allocation Framework

We continue to believe that an asset allocation framework makes the most sense for investors. First, by dividing your portfolio into risky and less risky asset classes according to your goals and risk tolerance. And then dividing your risky assets into broad categories of common sense proportions. This kind of strategy offers the most reassuring evidence that you’ve thought about things in advance. And satisfies the need or desire to ‘do something” – such as rebalancing, by lightening up on asset classes that may have become over valued and reloading asset classes that have performed poorly and have higher expected returns than they did previously.

Of course, even the most sensible strategy isn’t necessarily for the faint of heart. Take international stocks, which make up a portion of a rationally diversified portfolio and which have underperformed US stocks by a great deal in recent years. But focusing on the most recent performance ignores the fact that over longer periods, there are times when international stocks significantly outperform US stocks. Relative performance is surely unpredictable in the short term. But at the moment it appears that international stocks may represent a better value; with the dividend yield being twice that of US stocks.

The following chart from Vanguard (US and International Stocks have alternated as global market performance leaders) shows when and by how much the difference in performance has been between US and international stocks at various times since 1971.

Take a Deep Breath

This may sound odd coming from a financial advisor; but the most important thing in your life is not your portfolio. A good result comes with the realization that, having worked hard to create a plan that is reasonably well thought out and reasonably easy to stick with – money and investing is the least of your worries. You’ll revisit your plan periodically or when there is an important change in your personal circumstances. And you understand that withstanding the periodic corrections and bear markets is the price to be paid for obtaining the long run returns of risky asset classes. You’ve controlled the controllable.

So, go enjoy yourself.

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