To take the right steps for the future, it is helpful to understand the past. Below is a chart highlighting the performance of various asset classes in 2014. As you can see, foreign equities, gold, and commodities performed poorly while US equities and real estate performed well. There are both headwinds and tailwinds for 2015. Let’s go through some of the major points.
It’s been nearly six years since the bottom of the last bear market – a time when the US government was seizing equity stakes in the biggest financial institutions and our entire economic system appeared at risk of collapse. That feels silly to think about now, but was very real in March of 2009. We will never know what would have happened if AIG was allowed to fail. But it wasn’t, and since then the S&P 500 Index has provided a total return of over 250%.
2015 Investment Outlook
Six years and 250% is a big bull market.
In the last hundred years, we’ve only experienced three longer periods without a 20% decline—two of those three periods came with a larger gain. The magnitude of the current advance tempts some to be bearish, but there are two reasons we don’t think it should.
- Of the three times there have been six consecutive calendar years of gains (1952, 1987 and 1996), the following (seventh) year was up in two of the three, and the average return for all three was +13%.
- Big bear markets usually experience most of their decline after the first year. The average calendar year loss in a down year following an up year is “only” about 10%. The average calendar year loss in a down year following another down year is over 20%.
We believe most investors should avoid market timing altogether. For those that can’t help themselves, the second point above crystalizes why it is very rarely a good idea to try to time an exact market top and jump out of a rising ship. Even in 2008, which was an awful year for stock investors, most of the decline came more than a full year after the peak in 2007. People are naturally fearful of the sudden crash, but most big bear markets roll over slowly.
Fundamentals are neither inspiring nor scary. Valuations are high, but not extreme. The forward price to earnings (P/E) ratio on the S&P 500 sits at around 17x, compared with a historical average of around 15x. A P/E of 17x suggests an earnings yield of close to 6%, which compares quite favorably to the current 2.2% yield on a Ten Year Treasury bond. It is important to note that high valuations are correlated with lower future returns, not negative future returns.
Sentiment remains mixed. We do not see high degrees of fear or greed. On balance we see more people moving to be more aggressive, but not overwhelmingly. Bull markets typically don’t end until greed (or at least confidence) is near-universal.
Some are nervous about the prospect of Fed rate increases. We’re not. Even with economic acceleration and a strong job market, there is simply no guarantee rates rise in 2015. The Fed has proven to be accommodating longer and more aggressively than almost anyone imagined. Interest rates are no easier to predict than the stock market. Also, while rate hikes often lead to slower economic growth and dampen stock returns, our research shows the real impact to stocks only surfaces 12-18 months after a cycle begins.
International markets remind us in some ways of where the US was three to four years ago. European and Japanese economies are struggling to stay out of recession and their central banks are becoming more assertive. Valuations on international stocks are cheaper than the US. The forward price to earnings ratio of the MSCI EAFE is at 14x and its dividend yield is 3%, compared with 2% on the S&P 500.
There is no way to know if 2015 will be the year international stocks regain leadership, but when it happens it could mark the start of a long powerful trend – one you won’t want to miss.
What About Bonds?
In the Wall Street Journal’s survey last January, 48 of the 49 participating economists predicted the yield on the 10-year Treasury note would rise to an average of 3.5%. Instead, it fell to under 2.2%. Almost everyone on Wall Street was wrong about bonds in 2014. Interest rates fell and the yield curve flattened.
Once again, most view rates as destined to rise, but it is important to consider that international rates are even lower. Demand for higher yielding Treasuries could keep US long rates low even if the Fed starts raising short rates.
The yield spread between the 5 and 30 year Treasury bond is 1.1%, the lowest in the last six years. Bonds should continue to play an important role in most portfolios, but with the yield curve as flat as it is, we caution against heavy concentrations in long duration bonds. Inflation may not be surface soon, but there is no way to predict interest rates five or ten years out.
Ten year TIPS (inflation protected Treasuries) are pricing in just 1.7% inflation. This year, TIPS underperformed regular Treasuries, but we think they are worth owning as a portion of a diversified bond portfolio to protect against potential inflation.
The Big Game of International Diversification
Globally diversified investors can be excused for feeling envious of the S&P 500’s recent returns. Since the bull market began in 2009, the S&P 500 has returned about 250% while international stocks earned about 150%. A 100% spread is nothing to sneeze at. It’s enough to make one question if international diversification is a good idea at all. Indeed, we see some investors abandoning it, or moving toward very light international exposure.
We think this is big mistake. International diversification can be frustrating, but it can also be a major blessing. In the end, over long periods of time, it works – especially if rebalanced appropriately. But very few get this right and many get it dead wrong. The reason is because the cycles tend to be long and emotionally draining. The current performance gap is not unusual. This chart shows the five year rolling spreads between the S&P 500 and MSCI EAFE, proxies for US and International equities, respectively.
The first thing we can see is that there are big, cyclical trends. From 1971 through 1988, international generally does better. At the peak of the Japanese equity bubble in 1988, the five year spread hits 250%. At this point you were feeling very left out if you didn’t own international stocks. The US then leads essentially through the entire 90’s and by the time the dot come bubble arrives most Americans consider it foolish to invest in overseas companies. Foreign then regains leadership around the bottom of the bear market and outperforms for six consecutive years until the sub-prime crisis hits. The US has mostly been leading ever since.
You may notice leadership generally shifts around the time when bear markets arrive. That can make it tempting to try and time these trends, but that is a very dangerous game to play. Emotionally, the market is very skilled at convincing investors to do the wrong thing at the wrong time.
These are long cycles with big spreads. So why do it? For those with patience, it works. This chart shows the inflation adjusted growth of $1 invested in the S&P 500, The MSCI EAFE, and a 70/30 split (our recommended allocation) rebalanced annually:
The green line is the blend. First of all, no matter what, if you just invested in stocks and stayed invested, you would have ended up with very satisfying results. But by diversifying you actually finish with a slightly higher return and experience much less volatility along the way. The green line is either at the top or close to it. It is never at the bottom.
This is the true beauty of diversification and disciplined rebalancing. If we can do this for our clients over full market cycles and across all six major asset classes, it is perhaps the biggest value we can provide.
The Price Of Oil
Oil’s decline has caught most people by surprise. A significant downward trend gained momentum in November when OPEC decided to maintain production levels (rather than reduce supply). The move shocked global markets, and marks a new strategic direction for Saudi Arabia. The nation appears to view new US shale producers as a long term threat and is willing to accept lower prices in an attempt to shake some of them out of business. It is a high stakes, long term bet with unknown consequences. In any case, the Saudi’s are tired of being forced to be the one to cut supply – their OPEC partners are notorious for cheating on supply reduction targets.
How low will it go? Tough to say. Brent crude has already dropped below the crucial $60 price level, which is where a significant number of US projects become unprofitable. As such, there could be a longer term floor at around $60, but in the coming months or quarters there is nothing preventing prices from dipping significantly lower. Whether that would be a positive or negative depends on where you sit.
Clearly, steep declines bode negatively for major oil exporting nations. Russia in particular has been hit very hard. With oil as its most important commodity, the decline in prices has put heavy pressure on its currency. The ruble has fallen more than 50% over the last 6 months against the dollar. And failed attempts by their central bank to shore up the currency sent it into free fall. All of this has placed Russia on a difficult path. It will now have to battle lower oil prices, a weak currency, higher interest rates, and economic sanctions over Ukraine. At this point, there doesn’t appear to be an easy escape from the country’s predicament. In time, it could even weaken Putin’s stronghold on power.
But for most of the world, lower oil prices will be a net positive. They provide a much needed boost to economic growth in Europe, Japan and China. Here at home, it should help keep a lid on inflation.
If you haven’t done so already, click the Investment Checkup tab and then the Investment Checkup link on your Personal Capital dashboard. Our software will x-ray your portfolio for insights. Perhaps you have too much exposure to an industry you are uncomfortable with. Maybe you have a much lower bond weighting than you thought due to the move up in equities over the years. If you haven’t done a deep dive analysis of your investments in a while, there’s a good chance you’ll be surprised by how much your investment allocations have changed.