Déjà Vu Again


As 2016 gets underway, January ushered in what is becoming the traditional market decline of the New Year.  The S&P 500 was down at least 3% in the prior two years, and, not unlike the preceding years, the melodramatic headlines and proclamations of disaster are front page news.  If you think this feels like déjà vu, you’d be right.  Stories highlighting concerns over slowing global growth, extreme volatility in the Chinese stock market, and seemingly bottomless oil prices aren’t difficult to find and are all headlines that have carried over from 2015.  So how did we get to where we are today?

The Challenge of 2015 Markets

Without a doubt, 2015 was a difficult year for the majority of investors.  Not difficult in the way of the Financial Crisis of 2008 or the Dot Com bust of the early 2000’s, but in that nearly all broadly diversified, publically traded asset classes were flat or down.  When examining the returns of the various benchmarks of traditional stock, bond, and hedge fund indices, it isn’t a pretty picture.  At the broadest level, the global benchmarks for all 3 asset classes declined, with returns ranging from -2.4% (stocks) to  -3.6% (alternatives as measure by the Global Hedge Fund Index).  Historically, the norm in the markets has been for at least one sub-asset class (e.g. US Small Cap stocks, International bonds) to produce returns of 10% or greater.  In 2015, the trend was broken and resulted in a rather uninspiring year for most investors with prudent, globally diversified portfolios.

What Really Happened?

  • The top performing sub-asset class for 2015 was Municipal Bonds, with a return of 2.4%.  High quality U.S. bonds also stayed out of the red, as Intermediate U.S. Government bonds returned 1.2%, and U.S. Investment Grade Corporate bonds were close behind with a 1.1% return.  Portfolios reaching for yield or going abroad for their fixed income exposure were not rewarded, as U.S. High Yield and unhedged International bonds lost 4.5% and 6.0%, respectively.
  • Overall, stock investors fared no better than their bond counterparts.  The top performing component was, again, U.S. Large Cap stocks.  The S&P 500 narrowly produced a positive year with a return of 1.4% (including dividends), but this return masked the concerning development regarding lack breadth driving the index’s results.  Lack of breadth refers to the performance of a relatively small number of stocks having an increasing influence on the performance of the broader index.  In effect, the market-cap weighted index was carried by fewer and fewer participants.  A small group of high growth tech stocks (Facebook, Amazon, Netflix, and Google – commonly referred to as “FANG” by the media) produced extraordinary gains on the year, averaging 83% between the four.  If these participants are excluded from the index, the return for the year turns negative, illustrating weakness in the broader market. The more economically sensitive U.S. Small and Mid-Cap components lost 4.4% and 2.4%, respectively. 2015 would not be the year that International stocks would rotate back into leadership.  Although International Developed stocks came in second on the year with a modest loss of only 0.8%, a myriad of problems affecting Emerging Markets led investors to flee the space, resulting in a sizeable decline of 14.9%.
As you can see, constructing a well-diversified portfolio that produced meaningful gains was a difficult task.
 
Headlines Du Jour

It is only natural for human beings to attempt to determine the specific causes for events we’ve experienced.  We are hardwired to seek out patterns that identify cause and effect, even when the information we have is limited and unreliable.  In regard to the markets, we have a wealth of potential culprits at which to point the finger.  Let’s revisit a few of economic and geopolitical concerns of the past year:

  • The crash in oil and commodity markets
  • Fears of a Greek default and potential exit from the Eurozone
  • Slowing economic growth in China and the ensuing stock market crash
  • The increasing influence of ISIS and terrorist attacks in Paris
  • The first market correction (10% decline) for the S&P 500 since 2011
  • The first interest rate hike by the Fed since 2006
  • Global deflationary fears
Each of these events drew significant attention from the media and was declared a potential turning point in the economic recovery.  And this isn’t to say that there is no truth in those opinions, but the fact remains that some form of global economic or geopolitical turmoil is the norm; not the exception.  More often than not, these types of headline grabbing events have little to no lasting effect on the underlying fundamentals that truly drive the economy and financial markets.  Many examples of this can be provided, but one needs to look no further than the current historic bull market that began in 2009.  Since the beginning, it has climbed a wall of worry as naysayers were quick to point the abundance of global concerns along the way:

  • 2010 – Flash crash, BP Oil spill, concerns over a Greek default
  • 2011 – US Government debt downgrade
  • 2012 – European double dip recession
  • 2013 – The ‘Taper Tantrum’
  • 2014 – Global slowdown fear, Ebola
The list could go on.  Meanwhile, the S&P 500 more than tripled over this time period.

Where Do I Focus?

Rather than getting caught up in the hyperbolic headlines created by the media, investors would be wiser to focus on long-term trends in the broader, macro level variables that are more closely related to the underlying state of the economy such as corporate earnings growth, unemployment rates, demographic trends, interest rates, inflation, GDP growth, and monetary and fiscal policies.  It is true that many of these variables are painting a worrisome picture.  We still have very real concerns, particularly in China.  As the world’s second largest economy continues to transition from a manufacturing economy to a consumption economy, slowing growth—and its impact on the rest of the world—is a valid concern.  Other factors too important to be ignored include the end of Zero-Interest-Rate-Policy by the Fed, the collapse of prices in the energy sector, a potentially flattening yield curve, and weak corporate earnings in the previous three quarters.

What fails to gather headlines are the many positive developments, both domestically and abroad.  The unemployment rate has declined to the lowest level since the recovery began as the U.S. job market continues to improve.  Consumer spending, which makes up two-thirds of domestic GDP, has been healthy.  The housing and auto markets are both strong and trending positively.  While the Fed finally raised interest rates in December, the fact is, that rates remain low and borrowing is still cheap.  Plus, the decision to raise rates indicates the Fed’s confidence in the strength of the economy.  Both household and corporate balance sheets have been dramatically strengthened since the financial crisis, reducing systemic risk.  Many foreign central banks are implementing accommodative monetary policies aimed at stimulating growth.

In Summary

As we have it, the economic picture remains mixed with plenty of ammunition to argue both sides of the story.  If history is any indication, then we know that many will try, but few will be successful at precisely forecasting the interplay of these factors and the immediate impact on global markets.  It is our belief that the underlying forces that drive long-term global economic progress remain in place, and should allow growth-oriented, riskier assets such as stocks to out-perform more stable assets such as bonds and cash.  But it is a certainty that market volatility and significant declines will occur along the way, as it always has.  Our advice is to be wary of making big bets on the direction of the market over the short-term.  Have a sense of your objectives, needs, and tolerance for risk, and ensure this is reflected in your portfolio strategy.  By staying committed to a disciplined approach influenced by an awareness and strategic assessment of your situation, you will be provided the greatest likelihood of financial success.