DWM End of 2014 Market Commentary

January 08, 2015

Diversification. We talk a lot about it. It’s basically our religion when applying reasoning to investing. Diversification is a technique that reduces risk by allocating investments among various financial asset classes, investment styles, industries, and other categories. It aims to maximize return by investing in different areas that would each react differently to the same event. Most investment professionals agree that, although it does not guarantee against loss, diversification is the most important component of reaching long-term financial goals while minimizing risk. As great as “diversification” is to CFA Institute practitioners, it might be just a long winded word to someone that doesn’t enjoy the occasional financial periodical. In fact, to that someone, diversification may seem pretty silly in a year like 2014 where really only a couple areas of the market stood out and made everything else seem trivial.

What am I talking about? Well, if you haven’t heard by now, the S&P500 just racked up another double-digit year, gaining 13.7% in 2014. However, the rest of the equity markets, weren’t close to this. In fact, the average US stock fund was only up 7.6% and the average international stock fund was down 5.0% for 2014. In other words, besides a few dozen mega-cap stocks that powered the market-cap-weighted S&P500, most stocks were up for the year, but only modestly.

Frankly, like I’ve said before, the S&P500 is not the best benchmark for a diversified investor. A better barometer or benchmark may be the MSCI ACWI Investable Market Index which captures large, mid and small cap representation across 23 developed markets and 23 emerging markets countries. With 8603 constituents, the index is comprehensive, covering ~99% of the global equity investment opportunity set. For 2014, this index was up 4.16%.

Changing gears, let’s talk about bonds. Like equities, developed international exposure didn’t help much shown by the Barclays Global Agg Bond Index only posting a 0.59% return on the year. Here in the US, it unexpectedly turned out to be a decent year for bonds with the average taxable bond fund notching a 2.8% return. Long-term US Treasuries, which everyone was afraid of going into this year, did really well (+5.1% for the Barclays US Total Treasury Index) because interest rates went down instead of up as almost everyone was predicting. In fact, the yield on the 10-year Treasury Note started 2014 right at 3.0% and just dipped under 2.0% at the time of this writing! One should not expect a marked rise in US rates any time soon and the basic reason is a lack of inflation. Remember the days when we fought inflation?! Well, now it’s looking like central banks around the world need to worry about deflation. Case in point: the US has not been able to get to its 2% CPI inflation target, the biggest culprit being oil down over 50% from its June 2014 peak. New Fed Head Janet Yellen has laid the groundwork for the central bank to raise interest rates around midyear 2015, but she’ll need the economy to keep cooperating to do so.

Liquid Alternatives were a mixed bag this year. Real estate securities had a great year as most real estate related funds were up well over 10%. Managed Futures also were a bright spot with our fund of choice AQR Managed Futures, up over 9% for the year. If you were long-only commodities, it was a terrible year with energy down big with the oil drop. And some hedge fund type strategies that employ a very active approach had difficult times. For example, a manager betting on rising rates and increased inflation going into 2014, most definitely was a loser. Like any other actively managed investment, the liquid alternative managers need to be monitored closely. Again, alternatives are a prudent part of someone’s overall portfolio because of the extra diversification it brings to the table. For the record, the Credit Suisse Liquid Alts Beta Index was up 3.6%.

Turning the page to 2015, we can only truly count on one thing: increased volatility. Volatility has been very low the last few years and that most likely will change as this bull market which started in 2009 has created equity prices in the US that are above historical fundamental standards. And whereas the US economy is now on a roll – evidenced by the best hiring stretch since the 1990s boom, record auto sales, unemployment falling to 5.8%, job openings near a 13 year high, and the number of Americans working surpassing its prerecession high – there are also significant headlines our global economy still faces. Some of these concerns include China’s slowing growth, Europe’s flirtation with recession, Russian instability, a US labor force participation rate that is near the lowest since the 1970s, US wage growth which remains weak, and US part-time workers that want, but can’t find, full-time work.

We would also like to point out how there is a relation to inflation and returns. When inflation is higher, expected returns are higher and vice versa. Inflation has averaged over 4% per annum over the last 40 years, e.g. a “balanced” portfolio with a historical nominal return may be around 7.3%, but adjusted for inflation, the real return is actually 3.1%. We are in a hugely different inflation environment now where inflation is much lower, hence expected returns will also be lower. Our clients know first-hand that it is the real return that is they key and what it used for their planning scenarios.

In conclusion, now perhaps more than ever is a good time to be working with a wealth manager to keep you on track to reach your long-range goals and to prevent you from taking on unnecessary risk, like loading up in any one stock or investment style. Investing is like a marathon. You want to be well prepared, resilient, disciplined and focused in order to complete the long race. Sprinting, like short-term investing or investing in the latest fad, is really a different sport entirely, and for a lot of people, a way to quickly hurt themselves. Just as a marathoner in training benefits from a good running partner or coach, your long term results can be enhanced with the right financial advisor.

Here’s to an excellent 2015.