Shifting Sands

January 13, 2015

Printer-Friendly Version

Baseball is a funny sport. Just when you thought you have seen everything, something happens in the course of a game that has never happened in the history of the sport. The same could be said for the stock market. Case in point was the first week of 2016. In the United States, the Dow dropped 6.1%, the S&P 500 6.0% and the Nasdaq 7.3% all in one week, making the decline the worst on record for the start of a year. U.S. markets were heavily impacted by a weak Chinese stock market and a devaluation of their currency. China has been in the global market spotlight for much of 2015 and certainly carried over into 2016. Whatever the case for the decline in the first week, this is a good reminder that bear markets happen!

Statistically speaking a bear market occurs once prices decline at least 20% from their peaks. On average, a bear market has occurred about every 3.5 years. Our last bear market in the U.S. was nearly 8 years ago meaning we are more than due for a bear market. The actions of the Federal Reserve keeping interest rates low has certainly had an impact on keeping the stock market afloat.

One of my favorite writers, Ben Carlson recently wrote an article discussing truths about bear markets. Below are some excerpts from his article as he discussed bear markets.

“They happen. Sometimes stocks go down. That’s why they’re called risk assets. Half of all years since 1950 have seen a double-digit correction in stocks. Get used to it.”

“They’re a natural outcome of a complex system run by emotions and divergent opinions. Humans tend to take things too far, so losses are inevitable.”

“Buy and hold feels great during a long bull market. It only works as a strategy if you continue to buy and hold when stocks fall. Both are much easier to do when stocks rise.”

“These are the times that successful investors separate themselves from the pack. Most investors mistakenly assume that you make all of your money during bull markets. The reason so many investors fail is because they make poor decisions when markets fall.”

Are the sands shifting towards a bear market for stocks in the United States? No one really knows. Whether or not we are in for our next bear market in 2016, it’s important for investors to understand and be prepared for the next bear market. Tried and true investing disciplines help during difficult markets:

  • Don’t panic. Keep a long term perspective relative to your stock holdings. Remind yourself that stocks are volatile assets and will go up and down more often than bonds and cash.
  • Continue to invest on a regular monthly basis. As stocks decline, you’ll be buying at lower prices.
  • Rebalance your portfolio. If the market drops 20% that usually means your allocation to stocks has also dropped 20% and your allocation to bonds or cash has increased 20%. Selling the winners, in this case bonds, and buying the losers, allows you to again take advantage of lower stock prices.
  • Keep an eye on international stocks and bonds and ensure proper allocation globally in a portfolio.

Federal Reserve Actions in 2015

The sands began to shift in the global economy in 2015 as the Federal Reserve lifted interest rates off zero for the first time since the Great Recession. The Fed had signaled its intentions to raise interest rates in 2015, but insisted they would only do so if the economic data improved. To the surprise of some, they chose not to raise interest rates during their September meeting. The Fed cited “tightened domestic financial conditions” among other reasons they did not raise rates in September. It was ironic that they chose to raise interest rates in December as “financial conditions” appeared to be tighter since that time. From the September meeting to the December meeting the Goldman Sachs Financial Conditions Index declined along with S&P 500 profit margins, high-yield bonds, inflation and other financial measures. I suspect the Fed raised in December to maintain credibility as they said they would raise rates at some point in 2015.

The Fed is now the only Central Bank in the major advanced economies to begin to tighten monetary policy. The Fed has signaled four additional rate hikes in 2016. The market is pricing in only two rate hikes. The Fed certainly faces challenges as it attempts to normalize monetary policy amidst a weakening global economy. Europe and Japan continue to fight slow growth and deleveraging while China fights lower economic growth, a volatile stock market, and managing its currency, the renminbi.

Clearly, low interest rates forever is not the solution as evidenced by Japan since the late 1980’s. The Fed knows that it must raise interest rates. Transitioning interest rates or in this case, the Federal Funds Rate, from zero to 3% or so will be a driving force in markets and the economy for the reminder of the decade.

Global Markets in 2015

It was a very difficult year to be an asset allocator. As shown below, most asset classes registered small to negative returns in 2015.

U.S. stocks rebounded in the fourth quarter to finish the year up 0.5%. Large cap growth stocks outperformed large cap value stocks. Large cap stocks also outperformed mid and small cap stocks.

International developed stocks declined slightly ending down 0.8%. Volatility was felt much more in emerging market stocks as that market fell 15% on the year. Lower commodity prices had an impact on emerging market stocks. Crude oil dropped 45% leading the Bloomberg Commodity Index to a 25% decline on the year. As can be expected with weak commodity prices, the US dollar strengthened on the year, up 7%.

The global bond market retreated 3.2% on the year while U.S. bonds edged up 0.6% on the year. Municipal bonds continued to shine up 3.3% on the year. High-yield corporate bonds declined 4.5% impacted by a large decline in energy prices. Emerging market local currency bonds were impacted by a strong dollar and registered a 10.4% decline on the year.

Looking Ahead

Valuations in U.S. stock and bond markets have risen over the past 8 years. Predicting market returns is a fool’s errand. However, looking at long term historical rates of return and current prices relative to long term returns can give investors some idea of current valuations in markets. Given very strong performance over the past 8 years for markets in the United States, valuations appear stretched. Does this mean investors should run out and sell their domestic stocks and bonds? No! However, investors should remember that we live in a global marketplace and their portfolios should reflect this fact.

In the chart below, I have listed recent performance for major asset classes along with a projected 10-year average annual nominal return for each market. The projected returns come courtesy of Research Affiliates. Investors that keep a domestic focus have the potential for lower projected returns. A balanced portfolio of 60% U.S. stocks and 40% U.S. bonds is projected to provide investors with only a 3.5% average annual return over the next 10 years. To put 3.5% into context, for the past 50 years, this same allocation has returned roughly 8% per year on average. Taking a 2.5% inflation projection into account, a 3.5% number drops to 1% real return.

It’s only natural that the asset classes that have performed poorly over the past 10 years may be poised to provide better returns for the next 10 years. Emerging market stocks and bonds along with international developed stocks and high-yield corporate bonds are at the top of that list. The point of this exercise should remind investors to stay diversified and rebalance portfolios on a regular basis. U.S. markets may be in for a bear market in the near future, but don’t forget that are many other opportunities globally for long-term oriented investors.

References

A Wealth of Common Sense – Ben Carlson.

Research Affiliates Expected Returns as of 12/31/2015.

DISCLOSURES & INDEX DESCRIPTIONS

For disclosures and index definitions please click here.

Relative to the chart listing expected returns. As of 12/31/2015. Source: These expected returns are calculated by Research Affiliates LLC using data provided by MSCI Inc., Bloomberg, and Barclays. These forecasts are forward-looking statements based upon the reasonable beliefs of RA and are not a guarantee of future performance. This content is not investment or tax advice or an offer, sale or any solicitation of any offer to buy any security, derivative or any other financial instrument. The use of the content is subject to important disclosures, disclaimers and provisions found at www.researchaffiliates.com/Pages/Legal.aspx.

comments powered by Disqus