As we enter the final quarter of 2014, we thought we’d take moment to reflect on how the year has evolved and share a few thoughts on our current investment thesis.
The financial pundits often voice worries about the month of October being a bad one for equity markets but it’s actually September that tends to be the worst and the one we just finished was no exception. The S&P 500 index was down 1.4% while mid caps and small caps were down 4.55% and 5.37% respectively. Many foreign indexes were down as well with the MSCI ACWI ex US index down 4.84% for the month.
What should we take away from all this? Not much. Markets don’t go up forever and since they’re comprised of millions of individuals making their own decisions based on a combination of emotions and analysis, it’s not always easy to discern the reasons for these moves.
Short term movements are often the result of emotions but longer term market trends tend to follow earnings and economic growth. This is why it’s important to look for sectors that are improving rather than simply focusing on those that are thriving. We certainly don’t ignore areas of growth but we’re always looking for areas that are going from bad to less bad.
These days, foreign markets fit this trend. The US has been steady but stock prices are starting to get expensive. We’ve been maintaining our US equity positions but we are adding allocations to carefully chosen areas in the developed and emerging markets.
Europe has had its share of problems over the past several years but we are seeing some improvements and we are carefully deploying money in selected parts of the region. Emerging markets continue to be bifurcated with some countries like Argentina heading downhill and other places such as Indonesia experiencing tremendous growth in their middle class.
In short, we continue to practice diversification over trend following. This, of course, means we will always be wrong about something as it’s very unusual for all investments to go up (or down) at exactly the same time. A diversified portfolio will never be the top performer in any particular year because by definition this is impossible. There will always be something doing better.
In 2008 the best returns came from bonds while the S&P 500 was down 37%. 2007 saw emerging markets at the top of the list and then at the bottom in 2008. This year it’s been REIT’s that have been doing the best so far.
The name at the top of the list in each individual year will constantly change but our diversified approach aims to be somewhere in the middle on a consistent basis. Our clients need their portfolios to provide steady retirement income and we can’t be chasing the hottest sector or index.
With all that said, here’s how we see things at present:
- After seeing some improvement earlier in the year, Europe has had an economic setback due primarily to the crisis in Eastern Ukraine. Winter is coming and many Europeans are worried about energy supplies. We feel the European economy will slowly creep forward as Mario Draghi and the European Central Bank continue to provide their own version of QE to Europe.
- German 10 year bonds are yielding around 1% while the US Treasury Bond is in the 2.4% range. We think money will continue to flow to US Treasuries for the immediate future driving up bond prices and keeping yields lower for now. We will most likely need to transition to a rising rate/inflationary economic environment at some point in the future but we don’t see this happening anytime soon.
- This influx has also driven up the value of the USD vs. the Euro making it less advantageous for us to make unhedged investments in foreign markets and Europe in particular. We aren’t eliminating or even reducing our foreign exposure but we are moving funds to managers and ETFs that hedge their currency exposure.
- Finally, the US economy continues to improve and for now, we’re the main engine of global economic growth. Despite this, small and mid-cap stocks in the US are substantially under performing the larger companies. We feel that an overweight allocation to the highest quality large cap stocks continues to be a prudent move.
We have no doubt Q4 will bring its share of surprises. The overall general trend these days seems to be 2 steps forward and one step back. We’ve often talked about the US having a “plow horse” economy that moves forward slowly but gets the job done.
Of course, we have more than our fair share of worries. ISIS, Ebola, computer hackers and a host of other things fill newspaper headlines but we are seeing lower unemployment and higher corporate earnings in the aggregate. We expect this current trend of excessively low interest rates and slow economic growth to continue for some time into the future.
The Takeaways:
Patience isn’t just a virtue; it is a key component to successful investing.
Here in the US, our economy is shifting from one psychologically dependent on extremely generous monetary and fiscal policy to one that can stand on its own. This transition will take some time and volatility will accompany the process.
Outside of the US, investors need to remain patient and remember that the dominant performance of US financial markets won’t last forever. Valuations, dividend yields, and central bank policies favor an allocation to overseas assets at the moment. Trends change slowly and the trend of US leadership won’t stop on a dime.
Maintaining a diversified portfolio and not succumbing to “what’s working now” will help protect and grow assets over the long term. It isn’t always flashy. In fact, it’s never flashy but it works.
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