Looking back on 2014, people are going to say it was a great year to be an investor.
They won’t remember how uncertain the journey felt right up to the last day of a year that saw the S&P 500 close at a record level on 53 different days. Think back over a good year in the market. Was there ever a time when you felt confidently bullish that the markets were taking off and delivering double-digit returns?
The Wilshire 5000–the broadest measure of U.S. stocks and bonds—finished the year up 13.14%, on the basis of a strong 5.88% return in the final three months of the year. The comparable Russell 3000 index will go into the history books gaining 12.56% in 2014.
The Wilshire U.S. Large Cap index gained 14.62% in 2014, with 6.06% of that coming in the final quarter. The Russell 1000 large-cap index gained 13.24%, while the widely-quoted S&P 500 index of large company stocks posted a gain of 4.39% in the final quarter of the year, to finish up 11.39%. The index completed its sixth consecutive year in positive territory, although this was the second-weakest yearly gain since the 2008 market meltdown.
The Wilshire U.S. Mid-Cap index gained a flat 10% in 2014, with a 5.77% return in the final quarter of the year. The Russell Midcap Index gained 13.22% in 2014.
Small company stocks, as measured by the Wilshire U.S. Small-Cap, gave investors a 7.66% return, all of it (and more) coming from a strong 8.57% gain in the final three months of the year. The comparable Russell 2000 Small-Cap Index was up 4.89% for the year. Meanwhile, the technology-heavy Nasdaq Composite Index gained 14.39% for the year.
While the U.S. economy and markets were delivering double-digit returns, the international markets were more subdued. The broad-based EAFE index of companies in developed economies lost 7.35% in dollar terms in 2014, in large part because European stocks declined 9.55%. Emerging markets stocks of less developed countries, as represented by the EAFE EM index, fared better, but still lost 4.63% for the year. Outside the U.S., the countries that saw the largest stock market rises included Argentina (up 57%), China (up 52%), India (up 29.8%) and Japan (up 7.1%).
Looking over the other investment categories, real estate investments, as measured by the Wilshire U.S. REIT index, was up a robust 33.95% for the year, with 17.03% gains in the final quarter alone. Commodities, as measured by the S&P GSCI index, proved to be an enormous drag on investment portfolios, losing 33.06% of their value, largely because of steep recent drops in gold and oil prices.
Part of the reason that U.S. stocks performed so well when investors seemed to be constantly looking over their shoulders is interest rates—specifically, the fact that interest rates remained stubbornly low, aided, in no small part, by a Federal Reserve that seems determined not to let the markets dictate bond yields until the economy is firmly and definitively on its feet. The Bloomberg U.S. Corporate Bond Index now has an effective yield of 3.13%, giving its investors a windfall return of 7.27% for the year due to falling bond rates. 30-year Treasuries are yielding 2.75%, and 10-year Treasuries currently yield 2.17%. At the low end, 3-month T-bills are still yielding a miniscule 0.04%; 6-month bills are only slightly more generous, at 0.12%.
Normally when the U.S. investment markets have posted six consecutive years of gains, five of them in double-digit territory, you would expect to see a kind of euphoria sweep through the ranks of investors. But for most of 2014, investors in aggregate seemed to vacillate between caution and fear, hanging on every economic and jobs report, paying close attention to the Federal Reserve Board’s pronouncements, seemingly trying to find the bad news in the long, steady economic recovery.
One of the most interesting aspects of 2014—and, indeed, the entire U.S. bull market period since 2009—is that so many people think portfolio diversification was a bad thing for their wealth. When global stocks are down compared with the U.S. markets, U.S. investors tend to look at their statements and wonder why they’re lagging the S&P index that they see on the nightly news. This year, commodity-related investments were also down significantly, producing even more drag during what was otherwise a good investment year.
But that’s the point of diversification: when the year began, none of us knew whether the U.S., Europe, both or neither would finish the year in positive territory. Holding some of each is a prudent strategy, yet the eye inevitably turns to the declining investment which, in hindsight, pulled the overall returns down a bit. At the end of next year, we may be looking at U.S. stocks with the same gimlet eye and feeling grateful that we were invested in global stocks as a way to contain the damage; there’s no way to know in advance.
Is a decline in U.S. stocks likely? One can never predict these things in advance, but the usual recipe for a terrible market year is a period right beforehand when investors finally throw caution to the winds, and those who never joined the bull market run decide it’s time to crash the party. The markets have a habit of punishing overconfidence, but we don’t seem to be seeing that quite yet.
What we ARE seeing is kind of boring: a long, slow economic recovery in the U.S., a slow housing recovery, healthy but not spectacular job creation in the U.S., stagnation and fears of another Greek default in Europe, stocks trading at values slightly higher than historical norms and a Fed policy that seems to be waiting for certainty or a Sign from Above that the recovery will survive a return to normal interest rates.
On the plus side, we also saw a 46% decline in crude oil prices, saving U.S. drivers approximately $14 billion this year.
The Fed has signaled that it plans to take its foot off of interest rates sometime in the middle of next year. The questions that nobody can answer are important ones: Will the recovery gain steam and make stocks more valuable in the year ahead? Will Europe stabilize and ultimately recover, raising the value of European stocks? Will oil prices remain low, giving a continuing boost to the economy? Or will, contrary to long history, the markets flop without any kind of a euphoric top?
We can’t answer any of these questions, of course. What we do know is that since 1958, the U.S. markets, as measured by the S&P 500 index, have been up 53% of all trading days, 58% of all months, 63% of all quarters and 72% of the years. Over 10-year rolling time periods, the markets have been up 88% of the time. These figures do not include the value of the dividends that investors were paid for hanging onto their stock investments during each of the time periods.
Yet since 1875, the S&P 500 has never risen for seven calendar years in a row. Could 2015 break that streak? Stay tuned.
Volatility is up. So what?Professional investors know something that most people find impossible to believe: that the threat of scary ups and downs in the markets is by far the best friend of the long-term investor. Why? Because over the long term, stocks have provided returns far higher than bonds or cash. If it weren’t for the occasional dizzying gyrations, any rational investor would put his or her money where the highest returns have been. Right?
This appears to be one of those times–a time when non-professional investors are reminded of the reasons why they have this lingering fear of the stock market. Since the end of September, the S&P 500 index has done something regularly that it normally does infrequently: moved more than a full percent up or down in a single day. Consider the recent pattern this month:
Contrast this to the calm before the storm: earlier this year, the markets experienced 42 consecutive days without a single 1% price move, and the accompanying chart shows that this is far from the record.
The question we should be asking ourselves is: why are we paying such close attention to daily market movements? Why are we allowing ourselves to fall for the trap of getting anxious over short-term swings in stock prices?
The second chart shows the growth of a dollar invested in the S&P 500 at the beginning of 1950, with dividends reinvested, compared with a variety of alternative investments which have not provided the same returns. (Note that small cap stocks, which are more volatile, have done even better.) The chart also shows all the scary headlines that the markets managed to sail through on the way to their current levels–all of which are scarier than the things we’re reading about today.
This is not to say that the markets won’t go lower in the coming days, weeks or months; in fact, we are still awaiting that correction of at least 10% which the markets delivery with some regularity on their way to new highs, which has been long-delayed in this current bull market. The thing to remember is that the daily price of your stock holdings are determined by mood swings of skittish investors whose fears are stoked by pundits and commentators in the press, who know that the best way to get and hold your attention is to scare the heck out of you. What they don’t say, because it’s boring, is that the value of your stock holdings are determined by the effectiveness of millions of workers who go to work every day in offices and factories, farms, warehouses, power plants and research facilities, who slowly, incrementally, with their daily labor, build up the value of the businesses they work for.
The last time we checked, that incremental progress hasn’t stopped. The economy is still growing. You won’t get a daily report on the value of the stocks you own; only the daily, changing opinions of skittish investors. But if you take a second look at the growth of an investment in stocks over the long-term, you get a better idea of how that value is built over time, no matter what the markets will do tomorrow.
Third Quarter Investment Report: Moving Into Choppy Waters
You could say that the markets took a breather in the third quarter of 2014, but you would come to that conclusion only if you looked at the overall returns and ignored the drama of the past 30 days. The markets experienced a difficult month of September, giving up some of the gains from the prior eight months and causing investors to worry that we’re about to experience more of the same. The end of the month was especially difficult, with a general market slide starting September 22, and some indices dropping more than 1% on the final day.
The Wilshire 5000–the broadest measure of U.S. stocks and bonds–rose a meagre 0.37% for the third quarter even as it lost 1.71% in September. But the index is hanging on to a 7.26% gain for the year. The comparable Russell 3000 index was essentially flat in the third quarter, which means it is still holding onto a 6.95% year-to-date gain with three months to go in 2014.
Large cap stocks were the market leaders over the past three months, but the gains were modest. The Wilshire U.S. Large Cap index gained 1.13% in the second quarter, and is now up 8.38% so far this year. The Russell 1000 large-cap index eked out a positive 0.70% return for the quarter, but is still provides 7.97% gains so far the year. The widely-quoted S&P 500 index of large company stocks posted an even smaller gain of 0.60% for the quarter. The index is up 6.7% since January 1, but it has fallen back from its record highs on September 18.
The news was less happy for smaller stocks. The Wilshire U.S. Mid-Cap index lost 3.54% in the third three months of the year, and is clinging to a 4.99% gain so far into 2014. The Russell Midcap Index fell 1.55% for the quarter (posting a 3.34% loss in the month of September), but still stands at a 6.87% gain overall since the first of the year.
Small company stocks, as measured by the Wilshire U.S. Small-Cap, fell 4.98% in the third quarter (4.38% in September alone), but the index is hanging onto a positive 0.44% return heading into the year’s home stretch. The comparable Russell 2000 Small-Cap Index fell 7.60% in the third quarter, representing its worst quarter in three years–and is now down 4.40% so far this year. Meanwhile, the technology-heavy Nasdaq Composite Index managed to gain 2.45% for the quarter, and is up 7.88% for its investors so far this year.
The rest of the world put a drag on diversified investment portfolios. The broad-based EAFE index of companies in developed economies fell 6.39% in dollar terms during the third quarter of the year, and is now down 3.63% so far in 2014. The stocks across the Eurozone economies contributed to the foreign stock slide, dropping 7.37% for the quarter, but the red ink spilled over to most of the foreign indices in Asia as well. Ironically, the emerging markets stocks of less developed countries, as represented by the EAFE EM index, represented a bright spot, losing “only” 4.33% over the last three months, and is still up 0.26% so far this year.
Looking over the other investment categories, real estate investments, as measured by the Wilshire REIT index, fell 2.54% for the quarter, but the index is standing at a robust 15.08% gain for the first three quarters of the year. Commodities, as measured by the S&P GSCI index, fell 12.46% this past quarter, and now sit at a loss of 7.46% for the year.
The expected rise in bond rates never materialized, confounding the experts yet again. The Bloomberg U.S. Corporate Bond Index now has an effective yield of 3.07%, while Treasury rates held steady. 30-year Treasuries are yielding 3.20%, and 10-year Treasuries currently yield 2.50%. At the low end, 3-month T-bills are still yielding a miniscule 0.02%; 6-month bills are only slightly more generous, at 0.04%.
Nobody seems to have a convincing explanation for the recent stock market slump. The economy still seems to be pushing along in a long slow, steady growth process, and corporate earnings are well-above historical averages. Oil prices are at their lowest level since November 2012, consumer spending has rebounded, and although the Fed will cease its bond purchases this month, there is no indication that it is going to sell its inventory back on the market, and its policymakers are projecting low interest rates well into 2015. Corporate cash at larger corporations is near an all-time high.
But pullbacks don’t always reflect reality. They are also affected by the sentiment of investors–in other words, human emotions and a crowd (or herd) mentality. Investors seem to be worried that stocks are overdue for a correction, and if these things operated on a schedule, they would be right. We are in the fourth-longest bull market since 1928, without having experienced even a small 10% correction since 2011. The Conference Board reported that U.S. Consumer Confidence slipped dramatically, and unexpectedly, in September, lending some credibility to the surmise that the investing herd has been startled–and their expectations appear to be creating market reality.
The best (although imperfect) way to chart investor sentiment is via the VIX Index, which measures the volatility of the market by tracking the behavior of S&P 500 index options. When the VIX spikes, it means that investors are excited or scared–as they seem to be now.
The interesting thing about the long-term VIX chart–shown here starting in the third quarter of 2007, is the heartbeat-like rhythm of the spikes and drops, as if people get nervous in a kind of pattern. The 2008-2009 market meltdown shows up in the enormous spike toward the left, but if you let your eyes move to the right, you can see that volatility has been pretty moderate since the end of 2012. Maybe it’s just time for the “heart” that represents how investors feel about the markets to give another tick.
Does that mean we should take action? Unfortunately, nobody knows whether the markets are poised to act on the good economic news and move up, or are ready for another fearful selloff that would finally deliver that long-delayed correction. History tells us that it’s a fool’s game to try to anticipate market corrections, and that investors usually get rewarded for sailing through choppy waters, rather than jumping off the ship when the waves get higher.
You can’t know in which direction the markets will experience their next 10%, 20% or 30% move. But unless you believe the world is about to end, you do know, with some degree of certainty, in which direction it will make its next 100% move. That’s the best prediction of the markets you’re likely to get, even if it doesn’t come with a timetable.
Financial advisors and the investment community were shocked this past Friday when Bill Gross, sometimes referred to as “the bond king” resigned from Pimco, a firm he founded in 1971 that rose to become one of the largest mutual fund management firms in the world. Gross also served as fund manager for the $221.6 billion Pimco Total Return fund, and made frequent television appearances.
Although the move was surprising, it was not hard to find reasons for the departure. The Total Return Fund had seen investor redemptions totaling $68 billion in the past 16 months, and more recently, Gross has been under investigation by the Securities and Exchange Commission on a charge that an exchange-traded fund he was managing had illegally inflated its performance numbers. Prior to that, Gross publicly feuded with the man regarded as his successor, Mohammed El Erian, who had become a public face of Pimco with his book outlining a “New Normal” in the investment landscape.
Gross has taken a new position at Janus Capital Group, where he will manage a new fund called Janus Global Unconstrained Bond Fund in a new Janus office to be opened near his home in Newport Beach, CA. Some have speculated that investors will pull more money out of the Total Return Fund and follow Gross over to the new fund, where Gross will have the total control that he sought, and was denied, in his later years at Pimco.
Meanwhile, Pimco seems to be in good hands, with Gross succeeded by Daniel J. Ivascyn, formerly deputy chief investment officer. The Total Return Fund will be managed by longtime Gross associates Mark Kiesel, Scott Mather and Mihir Worah.
What are we to make of all this? Today’s mutual funds are typically managed under a team approach. Gross was a throwback to an era when one manager would call all the shots and be rewarded (or not) according to whether his performance exceeded the market. Over time, it became obvious that he was impatient with consensus decision-making, which simply means he was out of step with modern fund management styles. It will be interesting to see if he is able to reproduce his (generally excellent) long-term track record in a more competitive market, particularly during this time period when the bond market has been dependent on Federal Reserve stimulus, which is winding down going into next year. Many advisors benefited from Gross’s investment talents, but some are also undoubtedly happy to see Pimco Total Return managed in a more collaborative atmosphere.
Here at Summit, we have avoided using PIMCO funds because of apparent leverage and opaqueness of their holdings.
Don’t Fear the CorrectionAt of the end of June, the Standard & Poors 500 index has completed 32 full months without a correction of 10% or more. We are living in a remarkably long bull market; the average time span without a full-blown correction is just 18 months. Since the last correction in September of 2011, the S&P 500 has gained 75%, threatening the remarkable 100% advance that began in March of 2003 and lasted until the market peaked in October of 2007.
Today, as the S&P moves near the 2,000 level, as the small cap Russell 2000 and the Nasdaq index both reach record highs, it may be a good time to prepare for that inevitable correction down the road. It may take the market down 10% or, worse, reach the technical definition of a full market correction, which is a downward move of 20% or more.
Prepare how? First, it helps to recognize that every market has pullbacks, and that these are a normal part of stock market behavior. Since the Great Recession lows in March 2009, the S&P index has experienced nine different corrections, ranging in magnitude from 6% to more than 21%.
Second, it helps to recognize that these pullbacks are almost totally unpredictable. Knowing there will be a pullback doesn’t tell us when or help us maximize returns. If we take money out of the market today, on the certainty that a pullback is coming, we are just as likely to miss another year or two of upward movements as we are of sidestepping an immediate downturn. Nor do we know how long the downturn will last. Add in trading costs and taxes, and the decision to guess when to step out of the market, and back in gain, is not likely to add value in the long run.
Third, recognize now that the next unpredictable correction will look blindingly obvious in hindsight. It will seem like everybody but you knew in advance what was coming and when. In reality, what you’ll be hearing is reporters quoting the same few people over and over again, people who confidently predicted that a downturn was nigh and turned out to be right. Look a bit more deeply than the reporters do, and you’ll find that this small number of people had been predicting that the end was nigh over and over and over again for years.
Finally, realize that inaction is actually taking strong and unusual action. People who simply kept their money in stocks during each of the market downturns ended up seeing the indices reach new highs once the correction had run its course. Strong long-term investors benefit from the incremental daily, weekly, monthly efforts of millions of workers who come into the offices, factories and warehouses and build the value of their companies.
People will change their opinions about what stocks are worth, but in general, over time, the value of most companies will rise to the extent that those workers add value during their workdays. When people lose faith in that value, as they will when the next correction hits, it will put stocks on sale and give the rest of us an opportunity to buy in at lower prices–if we have the courage to separate ourselves from the herd.