Monthly Market Commentary

February 2015

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On the heels of 2014's strong rally for U.S. large caps, 2015 started with a decline for the S&P 500 and a jump in market volatility. Larger company stocks fell 3% in January and smaller company stocks declined by a similar amount. We don't claim to have any particular insight on what drives stock performance over the very short term, but some of the factors that appeared to influence equities included disappointing earnings and economic growth. 

 

International stocks were more resilient than U.S. markets with developed international stocks coming in with a slight gain while emerging-markets equities were only slightly negative.  Treasury yields again defied general expectations and fell during the month. The core bond index rose 2% - its best January return in 27 years. Once again, very low bond yields across global markets and falling inflation expectations served to boost the attractiveness of U.S. Treasuries.

 

Not surprisingly, one month's market results and economic indicators haven't impacted our longer-term views. Mainly, we see January's constellation of news and events as further indicators of the complex economic and investment environment we continue to navigate.  We are not surprised to see market ups and downs. At the same time, our longer-term analytical framework puts us in a good position to capitalize on opportunities created by short-term volatility via our ongoing rebalancing activities.

 

Chasing Performance is a Mug's Game

 

One question we've received lately is "why has my portfolio not kept up with the S&P 500"? The short answer is that the S&P 500 (a proxy for US large cap stocks) represents only a portion of the globally diversified portfolios that we manage. But, we digress and invite you to look at the graphic below which showed up in Ben Carlson's A Wealth of Common Sense blog on January 2, in a piece titled "Updating my favorite performance chart."  

 

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If there were a consistent pattern in asset class performance, this colored chart would be a good way to recognize it. Think about the events of those years. Do you see any pattern to exploit? Even during times of great economic turmoil, many asset classes will have positive returns. A crisis of some kind may result in some or many equity asset classes turning negative, but how do you know which ones? For how long? This appears to be random - which is precisely the point.

 

What the periodic table illustrates is the randomness of relative performance from one year to the next.  And it is not merely the randomness but the extreme volatility thereof which captures the imagination. We need look no further than the emerging markets category in the chart to get the full effect of this.

 

This particular iteration of the periodic table shows that over the last ten calendar years (2005-2014), emerging markets have been the top performing equity sector four times-and the very worst sector twice. Indeed, two years in which emerging markets led all equity sectors-2007 and 2009 - actually bracket a year (2008) in which it finished dead last. And the other year in which it was the worst performing sector, 2011, was immediately followed by its finishing on top in 2012.

 

One can go on and on like this - though admittedly not to these extremes.  Yet, it might be noted that what the media constantly refers to as "the market":  large cap US stocks did not have a single year as the top performer.  The point is that we simply have no idea what sectors are going to outperform from one period to the next - the periodic table demonstrates that this is not knowable in advance.  

 

What we do know is that there is no statistical evidence for the persistence of outperformance. (Nor, for that matter, of underperformance: just before you short oil at $50, cast a weather eye over the commodity sector on the periodic table. It's next to last in 2011 and then dead last in every one of the three following years, to the point where it has the absolute worst annualized return for the ten years. This is not to say that oil is a "bad investment", it can be quite the opposite. In that regard, you might find this story about Harold Hamm, an Okie who struck it rich in the oil patch, interesting.

 

So, it is precisely the randomness of performance which moves us to diversify. And, effective diversification simply means that you'll never own enough of any one sector/idea to make a killing in it, nor enough to get killed by it.

 

Diversification and Discipline: Easy in Theory, Hard in Practice

 

Diversification sounds good in theory, but is very difficult to maintain in practice, because investors do not react well when parts of a portfolio perform poorly. Diversification requires that investors own the worst asset classes as well as the best at all times. Emotionally, investors hate owning things that perform poorly, and always feel like they do not own enough of what has performed well. It is harder still to maintain the practice of selling what has gone up and buying what has gone down through disciplined rebalancing. Research shows that very few individual investors can maintain the discipline required to capture the long-term returns that come from diversification.

 

For most investors, there is a gap, known in finance as the "behavior gap", which keeps average investor returns far below market returns (the most recent Dalbar study shows the gap of 9.22%/year S&P 500 returns over the past 20 years for the market vs. 5.02% for investor returns).  That difference means that instead of $100,000 turning into $583,503 over 20 years, the average investor only turned it into $266,342, losing over 50% of their potential wealth. This was primarily due to emotional investing as opposed to disciplined rebalancing by "selling high, and buying low".  Being sucked in by past performance is known as recency bias by behavioral finance researchers.

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We are trained to think short-term and follow the herd in investing when winning in the long-term is all about perspective, discipline and diversification, not what happened previously. This is why long-term results and returns accrue to those of us who can ignore the short-term noise and focus on maintaining a steady and disciplined process.

 

At Align, we have set up processes that maintain objectivity and discipline in our investment and avoid second-guessing and making mistakes.  We introduce disciplined rules, where investors natural behavior would make them want to run away from down periods and chase the latest trend (Think how hated international stocks are right now, or US stocks in the 2000s, or non-internet value stocks in the late 90s).

 

Why International Diversification Remains Important

 

Let's make the conversation relevant using recent market returns for our example. For five years (Jan 2010-Dec 19, 2014), investors have generated phenomenal performance from US equities, but much less out of international equities (105.70% vs. 23.05%).

 

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Many investors are frustrated with international investing and are wondering why we even bother. A great article on global diversification by Ben Carlson was cleverly titled - "Accepting Good Enough to Avoid Terrible".  For those who don't want to read the whole article, the reason that we invest globally is because we do not know the future. And if the future holds a Japan-like situation (where local equity markets are down 50% from 1990-2014) for the US markets or even something less severe, diversification will save us (and our retirements).

 

We actually saw this play out in a much less severe situation from 2000-2009. US markets over that time period were basically unchanged, but a 60% equity/40% bond allocation that had the global allocation in stocks more than doubled in the same time. It was only a "Lost Decade" for non-diversified portfolios.

 

US and international markets are not perfectly correlated. This means that a properly executed diversified portfolio will be consistently rebalanced by selling high and buying low (at the end of 2014 this meant mostly selling US to buy international) and over the long-term will generate higher than average returns through the "diversification return".  This means higher expected returns accrue to those investors who can avoid "recency bias" and can maintain discipline to international equities.

 

It harkens back to the famous Warren Buffett quote, "Be Fearful When Others Are Greedy and Greedy When Others Are Fearful". If you are a long-term investor, discipline and diversification would suggest being greedy about international markets and fearful about US markets rather than the other way around. 

 

In summary, we believe our globally diversified asset allocation strategy is a prudent way to manage your investments in volatile markets. Each asset class we invest in includes hundreds of stocks and bonds such that, in a fully diversified portfolio, a typical client owns more than 12,000 stocks and bonds in companies and governments across 50 countries around the world. And, everything is continually monitored to take advantage of rebalancing opportunities whenever and wherever they come.

 

As always, we welcome the opportunity to explore your particular goals and investments in light of this and any other market climate. 

Thanks for taking a look.  Please contact us with any questions whatsoever. We're here to help.

 

Sincerely,

  





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