"The smart person accepts; the idiot insists."
--Sign on Father Arsenios' door at Vatopaidi Monastery in Greece.
Happy New Year! I hope your holidays were enjoyable and that 2016 is off to a good start (this week's market gyrations notwithstanding). Let's start this quarterly commentary with a quiz. (You can come back after you complete it. It's very short.)
So, quiz results in hand, the 4th quarter was a positive one for most clients, with invested portfolios typically up between 1% and 3% for the quarter, depending on equity exposure and a few other factors. 2015, in its entirety, however, was a year of pretty widespread disappointment in most asset classes and for most investors at both the individual and institutional level. It was a year in which not much worked:
- US large value companies were down
- US small value and growth companies were down
- Europe - broadly speaking - was down, although there were exceptions (see answers to the quiz
- Gold fell 11%
- Oil plummeted more than 30% to lows (as I write this) not seen since 2004
- And, the icing on the cake: most bond categories - including US Treasuries - with durations longer than 10 years were negative. (Even in 2008/2009, bonds were up, so this made 2015 an especially disappointing year, as neither stocks nor bonds provided much portfolio lift this year.)
Here's a selection of various indices / asset classes that does a pretty good job painting a picture of a relatively disappointing year for most asset classes around the globe:
|Asset Class||Q4 Return||2015 Return|
|Emerging Markets||+ 0.79%||-14.92%|
|Bershire Hathaway (Warren Buffett)||+ 1.31%||-12.48%|
|US Small Companies||+ 3.59%||- 4.41%|
|30-Year US Treasuries||- 2.09%||- 3.20%|
|US Large Value Companies||+ 6.05%||- 3.13%|
|European Companies||+ 2.49%||- 2.84%|
|International Companies (EAFE Index)||+ 4.71%||- 0.81%|
|US Large Companies (Dow Jones Industrial Average)||+ 7.70%||+ 0.21%|
|US Large Companies (S&P 500)||+ 7.04%||+ 1.38%|
|Asia Pacific Region (Developed Countries)||+ 9.00%||+ 2.96%|
|International Small Companies (Broad Index)||+ 6.79%||+ 9.59%|
Marketwise, 2015 looked very much like too many of the Broncos' games this year (especially the 34-27 loss to the Steelers at Heinz Stadium): a reasonably strong first half, followed by a pretty poor showing in the third quarter. After posting positive returns through most of June, we then ran into the buzz saw that was Greece's never-ending debt crisis, China's slowing economy, August's 1000-point Dow Jones "flash crash", and finally, oil's precipitous drop that was indicative of too much oil and too little economic demand globally. Most of the damage in markets actually occurred in the 3rd quarter, not the 4th, with Q4 actually up for most clients and most asset classes.
Here were some of the big themes for the year:
Greece: I wrote about this extensively in my second quarter July commentary, and will spare you the repeat here. Suffice it to say, despite the gnashing of teeth and the hair pulling - and the very real impact, I am sure, on the average Greek citizen, this ended up being mostly a non-event in the ultimate market outcomes for 2015, but was probably more a symptom of the pervasive and general economic anxiety that was with us for the second half of the year. (It was a very bad year for Greek stocks, by the way: down 61% in US dollar terms.)
China: This was the big topic in my 3rd quarter commentary, and unlike the goings-on in Greece, the issues in China are very real, as China - like the US - is a global economic bellwether. China's economic slowdown - partly endogenous, partly exogenous - to something like 5% GDP growth (vs. ours at hopefully +3%) is a big problem internally, as it has oft been cited that China needs at least 7%, if not closer to 9%, GDP growth, just to keep the wheels on given their population demographics. More importantly, their slowdown is indicative of a broader global slowdown in economic activity and trade. Maersk, the Danish shipping company and the largest cargo-carrier in the world, twice last year lowered its expectation for shipping volume, which of course, is a proxy for global trade activity. Interestingly enough, despite China's huge disappointment in its 2015 economic growth and a precipitous plunge from its early-year market highs, its stock market ended up producing returns of between 7% and 9%, depending on which index you look at (the Shanghai A shares Composite and the Shenzhen Stock Exchange, respectively).
Oil: Like China, this is one of of those things about which you might ask, "And this hurts me how exactly?" Wouldn't lower gas and fuel prices be a good thing? At face value they are, and the price drop we've seen is akin to a $300 billion US federal and payroll tax cut in terms of the money it's put back into the pockets of US consumers. There are two factors that have driven the 50% drop in oil prices: a continuing supply glut as OPEC (read: the Saudi's) have refused to cut supply in an effort to drive low cost producers (read: US shale producers) from the market. This, along with a waning demand for oil due to slower trade and economic activity, has conspired to drive oil down to less than $35/bbl, a level not seen since 2004. (Side note: I can vividly remember oil hitting $144/bbl in Summer 2007, prior to the Great Recession, with seemingly everyone clamoring to own either more oil or more green energy stocks - or both. Hmmm…don't like the weather in Colorado? Wait long enough - and sometimes not that long at all - and things do change, don't they?) The bigger issue with oil is not the price drop itself, but rather what it says about the outlook for global economic activity, and what it's saying at the moment is "slow traffic ahead." Oil's price drop did unquestionably have a very negative impact on emerging markets as so many of those economies are tied to oil and other commodity prices. The good news on this front, if there is any, is that one has to think that at $35/bbl, it's getting close to its probable low, and any rebound is likely to have a buoying effect on emerging market economies and their stocks.
Interest Rates: There was much discussion and wringing of hands about whether the Fed should/would hike the Fed Funds rate from zero to something infinitesimally higher than zero based on improving employment and economics (but still very low inflation numbers). I'm not sure anyone will know for a while whether this was the right move, but psychologically, I believe it was, if for no other reason that getting the first interest rate hike behind us. In the end, I think a quarter-point hike up from zero, is a non-issue, and I for one am glad it's behind us. There will almost certainly be additional hikes to follow, but I think little of what we're seeing this week has anything to do with the Fed's December action.
US Economic Activity: The US continued to be a relatively strong economic performer (although again, see the answers to the quiz on the first page: many countries with lower-than-US growth numbers dramatically outperformed the US stock market, once again proving the point that even if you had tomorrow's economic headlines, you might still have trouble predicting what that means for markets). The US dollar's continuing strength helped consumers, but on balance, probably hurt company profits more than it helped, as so much of what we make is exported elsewhere, and a strong dollar reduces the ability of a foreign buyer to acquire US-made goods. Even so, with unemployment near 5%, which is considered to be "full employment" (although there are still a fair number of "under-employeds" out there), auto sales up 6%, retail sales up 2.1% from 2014, and home prices up 5% nationally, the underlying economic picture here is a relatively sanguine one. It is worth remembering, though, that ultimately, it's not how well a country's economy does that drives its stock market performance; it's how well it does relative to expectations (and therefore relative to the market's starting price) that really drives returns - and that differential explains the pretty anemic returns in US markets this year despite a decent economy.
Market Valuations and Expectations: While valuations in US stocks continue to be high by most historic measures (and this does not bode especially well for expected US market returns), valuations overseas - especially in the emerging market economies - are at considerably lower levels, and this does portend higher-than-US expected returns for those asset classes over a 5- to 10-year stretch. The oft-cited Shiller CAPE ratio (Cyclically Adjusted Price to Earnings Ratio) stands at 26 for the US market, which is well above its long-term average. Japan's is at 20; Europe's at 15; and most emerging markets stand at 10 or below. I should note that using the CAPE ratio as a timing mechanism is not a good idea as things can stay over- or under-valued for longer than you might expect, and even Nobel-prize winning economist Robert Shiller, who has popularized the CAPE ratio, makes the point that it's better used for setting expectations than for setting asset allocation policy. However, if history is any guide - and I'm not sure we have a better guide - it would not be unreasonable to expect internationals, and especially emerging markets - to deliver higher 5- to 10-year returns than domestic markets.
So, as I said at the top, 2015 was a year of pretty widespread disappointment, largely due to market gyrations in the third quarter. Economic activity across the globe has been slower than one would have hoped for, especially given that there are still many economies that have not fully recovered from the 2008-9 recession. Global GDP grew at a nearly 4% rate from 1950 to 2014, and most expectations today are for something closer to 3% than to 4%. While the concept of 3% vs. 4% GDP seems very abstract and is "just a number", consider this: In 1990, 1.9 billion people in the world lived in extreme poverty; today, that number is closer to 800 million, despite the world's population having grown from about 5 billion to 7 billion in the same timeframe. Most of that improvement in the global poverty picture is due to the growth in global economic activity and the larger percentage of the world's population being able to participate in that growth. While a 33% reduction in GDP growth undoubtedly has an economic impact on the rate of return in our retirement portfolios, it has a much larger and more fundamental impact on the standard of living of billions of people around the globe.
Secondly, diversification still makes sense. After several years where US large company stocks were generally the best game in town, we're starting to see many countries and regions outperform (in some cases, dramatically outperform) the US markets. Given that valuation metrics tend to be the best single predictor of longer-term returns, I would not be surprised to see that trend continue, especially in light of Europe's quantitative easing program, which just got going this past year. (I'll also add that diversification is very much like homeowner's insurance: you write the check every year without much in the way of return, and then every so often, it really pays off. Diversification is insurance for your portfolio against our collective uncertainty about what the future holds.)
Finally, I'll go back to the quote at the top of this commentary, "The smart person accepts; the idiot insists." This came from a 2008 Vanity Fair article entitled Beware Greeks Bearing Bonds written by (IMO) the best financial writer out there, Michael Lewis (who also wrote the book, The Big Short, now a movie in your local theatres). In that article, he recounts the story of a group of Cypriot monks who took over the ruins at Vatopaidi Monastery, overlooking the Aegean Sea, in the early 1990s. Over the next 15 years, the order, led by CFO Father Arsenios, would trade their way from next-to-nothing to a nearly $2 billion real estate portfolio, which came to be be known as the Vatopaidi Real Estate Fund. When asked how he did this, Father Arsenios referenced a sign posted on his door that reads, "The smart person accepts; the idiot insists." From the article: "This is the secret of success for anywhere in the world, not just the monastery," he says, and then goes on to describe pretty much word for word the first rule of improvisational comedy, or for that matter any successful collaborative enterprise. Take whatever is thrown at you and build upon it.
Notwithstanding the monks also selling absolution as part of the package deal (some things never change!), so it is with the global economy today: it is what it is. To wish for another time, another set of circumstances, misses that which is before us today and the opportunity for growth that it presents - albeit perhaps, slower, more patient growth (and with that, for the moment anyway, lower inflation). Globally, despite a slightly negative 2015 (more specifically, a strongly negative third quarter), equities are up in the neighborhood of 25% cumulatively over the last three years (balanced portfolios a bit less, of course) vs. inflation's cumulative increase of about 3.5% over that same time frame. That's a 7% per year growth of purchasing power relative to the cost of living, and in the end, that's not a horrible outcome by any stretch. That's a far bigger spread than we've planned for in any of our retirement projections.
I wish you and your family a very happy, healthy (and, yes, even prosperous), 2016. Despite the rough start to this first week of the year, let's hope 2016 looks more like the first, second and fourth quarters of 2016, and less like the third. As always, please don't hesitate to reach out if you'd like to talk any of this over or if there is anything we can do for you.