Our Thoughts

Year in Review

Dare to Believe?

The plummeting price of oil was one of the biggest stories, and certainly the biggest energy story, of 2014. Back in June, the price of West Texas Intermediate (WTI) crude was almost $108 per barrel. It ended the year at $53, and as of January 12th had fallen to $46.

Equities: The combination of the oil price collapse and the continuing conflict in Ukraine proved particularly toxic for investors in Russian equities. As measured by the MSCI (Morgan Stanley Capital International) index, Russia’s was the worst-performing stock market in 2014 with a total return of negative 42.3%. Other energy producers such as Norway (negative 20.3%) didn’t fare much better.

Bad news for energy exporters was good news for energy importers. India – an energy importer – was among the countries with the best stock market returns. Investors in India have been cheered by the election successes of the governing Bharatiya Janata party, which they hope will encourage Premier Narendra Modi to press on with his reform program. The combination of the oil price collapse and the election outcomes propelled the Indian stock market as measured by the MSCI to a positive 22.6% return.

Bad news for energy exporters was good news for U.S. consumers, as well. The 46% decline in crude oil prices saved drivers approximately $14 billion in 2014 – $14 billion that consumers have been spending on other things, helping to boost the U.S. economic recovery. Given the strength of that recovery and the surge in the value of the dollar, it is perhaps surprising that the U.S. ranks only eighth among the MSCI indices, with a total return of 14.5 % in 2014.

Alternatives: The top-performing asset class in 2014 was U.S. commercial real estate. Real estate investment trusts (REITs) as measured by the NAREIT index were up a robust 28.03% for the year. The worst-performing asset class, with a negative 17.01% return, was commodities. Managed futures, as measured by the Dow Jones Credit Suisse Managed Futures index, had their best year since 2008, generating a positive total return of 8.37%.

Fixed Income: One of the reasons that U.S. stocks and REITs performed so well 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. 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 0.04%; 6-month bills are only slightly more generous at 0.12%.

PIMCO dominated the fixed-income headlines after the surprise departure of Bill Gross on September 26. The $162.8 billion (as of December 31) PIMCO Total Return Fund now managed by Chief Investment Officers Scott Mather, Mark Kiesel, and Mihir Worah, returned 4.7 % in 2014, trailing 53 percent of comparable funds, according to data compiled by Bloomberg. The fund missed a rally in longer-term bonds and bet incorrectly that inflation would rise.

Although the process took several days to complete, FJY pulled the plug on PIMCO Total Return on September 26. We were ahead of the curve compared to investors, especially institutional investors. As an example, the New York City Pension Funds moved $4.9 billion out of PIMCO, but only decided to do so in December.

Frame of Reference Risk: One of the most interesting aspects of 2014 – and, indeed, the entire U.S. bull market period since 2009 – is that many investors have concluded that portfolio diversification is a bad thing for their wealth. When asset classes such as international equities and/or commodities underperform relative to U.S. stocks, U.S. investors tend to look at their statements and wonder why they’re lagging the Dow and S&P indexes that they see on the nightly news.

Roger Gibson, a well-known advisor who spoke to FJY clients in April 2009, calls this “frame of reference risk.” That is, investors instinctively benchmark the performance of their portfolios against U.S. stocks, specifically large U.S. company stocks. When U.S. stocks underperform and other asset classes do better as they did in 2000, 2001, 2002, 2003, 2004, 2005, 2006, 2007, 2008, and 2011, we sing the praises of diversification saying “thank heavens I have bonds, and/or international equities, and/or REITs, and/or commodities, and/or managed futures.” But, when U.S. stocks do better than those other asset classes we think, “Hey, diversification is impairing my performance!” Gibson reminds us that our reaction ought to be exactly the same under both of these scenarios. Our frame of reference should be a balanced benchmark, not the S&P 500.

That’s the point of diversification. When 2014 began, none of us knew whether bonds, and/or U.S. equities, and/or international equities, and/or REITs, and/or commodities, and/or managed futures would finish the year in positive territory. Holding some of each is a prudent strategy, yet the eye inevitably turns to the declining investment(s) which, in hindsight, pulled the overall returns down. In 2014 those investments were international equities and commodities. At the end of 2015, we may be looking at U.S. equities with the same gimlet eye and feeling grateful that we were invested in other asset classes as a way to contain the damage; there’s no way to know in advance.

Is a decline in U.S. stocks likely? The S&P 500 completed its sixth consecutive year in positive territory, although this was the second weakest yearly gain since the 2008 market meltdown. Since 1926, the year that Standard & Poor’s introduced its first stock index, the S&P 500 has risen for seven or more calendar years in a row only two times (1982-1989 and 1991-1999). Could 2015 be the third? One can never predict these things, but the usual recipe for a terrible market year is a period right beforehand when investors finally throw caution to the wind, and those who never joined the bull market run decide that it is time to crash the party. We don’t seem to be seeing that overconfidence.

Nevertheless, the Fed is widely expected to raise short-term interest rates in 2015 for the first time in nine years. A rate increase may well damp economic growth and make it more expensive for companies to expand.

In his column in the Wall Street Journal (Saturday/Sunday, January 3-4, 2015), Morgan Housel made the case for “Why Stocks Could Thrive if the Fed Raises Interest Rates.” According to Mr. Housel, history shows that stocks can rise considerably during periods when the Fed is tightening credit. In fact, the average annual return for the S&P 500 for all 14 periods since 1957 (when the index was launched in its present form) during which the Fed was raising interest rates was 9.6%, nearly equal to its average annual return of 10.1% since 1957. Furthermore, the S&P 500 fell in only two of the 14 periods, both in the early 1970s.

So, will the S&P 500 complete its seventh consecutive year in positive territory? There’s no way to know in advance, so dare to believe but stay diversified!