Nathan Geraci is President of The ETF Store, Inc. and host of the weekly radio show “The ETF Store Show“.
Heading into 2014, most market prognosticators confidently expected interest rates to rise and stocks to struggle eking out low single-digit gains. After all, with lofty 30%+ returns from U.S. stocks in 2013, valuations were surely stretched and the Federal Reserve was removing the fuel (quantitative easing) responsible for igniting a spectacular rally the past several years. This combination of rich valuations and Fed tapering was projected to, at a minimum, lead to an uphill battle for both stocks and bonds (remember, bond prices decline as interest rates rise). Instead, 2014 saw US stocks rise over 13% and the 10-year U.S. Treasury yield fall nearly 1%, leading to a rather remarkable year in bonds. Add in 30% returns from real estate investment trusts (REITs) and it might seem as though 2014 was smooth sailing for investors.
However, a constant flow of headline events kept investors on their toes (and in some cases, on the sidelines) for much of 2014. Attention-grabbing news stories came fast and furious – the rise of ISIS, Russia invading Ukraine (including Malaysia Airline flight MH17 being shot down), conflict between Israel & Gaza, an Ebola outbreak, Europe’s economy dipping back into recession, oil’s 50% price plunge, Fed tapering/potential interest rate hikes – the list goes on and on. If ever there was the proverbial “wall of worry” for the markets to climb, 2014 might have provided one of the highest. A perfect example of this market anxiety was displayed from mid-September through mid-October, when the S&P 500 plummeted close to 7.5% and market bears began taking victory laps. However, this decline proved to be short-lived as the S&P 500 proceeded to recapture this loss and tack-on an additional 3% gain through the end of the year. Nevertheless, headline events of 2014 reaffirmed that, after the financial crisis of 2008, many investors are now closely monitoring every bit of news and have shown an eager willingness to rush for the exits at the slightest sign of turmoil (hence creating the wall of worry).
While the U.S. financial markets were successfully (albeit precariously) climbing the wall of worry, there were real and more warranted concerns elsewhere around the globe. International stocks continued their recent bout of underperformance, with the aforementioned Europe weighing on the minds of investors. Japan, the world’s third largest economy, struggled with weak growth – a challenge the country has been trying to overcome for well over two decades now. Even emerging markets, notwithstanding a strong year from China, struggled to find footing as an improving U.S. economy (and stronger dollar) caused investors to pull capital from these countries. Emerging markets were also hurt by falling commodity prices, led by oil’s dramatic decline (many emerging market countries tend to rely heavily on commodities which, as a whole, took it on the chin in 2014). All of which leads us to characterize 2014 as another year where investors continued to view U.S. markets as “the best house on a bad block”.
So, as we put a bow on 2014, there are several key takeaways we believe might benefit investors heading into to 2015. Interestingly, as we embark upon the New Year, many of the same predictions made at the beginning of 2014 are being repeated – namely, that interest rates will rise and stocks will struggle eking out low single-digit returns. In addition, major headline concerns from the second half of 2014 are carrying over into 2015 – lingering geopolitical issues, Europe’s floundering economy, falling oil prices, central bank actions, etc. Since the predictions and initial headlines of 2015 mirror those of 2014, why not take the lessons learned last year and apply them to the New Year?
Here are three key takeaways/lessons: 1) No investor, economist, or market prognosticator has a crystal ball. As you begin hearing forecasts for 2015, remember that the vast majority of predictions for 2014 were wrong. This tends to be the rule, not the exception. 2) Resist the temptation of reacting emotionally to headline events. Without question, 2014 brought us a laundry list of stomach-churning news stories. While it can certainly be beneficial to stay informed as an investor, often times, the news stories themselves are significantly bigger than any impact they have on your investments – especially for longer-term investors. 3) Expect the unexpected. Not only are market predictions typically of little or no value, but events will occur that nobody has predicted in the first place. And even though you should react carefully to these events (see #2), there is the possibility that they can negatively impact your investments. Having the right balance and diversification in your portfolio can help protect you when these events do occur.
While the above takeaways are likely good advice no matter the year, 2014 reinforced each of these. Given the current investment landscape, 2015 looks to do the same. More specifically, as the New Year gets underway, there are three other themes to also keep an eye on: 1) Central bank policy divergence and impact, 2) Increasing volatility, and 3) The return of diversification.
Over the past several years, central banks around the world, including the U.S. Federal Reserve, European Central Bank, and Bank of Japan, have taken extraordinary measures to help the global economy recover from the 2008-2009 financial crisis. Ultimately, these measures have forced investors to take additional risks in the pursuit of return, fundamentally changing the risk/reward equation for many types of investments. It is still unclear what the longer-term ramifications of these actions will be. In the short-term, with the Fed winding down stimulus while other major central banks are operating full-throttle, the U.S. dollar has strengthened relative to other currencies. This is a trend that bears further watching as its potential impact runs deep, across nearly every investment category. Longer-term, the question will be whether central banks can successfully remove stimulus and raise interest rates without grinding the global economy to a halt.
Given the questions surrounding the longer-term impact of central bank actions, a second theme to watch for in 2015 is increasing market volatility. As we discussed last quarter, volatility in the markets comes from tension, which is the result of uncertainty. As investors grapple with how these central bank actions will ultimately play out, volatility is likely to increase. Additionally, questions about global economic growth and elevated stock valuations make it unlikely that financial markets will remain placid. The 7.5% decline in U.S. stocks at the beginning of the fourth quarter provided a perfect example of returning market volatility and investors might be wise to expect additional volatility in 2015.
Lastly, a theme to watch for in 2015 is diversification or, more specifically, whether the benefits of diversification will return. We have previously discussed whether diversification still works. After all, diversified investors have watched the U.S. stock market race ahead over the past several years, while international stocks have lagged far behind. We said at the time that diversification does, in fact, still work – it is just waiting for you to forget about it. In other words, it is typically right around the time when investors become complacent and throw caution to the wind (i.e. load up on U.S. stocks), that the benefits of diversification make their presence felt. While recent market performance continues to make it more difficult for investors to stay disciplined with diversification, long-term investors will ultimately be properly rewarded. That might start in 2015.
