Market ReviewSubmitted by Karstens Investments on October 29th, 2015
By Michael D. Karstens, CFP®, AIFA®
We have put the wraps on 2014, and it was an interesting year indeed. On the surface, it looked like a very solid year for investors. U.S. stocks rose for the sixth consecutive year (which happens to be the fourth longest bull market in history) with the Dow Jones Industrial Average gaining 10.04 percent and the S&P 500 Index up 13.69 percent. As a matter of fact, the S&P 500 Index never fell for more than three consecutive days during 2014. That has not happened in over nine years. Interestingly, just five stocks – Apple, Berkshire Hathaway, Johnson & Johnson, Microsoft and Intel – accounted for more than 20 percent of the index’s gains. The S&P 500 was led by two unlikely candidates – utility stocks, which gained 24 percent and healthcare stocks, which rose 23 percent. The gain in utility stocks was particularly interesting. Utilities usually do well when interest rates fall and their higher yields seem more appealing. At the end of 2013, 71 of 71 economists polled by Bloomberg predicted interest rates would rise in 2014 which would normally not bode well for utilities. In hindsight, we know that 100 percent of the 71 economists were wrong and interest rates fell in 2014, driving utilities higher.
Below the surface, things were less rosy. Smaller U.S. stocks underperformed larger U.S. stocks by a wide margin and posted low single-digit returns. Overseas, Japan slipped into a recession, Europe was on the brink of recession and China’s economy slowed dramatically. From a stock perspective, the MSCI Europe Index lost 8.6 percent, and emerging markets (MSCI Emerging Market Index) lost 4.6 percent. Commodity markets were also down in 2014. The worst performer was oil with prices down over 50 percent, oil dropped from $107 a barrel in June to $53 at year end.
For our portfolios, 2014 was a disappointing year. Despite the fact that we were over weighted to large U.S. stocks, our diversified portfolios returned low to mid-single digit returns, which was well below the S&P 500. Obviously, cash yielding near zero percent, and negative returns for our international, developing markets, and natural resource holdings dragged down returns. In addition, according to Lipper, 85 percent of active stock fund managers trailed their benchmarks in 2014. The majority of our managers were not an exception to this.
We strongly believe that over 10 and 20 year stretches, geographic and asset class diversification have proven beneficial not only for risk management, but also for total returns. Unfortunately, you’re unlikely to see the benefits of this diversification over any short period of time, and 2014 was certainly one of those times.
If you look at Chart 1, you will see returns over 1, 5, 10 and 15-year time periods for three different portfolios. They include one portfolio that is 100 percent invested in the S&P 500, another invested 100 percent in stocks but diversified internationally (including commodities) and a third portfolio that was 60 percent diversified stocks and 40 percent in bonds. As you can see in the chart, an investment in the S&P 500 has outperformed by a wide margin over the 1 and 5-year periods. This is not a big surprise since the 5-year period coincides very closely with the end of the financial meltdown of 2008-2009, and U.S. stocks had outperformed during that period.
Perhaps more interesting are the 10-year numbers. Here, the returns are much closer. The S&P 500 gained 7.67 percent, the 100% Stock/Diversified1 portfolio gained 6.67 percent and the 60/40 portfolio gained 6.47 percent per year. An investor in the 60/40 portfolio shouldered much less risk and volatility than the S&P 500, however the return difference is fairly minimal.
Perhaps even more surprising are the 15-year numbers. The 15-year period included the 50 percent market declines during the technology bubble (2000-2002) and the financial meltdown of 2008-2009.
For the 15-year period, the S&P 500 returned 4.31 percent, the 100% Stock/Diversified1 portfolio returned 7.38 percent and the much more conservative 60/40 portfolio was up 7.22 percent. Despite strong outperformance the past 5 years, the S&P 500 has underperformed more diversified portfolios by a wide margin over the past 15 years.
Some observers today would tell an investor to simply invest in the S&P 500. This was also a common theme back in the late 90s with a huge run-up in the S&P 500. It did not work all that well. As a matter of fact, someone who invested 100 percent in the S&P 500 on 1/1/2000 had a total return of -9.10 percent over the next 10 years, compared to 6.49 percent for a 60/40 diversified portfolio. For someone to stick with the S&P 500 strategy after 10 years of gross underperformance would have taken a great deal of discipline and fortitude.
We believe you can eliminate that pain by properly diversifying. Certainly there will be shorter periods of time in which a diversified portfolio underperforms, but in the long-term, we believe this type of portfolio will offer similar returns (if not better) with much less risk.
Looking ahead, today’s investment environment strikes me as one of the most difficult in my 30 years in the business. I mentioned this to someone recently and they asked if it reminded me of the late 90s. In many ways today is very different. In the late 90s, it was quite obvious that there were a few market sectors that were grossly overvalued.
Large U.S. stocks, especially growth stocks, were trading at 30, 40 and 50 times earnings and were well above the highest levels we had seen historically. Technology stocks were even more absurd.
I remember writing about Cisco Systems, at the time the largest company in the world, trading at over 100 times earnings. Many other tech stocks had no sales and only a business plan, yet were afforded crazy valuations. Although it took longer to fall apart than we envisioned, the balloon eventually popped. What made the late 90s less difficult was that there were bargains available. You could still buy bonds with decent interest rates, developing markets were very inexpensive, small cap stocks were trading at historic discounts to large stocks, and REITs were selling at discounts to the underlying real estate and providing 7 percent to 10 percent dividend yields. Today there are far fewer bargains available.
Today’s investment environment seems more difficult for several reasons. One, stock prices today seem higher than normal although they are not clearly ridiculous, as some sectors were 15 years ago. However, the current price to sales ratio is at an all-time high and the market capitalization ratio to GDP (reportedly one of Warren Buffett’s favored indicators) is the second highest in history. The Schiller adjusted PE ratio for the S&P 500 is at 27 today. That ratio has only been at or exceeded that level three times – 1929, 2000, and 2007. Those were all very significant market peaks. According to Fact Set, based on forward earnings, the current PE for the S&P 500 is 16.2 or about 17 percent higher than the average of 13.8 times earnings.
As we discussed in previous newsletters, corporate earnings are two standard deviations higher than normal and should these earnings revert to the mean, the market would be much more overpriced than it looks currently.
So, in our opinion, U.S. stocks are expensive but not as obviously expensive as they appeared 15 years ago. With all the money printing by the Fed, should the economy strengthen and geopolitical concerns lessen, we would not be shocked to see stocks get more expensive, perhaps much more so.
Our second area of concern is the uncertain geopolitical situation. The Russian situation with Ukraine, the escalating situation with the Islamic State, Iran, the Middle East, global terrorism, etc. all seem to be escalating. Normally, these are areas that we try not to become too concerned about. The late John Templeton said that in all his years, there were times filled with great worries, but not worries bad enough to deter from investing. For more than 30 years, I have found this to be very sage advice. I guess the reason that this does concern us today is that much of the problem seems to be very widespread with government intervention, social unrest and government money printing.
The third and probably greatest concern to us is massive debt and money printing. From 2007 to 2009, we had arguably the worst financial collapse since the Great Depression. This crisis was brought on by excess debt and falling prices. We “solved” this debt problem by adding more debt. Over the past five years, we have printed in excess of $4 trillion in the U.S. We used this printed money to buy U.S. bonds (bonds issued to cover the short fall of expenditures versus revenues), which in turn drove short-term interest rates to zero and longer term bond yields to record lows. Investors, in search of higher yields, have driven up prices of anything with a yield, i.e. utilities, junk bonds, real estate, dividend-paying stocks, etc. The amount that low interest rates have propped up asset prices has to be very significant.
We believe the Fed anticipated that the excess money would flow into the stock market, raise asset prices, stimulate the economy and create a wealth effect. Unfortunately, the wealth effect helped the wealthiest families a great deal, but the Fed’s engineered asset inflation had the unintended consequences of raising the cost of living for everyone else. In addition, at the start of 2015, there seems to be a massive race to debase. Many countries around the globe seem to be content to print massive amounts of money in hopes of devaluing their currency and improving their economy. Money printing schemes like this have been tried many times in the past and have always ended poorly with unintended consequences. Perhaps this time is different but those are scary words in the investing world. We need to be prepared for more volatility and uncertainty. •