Overall, we’ve had a pretty smooth, upward path in the markets since the 2008 financial crisis, but each year brings its share of upsets. 2015 is ending on some uncertain notes with a spate of worrisome headlines, related to this week’s Fed meeting and interest rate hike; the closing of the Third Avenue Focused Credit Fund, an aggressive high-yield bond fund; and the continuing decline in oil prices, to name a few. Meanwhile, Congress looks to be on the verge of passing tax and spending bills that would keep the government running through next September, after the usual last minute deliberations.
Until last week, the fourth quarter had shown some nice recovery after the third quarter’s retreat. While the S&P 500 is still up for the quarter (+5.3%), the full-year results for 2015 have turned negative (-0.3%) on last week’s 3.7% decline.
The relatively flat performance of the index in 2015, as a whole, masks a large differential between the 10 largest stocks and the rest of the index — 24% as of last week, the largest spread we’ve seen since the dot-com boom in 1999 and 2000. And within the top 10 stocks, less than a handful are driving the positive performance with huge gains: Amazon.com, Alphabet (Google), Microsoft and Facebook.1
With such a small subset of mega-cap tech stocks influencing the indices, broadly diversified portfolios have not compared well to what investors may be hearing in their news updates. Small-cap, international and emerging-markets stocks have lagged, while large-cap U.S. stocks have dominated.
Even within large cap, growth stocks have outperformed value stocks for an extended period. The effect has been particularly strong this year with about a 10% performance differential: the Russell 1000 Value Index is down 5.7%, while the Russell 1000 Growth Index has a 4.3% gain. Recently, investors whose portfolios emphasize the small cap and value factors — which have higher expected returns over time — have not been rewarded.
We know that investment styles go in and out of favor, and that these cycles can last for extended periods. It is impossible to predict when the cycle will change, which is one of the reasons why it’s important to have diversified portfolios that smooth out the extremes of those dynamics. Here, we see what ensued after the dot-com bubble burst:
For the five years following the last big period of large-cap growth outperformance, value and small-cap stocks were rewarded handsomely.
And then there’s energy…
Also hidden in that rather flat, year-to-date S&P 500 return are the punishing results in the Energy sector — oil prices have dropped sharply again, in the face of lower global growth expectations and prospects for a supply glut with OPEC’s decision not to curtail production. U.S. WTI Crude fell 11% last week, and is down 15% over the past two weeks; at $35.62 per barrel, it is down 33% for the year at levels we have not seen since 2009.2
The Energy sector in the S&P 500 is down 24.5% for the year-to-date period; the index has about a 2% higher return in 2015, when the Energy sector is excluded.3 This is another factor contributing to the recent underperformance of value stocks; growth indices have minimal energy exposure.
At the end of the year, it’s an interesting undertaking to look back and reflect on how last year’s predictions have panned out. Every month, The Wall Street Journal (WSJ) surveys economists on their forecasts for a number of economic indicators. In the January 2015 survey, the average forecast for the price of crude oil in December 2015 was $63.03, 78% higher than the actual price of oil on December 11.4 That’s quite a miss for the forecasters. Investors who may have steered their portfolios to that sector based on expectations like these are worse off for not sticking with more broadly diversified market exposure.
And emerging markets…
The impact of the commodity price-collapse has been significant in emerging markets, since many of their economies are highly dependent on commodity exports.
Emerging-markets stocks are down about 17% in 2015, and are in the red for the past five-year period. This is a volatile asset class, and it is not unexpected to have declines of this magnitude from time to time. By limiting exposure to emerging markets to a small share of one’s portfolio, the impact of this volatility can be reduced.
The decline in emerging-markets equity has been accompanied by a decline in emerging-markets currencies. As a result, local currency bonds have suffered, posting double-digit declines so far this year. Political and economic issues in South America have also taken a toll — particularly the downgrade of Brazil — creating a double whammy of currency and interest rates. Recent political developments in Brazil and Argentina may be cause for some hope, though.
Bond predictions…and liquidations…
U.S. Treasuries have been the safe-haven beneficiaries of the declines in these other asset classes, defying expectations for rising rates again this year. In last year’s review, we noted the more than 1% miss in interest rate forecasts by participants in the WSJ survey. This year has been a little better, but not much. In the January survey, the average expectation for the yield on the 10-year Treasury note in December 2015 was 2.87%; the yield closed at 2.13% on December 11, remarkably close to the 2.17% yield on December 31, 2014. The Barclays Capital Aggregate Index was up 1.2% for the year through December 11.
At its meeting this week, the Fed did what was widely expected– it began raising short-term rates for the first time since 2006, with a .25% hike. Its unemployment target has been hit, with the official rate falling to 5%, although inflation remains below the 2% growth also targeted by the Fed. Further increases are expected to be gradual.5
The yield on the 10-year Treasury note closed at 2.30% following the announcement, still far below those predictions.
As they anticipated a Fed move, investors were also hit last week with the news of the Third Avenue Focused Credit Fund’s closure and the freezing of redemptions.
This high-yield fund holds relatively concentrated positions of very low-rated or unrated bonds. High-yield bonds tend to be more correlated with equities than with government bonds, and they suffer along with them in a “risk-off” environment.
After last week’s tumble, high-yield bonds are down about 3% year-to-date.
This particular fund is riskier than the average high-yield bond fund, holding distressed, illiquid positions; it had also been experiencing investor outflows. It’s important to distinguish this fund from the type of high-yield exposure we would have in a portfolio — the Third Avenue Focus Credit Fund targets the lowest-quality tier of high-yield securities rated below B (some of which are in bankruptcy), and is concentrated.
Due to the extended, low interest rate environment we’ve had over the past few years, many investors have increasingly moved to riskier areas of the markets in their search for yield and income. Assets have flowed into high-yield funds and other areas like energy and REITs. If investor sentiment changes, outflows can exacerbate the declines, especially if the positions held have limited liquidity; this appears to be the case with the Third Avenue fund.
When it comes to bad news in the financial markets, it is impossible to say whether the worst is over or if there is still more to come. As much as financial pundits would like you to believe they have a crystal ball, we can see their inability to accurately predict the future in the “expert WSJ forecaster” surveys referenced above. In times such as these, your best defense is having an investment philosophy that you can stick to, which leads back to our own philosophy of investing for the long term in globally diversified portfolios. At times, these portfolios can underperform when advances are limited to particular areas (like large-cap growth or U.S. Treasuries), but they can help avoid the problems associated with trying to position portfolios to benefit from unreliable forecasts or big sector bets. Our portfolios are structured to meet our clients’ goals over the long term; importantly, this does not require making the same progress each and every year, but it does require having the discipline to stick with it through the hard ones.