What a difference a year makes. Well, usually … but not last year. 2015 was a year rife with divergence and volatility. The U.S. dollar soared relative to most other major currencies, and oil continued to plunge; the Fed finally raised rates in the U.S., while the European Central Bank (ECB) reduced rates there; the world’s developed economies grew modestly, while emerging markets slowed. Uncertainties and geopolitical issues were plentiful, causing markets to gyrate wildly. The overall results were mostly negative for global stock and bond indexes.
The policy-makers’ month
Last month we highlighted a couple of key meetings slated for December: the OPEC meeting on the 4th, and the Federal Reserve meeting that concluded on the 16th. Additionally, during December, the International Monetary Fund (IMF) added the Chinese Yuan to its basket of key international currencies used for foreign exchange reserves. The IMF does a review every five years, and while the Yuan was added, it was done to a smaller degree than initially projected.
Most market participants were betting on a Fed Funds interest rate hike in December. Modern central banking is as much an exercise in effective communication as it is economic analysis, so an intense amount of scrutiny is now being applied to every word in Fed statements, meeting notes, and press conferences. It’s become somewhat of a circus, and the focus will now shift to the narrative of how the Fed will communicate and implement their plan to raise rates over the next several quarters. When will they increase rates next? By how much? Are they worried about the strength of the U.S. dollar? How much importance will the Fed place on declining oil prices?
Plunging oil prices were a huge headline all through 2015 and their precipitous fall absolutely clobbered the energy sector. We’re now teetering around prices we last saw during the depths of the financial crisis in February 2009, when demand evaporated due to a reeling world economy. OPEC left its output policy unchanged in their December meeting, even though the cartel “pledged” to reduce production in the future. OPEC’s strategy to cripple higher-cost producers (read: frackers and shale players) is very much still in play. Also, the U.S. ban on exporting oil was lifted in a tax bill passed last month, which will only add to global supply in the future, a factor that should apply even more downward pressure to oil prices. Add to all this that Iran is gearing up for a return to the list of global oil market suppliers and, barring some geopolitical event, oil’s dark winter could continue indefinitely as massive supply meets with demand that is lacking due to subdued global growth.
Science is how we organize and test knowledge about the universe, and when it comes to the markets, a lot of investors simply pay attention to results. They simply ask, “did my account go up or down?” But if we look at the nature of the markets in the past two years, we are presented with some information that is absolutely confounding. Bloomberg, a financial news and research
company, ran an article last year highlighting some strange market occurrences (go here for more info: Six Strange Things), and we want to focus on their findings regarding volatility (Point 6 in the attached article).
Volatility is reflected in the literal ups and downs of the market. “Standard deviation” is a measure of the variability of volatility. In other words, it’s the measure of how spread out the percentage numbers are. Let’s look at a quick example (below) to make these statistical concepts easier to understand. Let’s assume large cap stocks have a long-term average return of about 7% with a standard deviation of about 17%. On a normal distribution curve (below), about two-thirds of the time, 68% in this example, large cap stock returns would fall within our average return plus or minus one standard deviation. So, returns would usually be between -10% and +24% (7% – 17% = -10% and 7% + 17% = +24%). On that same normal distribution curve, about 95% of the time, returns should fall between our average return plus or minus two standard deviations. So, returns would fall between -17% and 31%. And about 99% of the time, returns fall within three standard deviations of our long-term average return.
Now, let’s apply this Statistics 101 lesson to the present time. In 2015, the S&P 500 experienced a 4-standard deviation move. The U.S. 10-year Treasury yield experienced a 7-standard deviation move. In 2014, the Swiss Franc experienced a 10-standard deviation event. As you can see from the chart above, any standard deviation event over 3 is very rare. In fact, a 7-standard deviation event is so very rare, it should happen only about once in a billion years. A 10-standard deviation event shouldn’t happen ever – at least not in statistical terms.
So, describing the very rare events spelled out above as simple “market dislocations” is a huge understatement. Consider that an earthquake with a magnitude of 8.0 on the Richter scale usually occurs somewhere on the planet about once every 5-10 years. Similarly, a bear stock market – a move down of 20% or more – occurs about once every 5 years. So, by way of statistical comparison, the moves in the S&P 500, the 10-year Treasury, and the Swiss Franc would probably equate to a 9.0 earthquake or higher. Now when we consider that the world has experienced about five real 9.0 earthquakes since 1900, and we’ve experienced these three 9.0 equivalent statistical “earthquakes” in only a 24-month period, and it is extremely difficult to identify the culprit, that makes for very weird science indeed.
A step back
It is wise to take a step back from the crowds, all of the noise, and the many distractions that the investing world shoves in our faces. We need to ask ourselves, where are we, and what’s really going on in the world? In the U.S., it looks like we’re floating around in the mature phase of the business and market cycle. Profit margins are at historical highs. The Fed has started interest
rate hikes due to its belief that this almost fully-employed economy is getting healthier, and that is not necessarily a signal that we’re at the onset of a bear market or a recession. It does tell us that stock market gains will probably have to come as a result of increases in revenue due to better sales, as margins are about as stretched as they can get. At some point, the U.S. consumer has to come to the rescue and start purchasing more.
And while we’re on that topic, where has the U.S. consumer been? Typically, lower gas and energy prices mean more discretionary cash in the hands of consumers, who usually spend this extra money on goods and services. As a stronger consumer feels more confident, he usually spends more, which drives up corporate revenue and profits, which in turn supports higher equity prices. So far, the “cheap gas” windfall to consumers is not being spent on goods and services. That extra cash is mostly being put away in savings, as evidenced in the personal saving rate data. (See chart below) During pre-crisis years of 2005-2007, the savers rate averaged around 3%. In the years following 2008, the savers rate increased to well over 5% and got as high as 11% in December of 2012. That was evidence of a lack of consumer confidence. When people are unsure about their futures and their jobs, they (wisely) don’t spend as much. However, the savers rate dropped back below 5% in 2014 but, since then it has hovered at just over 5% for all of 2015. It appears that consumers are either using their gas savings to pay down debt or add to their investments and savings accounts.
What about the global markets and economies? How did they fare in 2015? The strong U.S. dollar was favorable for U.S. imports as foreign goods were cheaper, but it was hard on U.S. exporters, whose goods became more expensive, which hurt sales. So, a strong dollar is generally bad for the U.S. in terms of trade but is good for the rest of the world selling goods to the U.S. consumption behemoth. To add to the strong U.S. dollar dilemma, many countries have allowed their currencies to float lower versus the dollar, countries like China, Argentina, and Azerbaijan, to name a few.
And while we’re on the subject, the Chinese economy has been slowing for years now, and the impact of this slowdown on global trade is becoming more and more apparent. China’s slowing economy translates to less demand globally for commodities, which results in lower commodity prices. These lower prices for fuels, metals, and agriculture goods have a negative impact on the emerging market countries that supply those goods to the world and rely on the sale of commodities to drive their economic growth.
However, while there have been a number of headwinds, the global economy is still growing, albeit at a sluggish pace. While there are troubled countries and regions all around the world like Russia, much of Europe, the Middle East, and Latin America, many central bankers are following the U.S. script of “easy money” via low interest rate policies and capital injections. These central bankers are trying to create tailwinds that will promote economic growth by fostering an environment where profitability rises, tax receipts increase, and their citizens can happily go on about their lives.
What did well in 2015?
In two words, not much. Most major assets classes – stocks, bonds, commodities, etc. – were negative or barely positive for the year. High profile investors like Warren Buffet had a hard time, too. Buffet’s Berkshire Hathaway was down about -12% for the year whether you look at his class A or class B stock. The “smart money” as represented by hedge funds had mostly poor results as well. There are dozens of hedge fund strategy categories out there, and most were negative for the year with only a few categories posting single digit results (see some examples here on Hedge Fund Research’s website).
Investors who experienced positive returns did so primarily by having concentrated portfolios. Investors who loaded up on Facebook, Amazon, Netflix, and Google did well last year. Business Insider, a financial publication, ran an article that highlighted the performance of these stocks, plus a few others, that did well in 2015 (more info here: Fang and Nosh). The list isn’t that long. If you had put all of your money in these stocks, you would have done well. However, that type of concentration is contrary to how most people should invest. Concentration, the opposite of diversification, can create wealth, but it can quickly destroy wealth as well if you buy the wrong companies or sectors (see above on the Energy Sector).
Most investors are looking for both growth as well as stability in their investments, and in 2016, we’re likely to see more volatility and a steady dose of interest rate hikes. Investing basics like asset allocation and diversification have not done a lot for investors over the past two years, but we firmly believe these are still the fundamental elements of a prudent investment strategy.