4th Quarter 2013 Market Commentary

The US stock market pleasantly surprised everyone in 2013.  The S&P 500 Index experienced a record year. International stocks also had strong year, although emerging market stocks were down and trailed global stock markets significantly. Interest rates rose in 2013, causing negative returns for the bond market. Emerging market bonds, following a strong 2012, fell further than domestic bonds. Alternative investments were a mixed bag.  Global real estate was up slightly, while commodities were down due to weakness in gold, agriculture, and industrial metals. Of course calendar years are arbitrary measures for long-term investors who do not buy in on January 1st and sell on December 31st, but they do serve as convenient time periods for reflection and review of market performance.

Human nature dictates that we gravitate towards that gleaming return of the S&P 500 Index last year. We are tempted to measure our success against this number. How quickly we forget the reason we choose diversification in the first place! Remember the discussion about not “putting all of your eggs in one basket”? Let’s assume you were invested in a portfolio comprised only of the S&P 500 Index, and compare it to two hypothetical portfolios; a properly diversified 60/40 (moderate risk) portfolio and an aggressive portfolio of global stocks. We will compare an investment of $100,000 on January 1, 1995; one portfolio contains only the S&P 500 Index, one is globally diversified portfolio with 60% in global stocks and 40% in bonds, and the third is a globally diversified portfolio with 100% in stocks.[1]

Below are the year-end values for each portfolio, and it’s no surprise that the two 100% stock portfolios had higher returns than the more moderate 60/40 portfolio. The S&P 500 Index has an annualized return of 9.22% with a standard deviation of 15.22%, the 60/40 portfolio earns a slightly lower annualized return of 8.17% with a considerably lower standard deviation of 9.61%, and the 100/0 earned 8.92% each year on average with the standard deviation of 16.17%. The globally diversified stock portfolio is riskier than the S&P 500 Index because it includes small cap stocks, international stocks, and emerging market stocks. Overtime, the diversified stock portfolio is expected to have higher returns than the S&P 500 Index, even though it doesn’t in the time period used in this analysis.

To better understand the real impact of diversification, compare the portfolio’s values in 2007 versus 2008. The S&P 500 portfolio lost $148,212 in 2008, a -37.00% return, while the 60/40 portfolio lost $74,320, a -21.64% return. The 100/0 portfolio lost $160,658, a -39.52% return. This was likely the greatest test for diversified investors with no bonds in the portfolio. As you can see, staying the course was the right decision for investors as global stock markets have rallied over the past 5 years. While all of these experiences are painful, the 60/40 portfolio is considerably less so. Risk averse, long-term investors trade slightly higher returns for an acceptable level of volatility that will enable them to stay invested during painful bear markets.

 

Date

S&P 500 Index

60/40 Portfolio

100/0 Portfolio

Dec-94

$100,000

$100,000

$100,000

Dec-95

$137,578

$121,118

$122,828

Dec-06

$379,741

$314,281

$366,953

Dec-07

$400,604

$343,440

$406,514

Dec-08

$252,392

$269,119

$245,855

Dec-09

$319,186

$333,049

$333,459

Dec-10

$367,268

$374,923

$389,040

Dec-11

$375,024

$376,228

$370,930

Dec-12

$435,043

$420,830

$433,795

Dec-13

$575,945

$485,595

$551,171

[2]

We are getting lots of questions about the bond market. Rising interest rates caused negative returns for bonds last year. The 10-year US Treasury yield, currently 2.88%, is 100 basis points higher than a year ago. The Federal Reserve announced in December, that it will begin tapering its monetary stimulus from $85B to $75B in bond purchases per month.[3] Most economists expect the Fed will further reduce bond purchases after their next meeting in March under the new Chairman, Janet Yellen. While these conditions are likely challenging for the bond market, bonds remain a less risky asset class than stocks. Consider that a bad year for the bond market is -2.0%, while a bad year for stocks is -37.0%. Longer-term, rising interest rates means higher coupon yields for bond investors, undoubtedly a welcome change for investors living on fixed incomes.

The burning question is always – Where do we go from here? The Federal Reserve expects higher economic growth and a strengthening job market in the US in 2014. This is their rationale for dialing back QE stimulus. US stocks appear slightly over-valued, but we’ve never seen a bull market stop at fair valuation. Emerging market stocks, on the other hand, seem under-valued and look attractive. There is always a chance of an unexpected major event to throw off these projections; weather, terror attack, war, oil shock.

Crystal BallOn a lighter note, we recently added a new piece of technology in our office.  We have a 100% real crystal ball in the main conference room. It serves as an ongoing reminder, that predictions are impossible and that global diversification is the most prudent course for long-term investors.

 

 

 

Index

QTD

YTD

1 Year

3 Year

5 Year

10 Year

S&P 500 Index (US Stocks)

10.51%

32.39%

32.39%

16.18%

17.94%

7.41%

MSCI EAFE Index (Intl Stocks)

5.71%

22.78%

22.78%

8.17%

12.44%

6.91%

MSCI Emerging Markets Index (EM Stocks)

1.83%

-2.60%

-2.60%

-2.06%

14.79%

11.17%

Barclays Aggregate Bond (Bonds)

-0.14%

-2.02%

-2.02%

3.26%

4.44%

4.55%

S&P Global REIT Index (Global Real Estate)

-0.73%

2.81%

2.81%

8.96%

16.38%

7.89%

DJ-UBS Commodity Index (Commodities)

-1.05%

-9.52%

-9.52%

-8.11%

1.51%

0.87%

 

Blair Hodgson duQuesnay, CFA, CFP®

January 2014

 

 

Disclosures:

All expressions of opinion reflect the judgment of the authors as of the date of publication and are subject to change. It should not be regarded as a complete analysis of the subjects discussed.

Information presented does not involve the rendering of personalized investment advice and should not be construed as an offer to buy or sell, or a solicitation of any offer to buy or sell the securities mentioned herein.

Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment or strategy will be suitable or profitable for a client’s portfolio. All investment strategies have the potential for profit or loss. There are no guarantees that an investor’s portfolio will match or outperform any particular benchmark. Index returns do not represent the performance of ThirtyNorth Investments, LLC, or its advisory clients.

ThirtyNorth Investments, LLC, is registered as an investment advisor with the SEC and only transacts business in states where it is properly registered, or is excluded or exempted from registration requirements. SEC registration does not constitute an endorsement of the firm by the Commission nor does it indicate that the advisor has attained a particular level of skill or ability.

 


[1] Hypothetical 60/40 portfolio is comprised of; 22% S&P 500 Index, 14% S&P Small Cap 600 Index, 15% MSCI EAFE Index, 9% MSCI Emerging Markets Index, and 40% Barclays US Aggregate Bond Index. Hypothetical 100/0 portfolio is comprised of; 36% S&P 500 Index, 24% S&P Small Cap 600 Index, 25% MSCI EAFE Index, and 15% MSCI Emerging Markets Index.

[2] 60/40 hypothetical and 100/0 hypothetical – from 01/1994 to 12/2013 with annual rebalancing to the target asset allocation shown prior.

[3] Federal Reserve Statement; December 18, 2013 – http://www.federalreserve.gov/newsevents/press/monetary/20131218a.htm