Don’t Change Course Based On The 2014 Anomaly

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Forbes.com, Winter, 2014. This article was written with Jim Cahn, the Chief Investment Officer at Wealth Enhancement Group. It was part of a series of articles developed under an agreement with Forbes to work with a variety of contributors and assist them in delivering actionable investment ideas each week. The site forbes.com is one of the top 500 sites in the world with nearly 10 million subscribers and nearly 100 million page views a month.

For investors, 2014 was about the disconnect between the significant growth of U.S. large cap stocks and U.S. long bonds and the weakness of practically everything else. Large cap U.S. stocks rallied over 14%, while the 30-Year Treasury climbed 24%. Compare that to U.S. small cap stocks, which rose less than 5%; international developed stocks, which fell almost 8%; emerging market stocks, which fell more than 5%; and oil, which fell almost 45%.

If you held a diversified portfolio in 2014 and you were watching major U.S. markets, you’re probably asking yourself if you should be moving away from a diversified portfolio toward a more U.S.-centric one.

2014 was the exception, not the norm. We call this disconnect “the 2014 Anomaly,” because such a large divergence is rare. Don’t let this year fool you into making drastic changes. Making decisions based on exceptions can hurt your long-term returns

Why was 2014 so exceptional?  Firstly, the performance gap between the S&P 500 and international stocks is the largest it has been in 18 years. History has shown that when the gap is this wide, the laggard (in this case, international stocks) tends to catch up over the next 12 months. Since 1970, the last 4 times U.S. large cap stocks outperformed the world by as much as they did in 2014, global stocks beat the S&P 500 by an average of 14% the following year. Of course, there’s no guarantee this will happen again.

Secondly, 2014 was a rare year in which informed investing wasn’t rewarded. According to Lipper, 2014 was the worst year for active managers in the last 30.

Thirdly, going into 2014, bond market analysts were at near-unanimous consensus that interest rates would be higher at the end of the year. Just about every investor got it wrong and missed out on the rally in U.S. long bonds.

Finally, according to the Leuthold Group, 70% of the 1500 largest U.S. stocks underperformed the index. Outperformance was concentrated in a handful of stocks—namely the Healthcare and Utilities sectors, an odd instance that very few investors foresaw.

2015: A Return to Normalcy?  There are some underlying themes that make us think 2015 will be more normal. International developed markets (Europe and Japan), look relatively inexpensive compared to U.S. stocks. While international growth lags that of the U.S., international developed economies are continuing to ease monetary conditions (quantitative easing), while the U.S. will likely continue tightening in 2015. The result is that growth expectations for international economies and the U.S. may converge (U.S. expectations falling, international expectations rising), which would support international stock prices. The U.S. dollar will likely strengthen against the Yen and Euro, but as we saw with Japanese stocks in 2013, a falling currency tends to be good for local markets, offsetting currency fluctuations. Further, tightening in the U.S. is likely to be bad for U.S. bonds, while easing internationally will likely be supportive to international bonds.

Emerging markets have made lots of negative headlines (especially China, Russia and Brazil) in 2014, but those headlines are reflected in current security prices, which look inexpensive. We expect headline risk to settle down in 2015 (i.e., Russia’s not likely to invade another country), supporting emerging market stocks.

Turning to energy,  we believe that strengthening global growth, coupled with reduced supply (resulting from less drilling due to lower prices), will support oil around $60 to $70 a barrel with upside if growth accelerates and/or geopolitical issues escalate. We may be wrong and oil may drop lower in the near term, but in the long term, growing population, increased global wealth and the eventual threat of inflation will propel commodity prices higher.

2015 is likely to be a better year for informed investors than 2014. The large gap in performance between the S&P 500 and U.S. long bonds and just about every other asset is an anomaly, not the norm. It’s not time to change strategies. Keep in mind that diversification is a strategy built on decades of research that has served generations of investors well by providing strong risk-adjusted returns; the results of 2014 are no reason to change course.

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