To take the right steps for the future, it is helpful to know the past. Below is a chart highlighting the performance of various asset classes in 2014. As you can see, foreign stock markets, gold and commodities have performed poorly, while US stock markets and real estate have performed well. There will be both adverse and downwind in 2015. Let's discuss some key points.
It has been nearly six years since the last bear market bottomed out, when the U.S. government was grabbing stakes in the largest financial institutions, and our entire economy seemed to be at risk of collapse. It's silly to think of it now, but it's very real in March 2009. If AIG were allowed to go bankrupt, we would never know what would happen. But that's not the case. Since then, the total return on the S&P 500 has exceeded 250%.
Investment Prospects for 2015
In six years, 250% is a big bull market.
In the past 100 years, we have only experienced three long periods, no 20% decline, and two of these three periods have witnessed greater growth. The current rise has attracted some bears, but there are two reasons why we don't think we should.
- Of the six consecutive calendar years (1952, 1987 and 1996), the second year (the seventh year) is two years in three years, with an average return of + 13% in three years.
We think most investors should avoid market timing altogether. For those who can't pull themselves out, the second point above explains why trying to accurately calculate the time at the top of the market and jump off a rising ship is hardly a good idea. Even in 2008, it was a bad year for stock investors, with most of the declines exceeding the 2007 peak for a whole year. People are naturally afraid of a sudden crash, but most big bear markets fall slowly.
Fundamentals are neither inspiring nor terrible. Valuations are high, but not extreme. The forward price-earnings ratio (P/E) of the S&P 500 is about 17 times, while the historical average is about 15 times. Seventeen times P/E means that the yield is close to 6%, which is quite advantageous compared with the current yield of 2.2% on 10-year Treasury bonds. It is worth noting that high valuation is associated with lower future earnings, not negative future earnings.
Market sentiment remains mixed. We do not see high levels of fear and greed. Overall, we see more and more people becoming more aggressive, but not overwhelming. The bull market usually does not end until greed (or at least confidence) is near universal.
Some people worry about the prospect of the Fed raising interest rates. We are not. Even with the acceleration of the economy and a strong job market, the guarantee rate did not rise at all in 2015. The Federal Reserve has proved more proactive and longer-term than almost anyone imagined. Interest rate forecasts are not easier than stock markets. In addition, although interest rate hikes usually lead to slower economic growth and lower stock returns, our research shows that the real impact on stocks only emerges 12-18 months after the cycle begins.
The international market reminds us, to some extent, of America's position three to four years ago. European and Japanese economies are struggling to get out of recession, and their central banks are becoming more confident. International stocks are valued cheaper than American stocks. Morgan Stanley Capital International EAFE has a forward price-earnings ratio of 14 times, a dividend yield of 3%, and the Standard & Poor's 500 Index of 2%.
There's no way to know if 2015 will be the year when the international stock market regains its leadership, but when it does, it may mark the beginning of a long-term strong trend that you don't want to miss.
How about bonds?
In a Wall Street Journal survey last January, 48 out of 49 economists predicted 10-year Treasury yields would rise to an average of 3.5%. Instead, it fell below 2.2%. In 2014, almost everyone on Wall Street mistook bonds. The yield curve flattens as interest rates fall.
Again, most people believe that interest rates are bound to rise, but it is important to take into account that international interest rates are even lower. Even if the Fed starts to raise short-term interest rates, demand for high-yield bonds may keep long-term interest rates low in the United States.
The yield difference between five-year and 30-year Treasury bonds is 1.1%, the lowest in the past six years. Bonds should continue to play an important role in most portfolios, but given that the yield curve remains stable, we are cautious about the concentration of long-term bonds. Inflation may not surface soon, but there is no way to predict interest rates in five or ten years.
Ten-year Treasury bonds (inflation-protected Treasury bonds) are priced at a inflation rate of only 1.7%. TIPS has not performed well this year, but we think they are worth holding as part of a diversified bond portfolio to fight potential inflation.
The Great Game of International Diversification
Global diversified investors may have reason to be jealous of the recent earnings of the Standard & Poor's 500 Index. Since the start of the bull market in 2009, the S&P 500 index has rebounded by about 250%, while the international stock market has risen by about 150%. There's nothing to sneeze about 100% of transmission. If international diversification is a good idea, it is enough to raise a question. In fact, we see some investors abandoning it or turning to very slight international exposure.
We think it's a big mistake. International diversification may be frustrating, but it may also be a good news. Finally, in the long run, it will work, especially if it is properly rebalanced. But few people can get it right, and many people get it wrong. The reason is that this cycle is often long and emotionally draining. The current performance gap is not uncommon. The chart shows the five-year rolling spread between the Standard & Poor's 500 Index and the Morgan Stanley Capital International EAFE Index, representing the U.S. and international stock markets, respectively.
The first thing we can see is a big cyclical trend. From 1971 to 1988, the international community as a whole did better. At the peak of Japan's stock market bubble in 1988, the five year interest rate reached 250%. At this point, if you don't own international stocks, you will feel left out. Then, the United States basically led the whole 90s. When the dot com bubble came, most Americans thought it was foolish to invest in overseas companies. Foreign investors then regained leadership at the bottom of the bear market and performed well for six consecutive years until the subprime crisis broke out. Since then, the United States has been in the lead.
You may notice that when a bear market comes, the leadership usually changes. This allows people to try and time these trends, but it's a very dangerous game. Emotionally, the market is very good at persuading investors to do the wrong thing at the wrong time.
It's a long period and the price difference is very large. So why do it work for those who have patience? The chart shows inflation-adjusted growth of investment in the Standard & Poor's 500 Index, Morgan Stanley Capital International EAFE Index and 70/30 split (our proposed allocation), rebalancing every year:
The green line is the mixture. First, in any case, if you invest only in stocks and keep investing, you will end up with very satisfactory results. But by diversifying, you end up with slightly higher returns and much less volatility. The green line is either at the top or near it. It's never at the bottom.
This is the true beauty of pluralism and disciplined rebalancing. If we can do this for our customers throughout the market cycle and in all six asset classes, it may be the greatest value we can offer.
The fall in oil surprised most people. In November, when OPEC decided to maintain production rather than reduce supply, a clear downward trend gained momentum. This shocked the global market and marked a new strategic direction for Saudi Arabia. The United States seems to see the new American shale producers as a long-term threat and willing to accept lower prices in an attempt to get rid of some of these businesses. This is a high-risk long-term bet with unknown results. In any case, Saudi Arabia is tired of being forced to cut OPEC supplies, and its OPEC partners are notorious for cheating on supply reduction targets.
How difficult it is to say. Brent crude oil has fallen below the key $60 price level, at which a large number of U.S. projects have become unprofitable. So in the coming months or quarters, there may be a long-term floor of about $60, but nothing can stop prices from falling sharply. Whether it's positive or negative depends on where you sit.
Clearly, a sharp decline is a negative omen for major oil exporters. Russia, in particular, has been hit hard. Since oil is the most important commodity, the fall in prices has put heavy pressure on its currency. The ruble has fallen more than 50% against the dollar in the past six months. Their central bank's failed attempt to support the renminbi has allowed it to fall freely. All this has put Russia on a difficult road. Now it will have to fight lower oil prices, weaker currencies, higher interest rates and economic sanctions against Ukraine. At this point, there seems to be no easy way out of the country's plight. Ultimately, it may even weaken Putin's power base.
But for most countries in the world, falling oil prices will be a net positive factor. They provide much-needed impetus for economic growth in Europe, Japan and China. At home, this helps to control inflation.
If you haven't already done so, click the Investment Inspection tab, and then click the Investment Inspection Link on the Personal Capital dashboard. Our software will X-ray your portfolio for insight. Maybe you have too much contact with an industry that you are not satisfied with. Maybe your bond weights are much lower than you think, because stocks have risen over the years. If you haven't done an in-depth analysis of your investments for a while, you may be surprised at how much your investment allocation has changed.
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