Considering Central Bank Influence on Yields

September 2015lion tamer

Fed watching is a favorite pastime for many market participants. Investors read statements from the Federal Reserve as if they were tea leaves, parsing new information and seeking to forecast future Fed activity. The presumption is that Fed actions lead to specific market outcomes. Recently, some market prognosticators believed that the Fed was going to begin raising the federal funds target rate. However, what actually happened reinforced how difficult it is to accurately forecast when a Fed tightening cycle will occur or what its effects may be.

The presumption of many is that longer-term interest rates will rise when a tightening policy does begin. However, history shows that short- and long-term rates do not move in lockstep. There have been periods when the Fed aggressively lifted the fed funds target rate—the short-term rate controlled by the central bank—while longer-term rates did not change or “stubbornly” declined.

A good example is the Fed’s last campaign of policy tightening through the use of the fed funds target rate (see Exhibit 1). From 2004 to 2006, the Fed increased the rate by 4.25%, yet longer-term rates experienced a period of decline. Alan Greenspan, Fed chairman at the time, referred to this phenomenon as a “conundrum.”

jpeg 1

jpeg 2

Other periods of short- and longer-term rates moving independently include the 1980s, when the fed funds target rate was increased by more than 3% while longer-term rates remained largely unchanged. In fact, the late 1980s was a period marked by an inverted yield curve; long‑term rates yielded less than short-term rates. This can be seen in Exhibit 2: The green line representing the fed funds target rate yielded more than 5- and 10-Year US Treasury notes. There have been a number of instances of inverted yield curves throughout history in the US (and other developed markets).

Another period when market participants attempted to forecast specific outcomes based on Fed actions occurred in 2013. In a statement to Congress on May 22, 2013, Ben Bernanke, then chairman of the Fed, asserted that the Federal Open Market Committee (FOMC) was prepared to scale back its bond purchasing program. At the time, the FOMC was purchasing approximately $85 billion a month in mortgage-backed and US Treasury securities.1 The news of the FOMC’s scaling back of purchases in the open market resulted in what became known as the “taper tantrum.”

Market forecasters speculated that the scaling back of bond purchases by the FOMC would inevitably result in higher interest rates. But interest rates actually declined when the FOMC eliminated its purchases from January 2014 to October 2014.

Exhibit 3 illustrates yields on intermediate- and long‑term US Treasury bonds from the time Bernanke made his statement to Congress until the end of the FOMC’s purchases in open market operations.

As mentioned earlier, history shows that investors who attempt to forecast interest rates have not demonstrated any ability to consistently and reliably predict the future path of those rates. Changes in fed funds target rate, as well as short- and long-term rates,

jpeg 3

 

are not perfectly correlated—and are often driven by market forces.

When analyzing the Fed’s impact on short-term rates, we must also consider the unprecedented action taken by the Fed since 2008—its massive issuance of reserves paying rates of interest.

As Eugene Fama has noted in his research,2 the Fed paid no interest to banks on excess reserves prior to 2008; thus, there was an opportunity cost for banks depositing excess reserves at the Fed. This opportunity cost naturally encouraged banks to make loans and purchase securities; the availability of loans and the money supply created by banks purchasing securities creates downward pressure on interest rates.

The Fed’s recent policy of paying interest rates on excess reserves removed the previous opportunity cost, assuming available rates in the market are not higher than what the Fed is paying. Due to a lack of attractive spreads on loans in the current market, holding excess reserves at the Fed is now the more attractive option. Conventional wisdom has been turned on its head.

By paying interest on excess reserves, the Fed has, in essence, created new “short-term securities.” The issuance of these reserves, or “short-term securities,” pulls monetary supply out of the economy, which by definition should raise interest rates. The question then becomes: Has the Fed really been trying to keep interest rates low? It does not seem that way. Perhaps, in an effort to fight deflation, the Fed has actually been trying to push interest rates higher, yet the lack of attractive lending opportunities in the market has flooded banks with deposits, pushing interest rates lower and limiting the power of the Fed.

In his academic blog, Professor John Cochrane3 also analyzes the effect of the Fed on interest rates. He poses an interesting rhetorical question: “Is the Fed in fact ‘holding down’ interest rates?” To answer this question, he points out that the Fed, to keep interest rates low, will lend money to banks at low interest rates so banks can then lend that money to the rest of the economy, making a spread. But, instead of going out to the market to find “higher” interest rate opportunities, banks have deposited $3 trillion worth of reserves at the central bank despite the “low” rates being paid. If the banks find the Fed rates attractive, is the Fed really keeping interest rates low—or high?

 

  1. Fama, Eugene F., “Does the Fed Control Interest Rates?” working paper, University of Chicago Booth School of Business, 2013.
  2. johnhcochrane.blogspot.com/2015/09/is-fed-pulling-or-pushing.html.
    Exhibits  by Dimensional Funds Advisers

 

 

Registered Representative, Securities offered through Cambridge Investment Research, Inc., a Broker/Dealer, Member FINRA/SIPC. Investment Advisor Representative, Cambridge Investment Research Advisors, Inc., a Registered Investment Advisor. Lion’s Share U.S. Financial Services and Cambridge are not affiliated. Indices mentioned cannot be directly invested in. Past performance is no guarantee. When you access other linked websites, you assume total responsibility and risk of the websites you are linking to caveat emptor. All expressions of opinion are subject to change without notice in reaction to shifting market conditions. All materials presented are compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. Article are provided for informational purposes, and it is not to be construed as an offer, solicitation, recommendation or endorsement of any particular security, products, or services in Alabama, Florida, Georgia, and Tennessee. No offers may be made or accepted from any resident outside the specific state(s) referenced.

 

 

Taking Stock

A Note from Dave Butler:     basinga

 

Dimensional has been working with David Goetsch, co-executive producer of The Big Bang Theory television show, on various communication initiatives, including the Dimensional Stories video series. As the client of a California-based advisory firm that works with Dimensional, Dave has adopted a long-term view of investing, which he found transformational during the recent market volatility. He describes his experience in the essay below. His perspective is a testament to the importance of having a strong philosophy and underscores the value an advisor can play in educating clients and preparing them for uncertainty. I hope you enjoy it.


Before I realized that markets work and adjusted my investment philosophy accordingly, I used to wish for a white noise machine to drown out the sound of market fluctuations and their accompanying hysteria. I thought my mood and sanity would always depend on whether the stocks I had chosen were trending up or down.

To me, investing in stocks was like playing roulette in a shady casino. The financial crisis of 2008 only validated what I felt I could count on for sure—that everyone loses, eventually. I would never be able to predict when or how, which meant that I might as well keep my retirement money in cash because what I lost to inflation was less than what I would lose in the market. Everything I read in the media or watched on TV stoked my fears. Even if the sky wasn’t falling, I knew that it was only a matter of time.

I feel completely different today. I understand that it’s not all or nothing. Academics have shown that, over the long haul, the stock market is the best place to get a long-term return. Research has also shown that I can’t time the market or pick stock winners better than randomness. So I don’t.

I’m a long-term investor in the stock market. I don’t care about the ups and the downs of a certain day because my retirement is over 20 years away. I don’t seize on the possibility that this is a good time to buy or sell something because I know that I can’t time the market. I’m also not looking at an individual company that might create a unique opportunity given world events because the funds I buy hold thousands of companies.

I’m focused on the things that will really impact my long-term financial future: spending less and saving more. These are two things I can control (unlike when the Fed is going to raise interest rates). Journalists don’t write front-page articles about the automatic monthly contribution I make to my kids’ 529 college fund. For every hot stock tip that I receive, I can remind myself about the efficient market hypothesis.

The best thing about all of this is I managed to get off the emotional rollercoaster that many investors are trapped on—the same one on which I used to live. Even in 1987, when I was in high school and didn’t have any money in the market, I found myself poring over the business section of the New York Times, like a rubbernecking commuter trying to get a better look at the car wreck on the side of the road. Now I would rather spend time with my kids. I don’t know what the future holds. But I feel good knowing that I’m working on the things I can control instead of worrying about the stuff that I can’t.

—Dave Goetsch

Dave Butler
Dimensional Funds

Head of Global Financial Advisor Services and Vice President

Registered Representative, Securities offered through Cambridge Investment Research, Inc., a Broker/Dealer, Member FINRA/SIPC. Investment Advisor Representative, Cambridge Investment Research Advisors, Inc., a Registered Investment Advisor. Lion’s Share U.S. Financial Services and Cambridge are not affiliated. Indices mentioned cannot be directly invested in. Past performance is no guarantee.  When you access other linked websites, you assume total responsibility and risk of the websites you are linking to caveat emptor. All expressions of opinion are subject to change without notice in reaction to shifting market conditions. All materials presented are compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. Article are provided for informational purposes, and it is not to be construed as an offer, solicitation, recommendation or endorsement of any particular security, products, or services in Alabama, Florida, Georgia, and Tennessee.

 

 

The China Syndrome

kuling flag

The recent severe volatility in China’s share markets has raised questions among many investors about the causes of the fall and the wider implications for the global economy and markets.

The Shanghai Composite Index—the mainland stock market barometer and one dominated overwhelmingly by retail investors—more than doubled during the year from mid-2014, only to lose more than 30% of its value between mid-June and mid-July this year.

The volatility was much less in Hong Kong, where foreign investors tend to get their exposure to China. The Hang Seng Index fell about 17% from April’s seven-year high, though it had a more modest run-up in the prior year of about 25%.

Nevertheless, the speed and scale of the fall on the Chinese mainland markets unsettled global markets, fuelling selling in equities, industrial commodities, and allied currencies like the Australian dollar and buoying perceived safe havens such as US Treasuries and the Japanese yen.

The decline in Chinese stocks triggered repeated interventions by China’s government, which has been seeking to transition the economy from a long-lasting, export-led boom toward more sustainable growth based on domestic demand.

Investors naturally are concerned about what the volatility in the Chinese market means for their own investments and what it might signify for the global economy, particularly given the rapid growth of China in the past 20 years.

SHARE MARKET VS. ECONOMY

Measured in terms of purchasing power parity (which takes into account the relative cost of local goods), the Chinese economy is now the biggest in the world, ranking ahead of the US, India, Japan, Germany, and Russia.1

Yet China’s share market is still relatively small in global terms. It makes up just 2.6% of the MSCI All Country World Index, which takes into account the proportion of a company’s shares that are available to be traded by the public.

The Chinese market is also not a large part of the local economy. According to Bloomberg, it is capitalized at less than 60% of the country’s GDP. By comparison, the US total equity market is capitalized at more than 100% of US GDP as of July 2015, according to Bloomberg.

China is classified by some index providers as an emerging market. These are markets that fall short of the definition of developed markets on a number of measures such as economic development, size, liquidity, and property rights.

China’s stock market is still relatively young. The two major national exchanges, Shanghai and the southern city of Shenzhen, were established only in 1990 and have grown rapidly since then as China has industrialized.

With foreign participation in mainland Chinese markets still heavily restricted, many foreign investors have sought exposure to China through Hong Kong or China shares listed on the New York Stock Exchange.

As a consequence, domestic investors account for about 90% of the activity on the Chinese mainland market. And even then, the participation is relatively narrow. According to a China household finance survey, only 37 million, or 8.8% of Chinese families, held shares as of June 2015.2 As a comparison, just over half of all Americans own stocks, according to Gallup. In Australia, the proportion is 36%.

While the Chinese stock market is about 30% off its June highs, it nevertheless was still about 70% higher than it was 12 months before, as of late July 2015. As such, much of the pain of the recent falls will have been felt by people who entered the market in the past year.

A final point of perspective is that while the Chinese economy has been slowing, it is still expanding at around 7% per annum, which is more than twice the rate of most developed economies.

The IMF in April projected growth would slow to 6.8% this year and to 6.3% in 2016. Still, it expects structural reforms and lower oil and commodity prices to expand consumer-oriented activities, partly buffering the slowdown.3

While such forecasts are subject to change, markets have priced in the risk of a further slowdown to what was previously expected, as seen in the renewed fall in the prices of commodities like copper and iron ore, which recently hit six-year lows.

DRIVERS OF THE BOOM

The Chinese share market boom of the past year cannot be attributed to a single factor, but certainly two major influences have been the Chinese government’s promotion of share ownership and investors’ increased use of leverage.

The government has been seeking to achieve more sustainable, balanced, and stable economic growth after nearly four decades of China notching up heady annual growth rates averaging 10% on the back of an official investment boom.

But the transition to a shareholding economy has created its own strains. The outstanding balance of margin loans on the Shanghai and Shenzhen markets grew to 4.4% of market capitalization by early July, according to Bloomberg.4

Under a margin loan, investors borrow to invest in shares or other securities. While this can potentially increase their return, it also exposes them to the potential of bigger losses in the event of a market downturn.

When prices fall below a level set by the lender as part of the original agreement, the investor is called to deposit more money or sell stock to repay the loan. These margin call liquidations can amplify falling markets.

Chinese regulators, mindful of the potential fallout from the stock market drop, have instituted a number of measures to curb the losses and cushion the impact on the real economy.

These have included a reduction in official interest rates, suspension of initial public offerings, and enlisting brokerages to buy stocks backed by cash from the central bank. In the latest move, regulators banned holders of more than 5% of a company’s stock from selling for six months.

The government also has begun an investigation into short selling, which involves selling borrowed stock to take advantage of falling prices. In the meantime, about half of the companies listed on the two major mainland exchanges were granted applications for their shares to be suspended.

While such interventionist measures may seem alien to people in developed market economies, they need to be seen in the context of China’s status as an emerging market where governments typically play a more active role in the economy.

Whether the intervention works in the long term remains to be seen. But the important point is that this is a relatively immature market dominated by domestic investors and prone to official intervention.

SUMMARY

The re-emergence of China as a major force in the global economy has been one of the most significant drivers of markets in the past decade and a half.

China’s rapid industrialization as the population urbanized drove strong demand for commodities and other materials. Investment and property boomed as credit expanded and people took advantage of gradual liberalization.

Now, China is entering a new phase of modernization. The government and regulators are seeking to rebalance growth and bring to maturity the country’s still relatively undeveloped capital markets.

Nevertheless, China remains an emerging market with all the additional risks that this status entails. Navigating these markets can be complex. There can be particular challenges around regulation and restrictions on foreign investment.

We have seen those risks appearing in recent weeks, as about a third of the sharp rise in the Chinese mainland market over the previous year was unwound in a matter of weeks, prompting intense government intervention.

Markets globally are weighing the wider implications, if any, of this correction. We have seen concurrent weakness in other equity markets and falls in commodity prices and related currencies.

Yet it is important to understand that the stock market is not the economy. China’s market is only about 2.6% of global market cap and its volatile mainland exchanges are, for the most part, out of bounds for foreign investors anyway.

For individual investors, the best course in this climate, as always, is to maintain diversification and discipline and remember that markets accommodate new information instantaneously.

 

OUTSIDE THE FLAGS
By Jim Parker
Vice President
DFA Australia Limited

 

1. IMF World Economic Outlook, April 2015.

2. “China Households Raise Housing Investment in Q2,” Reuters, July 9, 2015.

3. IMF World Economic Outlook, April 2015.

4. “China’s Stock Plunge Leaves Market More Leveraged than Ever,” Bloomberg, July 6, 2015.

 

Registered Representative, Securities offered through Cambridge Investment Research, Inc., a Broker/Dealer, Member FINRA/SIPC. Investment Advisor Representative, Cambridge Investment Research Advisors, Inc., a Registered Investment Advisor. Lion’s Share U.S. Financial Services and Cambridge are not affiliated. Indices mentioned cannot be directly invested in. Past performance is no guarantee.  When you access other linked websites, you assume total responsibility and risk of the websites you are linking to caveat emptor. All expressions of opinion are subject to change without notice in reaction to shifting market conditions. All materials presented are compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. Article are provided for informational purposes, and it is not to be construed as an offer, solicitation, recommendation or endorsement of any particular security, products, or services in Alabama, Florida, Georgia, and Tennessee.

MasterChef of Investing

cheff

 

In the popular TV program MasterChef, contestants face a series of cooking challenges. From low quality ingredients to inadequate preparation and poor implementation, so many things can, and do, go wrong. It’s a bit like investing.

In the world of investment, there customarily are two broad approaches. The first is a traditionally active one: Managers attempt to find mispriced securities or seek to time their entry and exit points from various parts of the market.

This first approach is akin to the MasterChef challenge, which requires inventing a new and distinctive dish within a set time frame. The apparent advantage for the chef is flexibility of concept.

But what usually happens is that once the chefs have committed to a chosen recipe, they end up racing against the clock and are locked into particular ingredients to create a single dish. Of course, it may work out, but if they lose attention for a second, the dish is ruined and they have nothing to fall back on.

Likewise, in the investment world, the traditionally active manager locks in on individual ideas. That results in little flexibility and creates time constraints. The manager tries to trade on information not believed to be reflected in prices. If it doesn’t work out, there may not be a Plan B.

If your primary goal is standing out from the crowd, you are going to build cost and complexity into your process. In the cooking analogy, the price of your ingredients (out-of-season avocados, for example) is going to be a secondary consideration to having an impact. And once you’re committed to your distinctive dish, you may not be able to turn back.

The second approach to investing is when the investment manager seeks to track as closely as possible to a commercial index. The goal here is not to stand out, so the manager will be most conscious of “tracking error” (deviating from the benchmark).

This approach is more akin to the MasterChef challenge in which contestants must cook a standard, popular dish with set ingredients. The focus is not creativity but following an established process as dictated by an outside party.

The ostensible advantage of the second approach is the chefs don’t have to create something completely new. The ingredients (or securities, in the case of the investment manager) are known. It is just a matter of assembling them.

But the drawback of this latter approach is the absence of flexibility. The contestants can’t substitute one ingredient—or stock— for another. The recipe must be followed. What’s more, it must be achieved in a designated timeframe.

A dictated menu also may not suit the clientele. For instance, it may be the world’s best lasagna recipe made perfectly to order, but if your diners don’t care for Italian food, you have a problem.

But what if we had a system that combined the creativity of the first approach with the simplicity of the second? In this challenge, the focus shifts from being different for its own sake or following someone else’s recipe to drawing from a range of ingredients to produce a diverse menu suiting a range of tastes.

In this third approach, our contestants do not face unnecessary constraints either in terms of time or ingredients. Instead, they assemble a broad selection of dishes from multiple ingredients appropriate for the season and at times of their choosing.

The difference under this third way is that the chefs can focus on what they can control and eliminate elements that might restrict their choices. After all, their ultimate goal is to efficiently and consistently provide meals that suit a range of palates.

In the world of investing, we believe this third way is the optimal approach. Picking stocks and timing the market, like making brilliant-off-the-cuff meals in any conditions and in an efficient and consistent manner, is a tough task—even for the masters. Cooking meals off a provided menu, like the index managers, can be inflexible and costly.

The third way is akin to the Dimensional approach.

We don’t have to outguess the market to get results. We don’t have to lock in on a couple of our best ideas and hope they turn out. But neither do we have to throw up our hands and contract the job to a commercial index provider.

We can research the dimensions of expected returns, design highly diverse portfolios that pursue market premiums, and build flexibility into the system so that we efficiently and consistently serve up investment solutions for a wide range of needs.

Call it the MasterChef of investing.

The author would like to thank Marlena Lee for her inspiration for this article.

OUTSIDE THE FLAGS
By Jim Parker
Vice President
DFA Australia Limited

Registered Representative, Securities offered through Cambridge Investment Research, Inc., a Broker/Dealer, Member FINRA/SIPC. Investment Advisor Representative, Cambridge Investment Research Advisors, Inc., a Registered Investment Advisor. Lion’s Share U.S. Financial Services and Cambridge are not affiliated. Indices mentioned cannot be directly invested in. Past performance is no guarantee.  When you access other linked websites, you assume total responsibility and risk of the websites you are linking to caveat emptor. All expressions of opinion are subject to change without notice in reaction to shifting market conditions. All materials presented are compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. Article are provided for informational purposes, and it is not to be construed as an offer, solicitation, recommendation or endorsement of any particular security, products, or services in Alabama, Florida, Georgia, and Tennessee.

 

Weather vs. Climate

Acadia park

Notice how TV news bulletins put finance next to the weather report? 

In each, talking heads point at charts and intone about intraday events that are quickly forgotten. 

Meanwhile, the long-term wealth building story gets overlooked.

Many investors feel that they are not properly informed about the financial world unless they have checked daily, or even hourly, on how the Dow, FTSE, or Nikkei have moved in the intervening period.

In most cases, it’s a pretty harmless activity. It at least provides a bland conversation starter in fleeting social encounters, just as keeping up to date with tomorrow’s weather forecasts can fill an awkward silence.

But our very human focus on the day-to-day can often encourage us to make bad decisions that affect our long-term interests.

That’s because while we live moment-to-moment, what often affects us most are imperceptible, gradual changes that occur over many years.

Look at the way markets have begun in 2015, as reflected in daily news headlines from Reuters:

  • January 6: Wall St. in Longest Losing Streak in 13 Months
  • January 8: Wall St. Jumps for Second Day, Helped by Economic Optimism
  • January 14: US Stocks Fall Heavily on Growth Concerns
  • January 20: China Seen Posting Weakest Growth in 24 Years
  • January 20: UK Stocks Gain on China’s Growth

The China GDP story is a good example. The curtain-raisers announced it would be the weakest economic growth number for nearly a quarter century. And, sure enough, it was. But because the result was a fraction higher than what the market had priced, Asian stocks rallied.

As always, markets price expectations for events like this and then move if the outcome varies with what is in the price. It is hard enough for professional investors to keep track, never mind a layperson.

So, from minute to minute, market sentiment shifts in reaction to news—news about the economy, companies, governments and politics, and the wider world. Prices rise and fall in response to this news, which by definition is unpredictable.

To use an analogy, the market news is like the weather. One day it’s sunny. The next day it rains. It’s unseasonably warm one day but cool the next. The narrower is your frame of reference, the greater is the apparent variability.

Weather vs climate 1 graph

Look at Exhibit 1 (in USD terms) above, showing monthly moves in a common barometer of the global share market. All you see are the monthly ups and downs—the regular changes in “the weather.”

Weather vs climate 2 graph

Another way to look at this movement (see Exhibit 2) is to measure the growth of wealth. This way we are less focused on the day-to-day or month-to-month movements and more on how wealth accumulates through time.

For a long-term investor, this is the more important measure because it takes into account cumulative gains. The media, by virtue of its publication schedule, must focus on the short-term. They need a different story every day.

These two ways of looking at the market are like the difference between the weather and the climate. The former changes constantly, the latter more gradually. With long-term investment, it’s the climate you need to think about.

 

 

OUTSIDE THE FLAGS
By Jim Parker
Vice President
DFA Australia Limited

1 Charts provided by Dimensional funds

 

Registered Representative, Securities offered through Cambridge Investment Research, Inc., a Broker/Dealer, Member FINRA/SIPC. Investment Advisor Representative, Cambridge Investment Research Advisors, Inc., a Registered Investment Advisor. Lion’s Share U.S. Financial Services and Cambridge are not affiliated. Indices mentioned cannot be directly invested in. Past performance is no guarantee.  When you access other linked websites, you assume total responsibility and risk of the websites you are linking to caveat emptor. All expressions of opinion are subject to change without notice in reaction to shifting market conditions. All materials presented are compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. Article are provided for informational purposes, and it is not to be construed as an offer, solicitation, recommendation or endorsement of any particular security, products, or services in Alabama, Florida, Georgia, and Tennessee.

 

 

2014 Review: Economy & Markets

Despite a bumpy ride throughout 2014, the US economy gained pace while the US equity and fixed income markets outperformed most markets around the world. This performance came with higher market volatility in the US, a rallying dollar, slowing economies in Europe and Asia, and rising geopolitical tensions, including conflicts in Ukraine and the Middle East.

The Dow Jones Industrial Average rose for the sixth straight year, posting a 7.52% gain (price-only return). The S&P 500 Index rose 13.69% (including reinvested dividends), marking the third straight year in which the benchmark has returned more than 10%. The Dow closed at a record high on 38 calendar days, while the S&P 500 had 53 record closes. The non-US markets followed a much different track:  All major indices logged negative performance for the year (in USD). The MSCI EAFE Index had a -4.90% return and the MSCI Emerging Markets Index a -2.19% return (net dividends, in USD). The dollar’s strong performance relative to major regional currencies contributed significantly to the lower returns for US investors.

Government bond yields fell across major markets, including the US, where many expected higher rates in response to improving economic growth and an eventual rate increase due to the end of quantitative easing by the Federal Reserve. The yield on the 10-year Treasury note declined to 2.17% by year-end, down from 3.03% in 2013, with lower prices boosting its return to over 4.0% for the year. The Barclays US Government Bond Index returned 4.92%. World government bonds had slightly positive returns: The Citigroup World Government Bond 1–5 Year Index (hedged) returned 1.90%.

US_Stock_Market_Performance

The chart above highlights some of the year’s prominent headlines in the context of broad US market performance, measured by the Russell 3000 Index. These headlines are not offered to explain market returns. Instead, they serve as a reminder that investors should view daily events from a long-term perspective and avoid making investment decisions based solely on the news.

The chart below offers a snapshot of non-US stock market performance (developed and emerging markets),  measured by the MSCI All Country World ex USA Index. Again, the headlines should not be viewed as determinants of the market’s direction but only as examples of events that may have tested investor discipline during the year.

Non_US_Stock_Market_Performance

Economic Backdrop

Accelerating US Recovery

The economy showed signs of weakening in early 2014, with Q1 GDP growth reported at an annualized -2.9%. In Q2, GDP rebounded strongly at a 4.6% annual growth rate (seasonally adjusted)—the highest since 2003. Growth in Q3 was even stronger at 5%, capping its best six-month stretch since 2003 and reaching the highest annualized growth rate in 11 years. If the Fed’s Q4 estimates hold, 2014 GDP growth will have been in the 2.4% range.

A host of indicators pointed to improving conditions during the year, including:

  • Employment—The US economy added 2.7 million jobs through November, the best employment growth in 15 years. Claims for jobless benefits ran lower than at any point since 2000. By year-end, the US had recovered all jobs lost to the past recession, and joblessness was at a six-year low. Despite the lowest labor force participation rate since the 1970s, the economy entered 2015 with record employment.Major_World_Indices
  • Manufacturing—Economic activity in the manufacturing sectorimproved throughout most of 2014. The Institute for Supply Management (ISM) reported its purchasing managers index (PMI) at 59.0 in October, 58.7 in November, and 55.5 in December. (A reading above 50% indicates general expansion.) For the year, the PMI averaged 55.8, the best reading since the first full year after the recession in 2007–
  • Consumer spending—An improving labor market and lower energy prices translated into higher income and purchases among American workers. Real personal consumption expenditures increased at a seasonally adjusted 3.2% rate in Q3, compared to 2.5% in Q2. US equity market gains over the past three years have added $7 trillion to household wealth, which many believe has helped fuel spending.
  • Company earnings—The Department of Commerce reported a 2.8% rise in US corporate profits in Q2, followed by a 5.1% increase in Q3, marking 12 straight quarters of year-over-year growth. According to GDP data, Q2 after-tax profits hit a record high. However, after adjustments for depreciation and inventory changes, profit margins—particularly among smaller companies—appeared to be declining due to rising labor costs and capital expenditures.

 

Declining Oil Prices

Oil prices fell by almost half during 2014, a victim of excess supply due to rising production—particularly in the US, where production soared to its highest level since 1986—and to weakening demand from the economic slowdown in Europe and Asia. In the US, prices dropped from $107 per barrel in June to just over $53 at year-end. For the year, Brent crude was down 48% and West Texas Intermediate crude down 46%. The price decline most affected the economies and currencies of oil-exporting countries, especially Russia.

 Soaring Dollar

In 2014, the US dollar rose against every developed markets currency. Overall, it gained 12.5% against a basket of widely traded currencies, measured by the Wall Street Journal dollar index. This was the dollar’s best gain since 2005 and second-best on record. The rise was attributed to stronger US economic data, falling global oil prices, expectations of higher interest rates, and weakened currencies resulting from monetary easing by the Japanese and European central banks.

 Weak Inflation

Despite rising to an 18-month high in May and June (2.1% each), average US inflation remained low throughout 2014. In November, year-over-year inflation fell to 1.3%. Since rising inflation is normally viewed as a sign of an economic uptick, some believe that weak inflation influenced the Fed’s decision to not raise interest rates. Across the world’s largest economies, inflation eased for the sixth straight month in November, with the Organization for Economic Cooperation and Development (OECD) reporting average annual inflation for its 34 members at 1.5%.

2014 Investment Overview
Market Summary

Major_World_Indices_ranked

The US equity markets—and particularly the large cap segment of the market—logged a strong year. The S&P 500 Index returned 13.69%; the NASDAQ Composite Index gained 13.40%; and the Russell 2000, a popular benchmark for small company US stocks, returned 4.89%. US market volatility, measured by the Chicago Board Options Exchange Market Volatility Index (VIX), increased to its highest level in two years, with most activity occurring in Q3. Average volatility for the year, however, was the lowest since 2006.

Non-US developed stock markets experienced negative performance across almost all major indices (references in USD). The MSCI World ex USA Index, a benchmark for large cap stocks in developed markets outside the US, returned -4.32%. The small cap and value versions of the MSCI EAFE index returned -4.95% and -5.39%, respectively. Emerging markets proved no exception, with the MSCI Emerging Markets Index returning -2.19% and the value subindex returning -4.08%. The small cap subindex returned 1.01%.

Among the equity markets tracked by MSCI, more than half of the countries in the non-US developed markets index had negative total returns and the range of returns was broad. The top three return countries were Israel (22.77%), New Zealand (7.34%), and Denmark (6.18%). Countries with the lowest returns were Portugal (-38.24%), Austria (-29.77%), and Norway (-22.04%).

In emerging markets, 13 of 23 countries tracked by MSCI logged negative total returns and the dispersion of returns was broader. Egypt (29.33%), Indonesia (26.59%), and the Philippines (25.59%) were the top-performing countries in the index. The lowest returns in the index came from Russia (-46.27%), Greece (-39.96%), and Hungary (-27.44%).

Returns of major fixed income indices were positive due to falling yields and rising prices. One-year US Treasury notes returned 0.18%, US government bonds 4.92%, world government bonds (1–5 years USD hedged)
1.90%, and US TIPS 3.64%.

Real estate securities had a banner year: The Dow Jones US Select REIT Index returned 32.00%, and the S&P Global ex US REIT Index returned 10.94%. Commodities were negative for the fourth year in a row, with the Bloomberg Commodity Total Return Index returning -17.01%. Brent crude oil and gasoline futures were the worst performers in the index, posting -48.3% and -48.5% returns, respectively. Natural gas fell 31.7%. Gold was down for the second year in a row, falling 1.5%; silver prices were down 19.5%. Coffee was the top-performing commodity in the index at 50.5%.

Diverging Returns

While US equity returns were high relative to those of other regional markets, returns within various US market segments diverged. Based on the respective Russell 1000 and 2000 indices, US large cap stocks significantly outperformed small cap stocks, and within the relative price dimension, large value slightly outperformed large growth. Among small cap stocks, growth outperformed value.

In the non-US developed markets (based on the MSCI indices in USD), all segments had negative performance. Negative returns among large and small caps stocks were similar, while large growth slightly outperformed large value. In the emerging markets, small cap, which had a slightly positive return, outperformed large cap, and growth outperformed value, although both returns were negative.

The mixed results of the size and relative price dimensions in 2014 were not unusual from a historical standpoint. Although small cap and value stocks have offered higher expected returns relative to their large cap and growth counterparts, these return premiums do not appear each year. For example, since 1979, US small caps have outperformed large caps in 19 of the 36 calendar years—or 52% of the time. Results are similar for the relative price dimension: Since 1979, value has outperformed growth in 20 calendar years—or 55% of the time. Small cap value has outperformed large cap growth in 58% of the calendar years.

History also has produced multiyear periods in which small caps and value did not outperform large caps and growth. Noteworthy periods include 1984 to 1987 and 1994 to 1998, when small caps underperformed large caps, often by a wide margin each year. Since 1979, the value premium has also experienced extended periods of underperformance—and, in some cases, the differential exceeded 15% margin. The same is true of small value vs. large growth stocks. In the three-year period from 2009 to 2011, both value and small caps underperformed. Yet, despite even extended negative-premium periods, small caps and value have outperformed over time, and when the premiums reversed, they often did so strongly and in multiple years.

Currency Impact

The strength of the US dollar had a negative impact on returns for US investors with holdings in unhedged non-US assets. (As a general principal, investors gain when their home currency falls relative to the local currency of the foreign asset they own, but lose when a rise in their home currency reduces the value of the foreign investment in the local currency.)

For example, in 2014, the dollar’s rise relative to the euro hurt the returns of US investors in European markets. The MSCI Europe Index (net dividends) returned 6.84% in euros but -6.18% in US dollars. This was the case in regions where the dollar outperformed local currencies. Other examples: The MSCI UK Index returned 0.50% in pounds but -5.39% in USD. The MSCI Japan Index returned 9.83% in yen and -3.72% in USD.

Russell data © Russell Investment Group 1995–2015, all rights reserved. Dow Jones data provided by Dow Jones Indexes. MSCI data © MSCI 2015, all rights reserved. S&P data provided by Standard & Poor’s Index Services Group. The BofA Merrill Lynch Indices are used with permission; © 2015 Merrill Lynch, Pierce, Fenner & Smith Inc.; all rights reserved. Citigroup bond indices © 2015 by Citigroup. Barclays data provided by Barclays Bank PLC. Indices are not available for direct investment; their performance does not reflect the expenses associated with the management of an actual portfolio.

Investing risks include loss of principal and fluctuating value. Small cap securities are subject to greater volatility than those in other asset categories. International investing involves special risks such as currency fluctuation and political instability. Investing in emerging markets may accentuate these risks. Sector-specific investments can also increase these risks.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks, including changes in credit quality, liquidity, prepayments, and other factors. REIT risks include changes in real estate values and property taxes, interest rates, cash flow of underlying real estate assets, supply and demand, and the management skill and creditworthiness of the issuer.

Registered Representative, Securities offered through Cambridge Investment Research, Inc., a Broker/Dealer, Member FINRA/SIPC. Investment Advisor Representative, Cambridge Investment Research Advisors, Inc., a Registered Investment Advisor. Lion’s Share U.S. Financial Services and Cambridge are not affiliated. Indices mentioned cannot be directly invested in. Past performance is no guarantee.  When you access other linked websites, you assume total responsibility and risk of the websites you are linking to caveat emptor. All expressions of opinion are subject to change without notice in reaction to shifting market conditions. All materials presented are compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. Article are provided for informational purposes, and it is not to be construed as an offer, solicitation, recommendation or endorsement of any particular security, products, or services in Alabama, Florida, Georgia, and Tennessee. No offers may be made or accepted from any resident outside the specific state(s) referenced.

 

 

 

 

Living with Volatility, again

rollercosterVolatility is back. Just as many people were starting to think markets only ever move in one direction, the pendulum has swung the other way. Anxiety is a completely natural response to these events. Acting on those emotions, though, can end up doing us more harm than good.

There are a number of tidy-sounding theories about why markets have become more volatile. Among the issues frequently splashed across newspaper front pages: global growth fears, policy uncertainty, geopolitical risk, and even the Ebola virus.

In many cases, these issues are not new. The US Federal Reserve gave notice last year it was contemplating its exit from quantitative easing (an unconventional monetary policy used by central banks to stimulate the economy when standard monetary policy has become ineffective). Much of Europe has been struggling with sluggish growth or recession for years, and there are always geopolitical tensions somewhere.

In some ways, the increase in volatility in recent weeks could be just as much a reflection of the fact that volatility has been very low for some time. Investors in aggregate were satisfied earlier this year with a low price on risk, but now they are applying a higher discount rate to risky assets.

So the increase in market volatility is an expression of uncertainty. Markets do not move in one direction. If they did, there would be no return from investing in stocks and bonds. And if volatility remained low forever, there would probably be more reason to worry.

As to what happens next, no one knows for sure. That is the nature of risk. In the meantime, investors can help manage their risk by diversifying broadly across and within asset classes. We have seen the benefit of that in recent weeks as bonds have rallied strongly.

For those still anxious, here are seven simple truths to help you live with volatility:

  1. Don’t make presumptions.

    Remember that markets are unpredictable and do not always react the way the experts predict they will. When central banks relaxed monetary policy during the crisis of 2008-09, many analysts warned of an inflation breakout. If anything, the reverse has been the case with central banks fretting about deflation.

  2. Someone is buying.

    Quitting the equity market when prices are falling is like running away from a sale. While prices have been discounted to reflect higher risk, that’s another way of saying expected returns are higher. And while the media headlines proclaim that “investors are dumping stocks,” remember someone is buying them. Those people are often the long-term investors.

  3. Market timing is hard.

    Recoveries can come just as quickly and just as violently as the prior correction. For instance, in March 2009—when market sentiment was at its worst—the S&P 500 turned and put in seven consecutive months of gains totalling almost 80%. This is not to predict that a similarly vertically shaped recovery is in the cards, but it is a reminder of the dangers for long-term investors of turning paper losses into real ones and paying for the risk without waiting around for the recovery.

  4. Never forget the power of diversification.

    While equity markets have turned rocky again, highly rated government bonds have flourished. This helps limit the damage to balanced fund investors. So diversification spreads risk and can lessen the bumps in the road.

  5. Markets and economies are different things.

    The world economy is forever changing, and new forces are replacing old ones. This applies both between and within economies. For instance, falling oil prices can be bad for the energy sector but good for consumers. New economic forces are emerging as global measures of poverty, education, and health improve. A recent OECD study shows how far the world has come in the past 200 years.1

  6. Nothing lasts forever.

    Just as smart investors temper their enthusiasm in booms, they keep a reserve of optimism during busts. And just as loading up on risk when prices are high can leave you exposed to a correction, dumping risk altogether when prices are low means you can miss the turn when it comes. As always in life, moderation is a good policy.

  7. Discipline is rewarded.

    The market volatility is worrisome, no doubt. The feelings being generated are completely understandable and familiar to those who have seen this before. But through discipline, diversification, and understanding how markets work, the ride can be made bearable. At some point, value re-emerges, risk appetites reawaken, and for those who acknowledged their emotions without acting on them, relief replaces anxiety.

OUTSIDE THE FLAGS
By Jim Parker
Vice President
DFA Australia Limited

1.‘How Was Life? Global Well-Being Since 1820’, OECD, Oct 2, 2014.

 

Registered Representative, Securities offered through Cambridge Investment Research, Inc., a Broker/Dealer, Member FINRA/SIPC. Investment Advisor Representative, Cambridge Investment Research Advisors, Inc., a Registered Investment Advisor. Lion’s Share U.S. Financial Services and Cambridge are not affiliated. Indices mentioned cannot be directly invested in. Past performance is no guarantee.  When you access other linked websites, you assume total responsibility and risk of the websites you are linking to caveat emptor. All expressions of opinion are subject to change without notice in reaction to shifting market conditions. All materials presented are compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. Article are provided for informational purposes, and it is not to be construed as an offer, solicitation, recommendation or endorsement of any particular security, products, or services in Alabama, Florida, Georgia, and Tennessee.