Welcome to our first in a series of quarterly newsletters designed to communicate our thoughts and opinions surrounding the current investment environment. We hope these letters will provide further insight on things you are seeing in your monthly statements, or hearing about in the financial news. Our goal is to not only discuss what has already occurred, but also what we see going forward. Along with this letter, all current, past and future writings will be posted on our website in the "blog" section.
2014 - A Year of the "Haves" and "Have Nots"
If you owned nothing but large-cap US stocks and long-term US bonds, 2014 was a year to be celebrated! The S&P 500 kept humming right along, easily producing double digit gains with only a couple of bumps along the way. At the same time, interest rates surprisingly resumed their downward spiral (not sure why "surprisingly" anymore), providing double digit returns for holders of longer-dated US and corporate bonds.
Of course, no one owns solely large-cap stocks or long-term government bonds - if you do, you are hideously under-diversified and need to review your tolerance for risk! For those that held cash, shorter duration and high yield bonds, or floating rate securities - last year was probably more "ho-hum" than "ho-ho-ho". Many investments in emerging markets, energy, or commodities (especially oil) warranted a hearty ole "Bah Humbug"!
As always, there are varying opinions on the disparities listed above and what they may or may not mean for the future of our markets and economy. As with most of such ramblings, we neither completely agree or disagree with any of them. Is a tightening of the yield curve accompanied by a deterioration of the high yield market predicting recessionary times ahead? How about the fact that small cap stocks significantly underperformed their larger peers? Maybe....maybe not. While any of these observations - both positive and negative - are worth noting, they can always be refuted by some other observation or data point.
That said, there were a couple of 2014 observations that we did find particularly noteworthy....
Pleasure at the Pump = Pain for Your Portfolio?
Much has been said about the collapse of oil prices in the second half of 2014. Even if you didn't pay much attention to all of the noise surrounding it, you have at the very least enjoyed the positive effects each time you pull into the gas station. Here again, we hear countless arguments with one side saying that declining oil prices are signaling weakness in the world economy - while the other side states that declining prices at the pump will further jump-start the economy as consumers now have more of their income to spend.
Much like the previous arguments mentioned, we don't put a whole lot into either side. However, what WAS particularly notable to us was the effect that the decline in oil prices had on high yield bonds.....it wasn't good. Granted, most of the deterioration in the high yield space was directly related to exposure to energy companies relying on much higher oil prices. As the price of oil drops, so does the revenue for these companies - making them much riskier investments and causing the value of their debt securities to fall. Simple enough, and probably not cause for panic.
However, what also seemingly occurred was the "baby with the bath water phenomenon". As volatility set in, investors predictably began selling their high yield investments. As managers were forced to sell securities in order to meet redemptions, it became clear in some instances that "liquidity issues" were beginning to appear. In other words, there were not enough buyers to meet the demands of sellers - causing wild volatility in some cases. And while this was almost entirely limited to oil-related securities, it did get us thinking....
How much money has flowed into fixed income mutual funds, ETFs, or other managed products in the past 20 years? With two stock market "crashes", an aging population needing income, and interest rates now literally at zero - the simple answer is.....A LOT. We haven't even sniffed a sustained period of rapidly rising interest rates. What will happen when we finally do - will there be a never before seen exodus from these securities as their values fall due to rising rates? If so, will there be enough demand to meet supply - or is what we just witnessed in the high yield space a pre-cursor of what could occur across other areas of the credit markets? As always, we won't know for sure until it happens....
Valuations - "This Time is Different"
We won't bore you with another long-winded discussion of Dr. Robert Shiller's work on PE ratios - check out our blog or simply type "Shiller PE" into your favorite search engine for all the information you need. Using this metric in particular, one can easily see why equities may be considered "overvalued" in a historical context.
Aside from the Shiller PE, we can look at data concerning margin debt - a very loose definition being monies borrowed against investment securities (often for the purpose of purchasing additional securities). We are well above utilization levels seen in the market tops of 2000 and 2007. In fact, 2014 brought margin borrowing to levels that have never before been recorded.
Finally - and most important to us - we are left to ponder the effects of recent monetary policy on both stocks and bonds. One can argue exactly when the "easy" monetary policies enjoyed today began, but most will not argue that for the past 20+ years we have been in the midst of extremely accommodative monetary policy. It may or may not have had much to do with the creation of the "tech bubble" of the 90s. It most certainly was a driving force behind the "real estate" bubble that burst in dramatic fashion in 2008. What have we done as a result? We have taken interest rates to exactly zero while implementing Quantitative Easing versions 1-3. We are now about 5 years into that experiment.....
Having began my career in the early 90s, I was bombarded with information explaining why the historical run-up in stocks that we were witnessing was sustainable - the main reason being that new technology had changed the investment landscape forever. Wrong. We were then all led to believe that we should be leveraging to the max to purchase real estate - and we now all know how that ultimately worked out. Today, we are told that historical valuation metrics are no longer useful for this reason or that, and that the "uber-easy" monetary policies should have no negative impacts going forward. My favorite saying of today which is seemingly heard daily in the news is "You have to own stocks - there is no other place to put your money".
I will never forget what my father once told me during a conversation about stocks in the 90s. "When someone tells you that 'this time is different', cover your ears....and then run. It never is." He was right then, and I am in no hurry to assume that he is wrong this time around....
While the above discussions are decidedly negative in tone, it is important to note the many good things currently surrounding the world of investments and our economy. Unemployment has dropped substantially. The stock market continues it's upward trend, seemingly making new historical highs everyday. Prices at the pump are significantly lower, and this undeniably results in more discretionary spending / saving power for consumers. We are in NO way "predicting" or "assuming" that there is some sort of imminent crash coming for the markets or economy.
At the same time, we consider it irresponsible to ignore the potential risks that are present in the current environment. Our primary concern continues to be historically elevated valuation levels on both stocks and bonds, resulting (albeit arguably) from monetary policy never before attempted. One must remember that a definition of "risk" is "uncertainty" - and it is undeniable we have never before attempted the monetary policies of the past 5 years. Therefor, we cannot possibly know the outcomes of such actions.
For those reasons, we continue to believe that caution is prudent - preferring some reduction (NOT complete removal) of equity positions while shortening duration and increasing credit quality for income allocations. Unfortunately, managing potential volatility as described above also results in lower potential returns. While no investor (or advisor) looks forward to positioning themselves for "lower returns", we all must remember one universal truth about "protection" or the "exercising of caution" - it can never successfully be done after the fact.
We wish you and your family a very happy and HEALTHY 2015 - and, as always, we thank you for your continued trust and confidence in Round Hill Wealth Management.
Douglas Brymer - President & Wealth Advisor
David Swanson - Principal & Wealth Advisor
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Statements of forecast are for informational purposes and are not guaranteed to occur. Trends discussed are guaranteed to continue into the future. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly. Investments mentioned may not be suitable for all investors. Investing involves risk including loss of principal. No strategy assures success or protects against loss.