Q1 2015 - High Volatility Leads to a Whole Lot of Nothing
For all of those "high adrenaline adventure seeker" types, the first quarter of 2015 did not disappoint! Triple digit moves in either direction for the Dow became the norm rather than an exception. The price of oil continued to swing wildly while the "experts" argued as to whether we had hit bottom or there was more downside on the way. The dollar strengthened against other world currencies in dramatic fashion when put in a historical context. And then there are bonds, which most of us are conditioned to view as a "safe-harbor" against volatility. Yields continued to drop to begin the year, then rose sharply before falling back once again - producing a very volatile first quarter for bond prices.
So, what did all of this volatility across asset classes produce in terms of returns? Simply put, not much. Generally speaking, US stocks were flat for the quarter with the Dow Jones finishing slightly negative and the S&P 500 finishing fractionally higher. Small and mid-cap domestic stocks outperformed their larger counterparts by a considerable margin - a trend we could see continue as the dollar strengthens. Longer-dated bonds continued their remarkable outperformance even against the backdrop of historically low interest rates, while shorter maturities produced lower yet still positive returns for the quarter.
In summary, the first quarter of 2015 was the equivalent of watching a fantastic thriller which has you on the edge of your seat throughout....but the ending leaves you utterly unfulfilled.
"To Hike or Not to Hike - That is the Question"
The main storyline so far in 2015 has been the drama surrounding if and when the Fed will finally hike short term interest rates. We would expect this to continue dominating headlines throughout the year. That being the case, what does all of it mean to your investments? Couple of thoughts....
Depending on which "expert" you are listening to, an eventual rate hike by the Fed is either a strong indication that our economy (and stock prices) can continue to grow going forward - or, "the beginning of the end". Acknowledging the over-simplification, traditional economics tells us that rising rates will slow economic growth and corporate profits as the cost of capital becomes more expensive. That said, many pundits correctly point out that stocks have historically performed very well in the early stages of rate hikes. This leads to the obvious question - should we welcome or fear the first rate hike?
In our opinion, the answer is (drumroll please).....we have absolutely no idea. How is that for honesty? The reasoning behind that less-than-helpful insight is that the monetary policy that has been put in place over the past several years has never before been attempted - so how can we intelligently opine as to how the reversal of that policy will effect the economy or asset prices? We can't, and neither can anyone else. While we are usually enlightened and often times entertained by the "expert" opinions stating otherwise, we remain adamant that the ever present disclosure "past performance is never indicative of future results" holds no greater significance than when applied to today's investment landscape.
So while we will not offer opinions as to the ramifications of eventual rate hikes, we do have some thoughts as to "if, when, and how" the hikes might occur. We would like to first point out that these are "quasi-educated guesses" at best as no one can truly know what the Fed is thinking. As a result, what is written below is better used as a topic for discussion rather than a basis for some sort of short-term market timing. First, as we all know, this country has a LOT of debt. Higher interest rates will make it more expensive for the US to roll-over that debt. Based on recent history (maybe all of history), we find it highly unlikely that our politicians are in any rush to curb spending for the sake of debt reduction - which makes lower interest rates extremely favorable politically. Next and equally important is the fact that the Fed has no better way of predicting the ramifications of rate hikes than the rest of us - or maybe they think they do and their predictions are dire. The simple fact that they have not raised rates already seems to support this thesis. For those reasons (and others too long to list), we are of the opinion that the Fed will continue to drag their feet as long as possible before finally raising rates - and that it will be an incredibly slow process if and when it ever begins.
Our Outlook
We continue to view the current investment environment as one where caution is prudent. In fact, maybe everyone reading these pieces consistently should view our letters the way they do Fed statements and try to guess when we will remove the language "caution is prudent"?
On the domestic equity side, stocks continue to look expensive in a historical context based on many of the valuation metrics we study. Additionally, margin debt is still at glaringly high levels. For a variety of reasons, it would not surprise us to see small and mid-cap stocks continue to outperform in the short term, especially if the dollar continues to strengthen. That said, the move to smaller capitalization stocks is a double-edged sword as the larger names can be less volatile if markets experience a pullback of significance. As a result, we do not advocate a drastic move from larger to smaller names. Overall, we continue to recommend a reduction (NOT removal) of equities from one's overall target allocation.
In our view, the bond market continues to be even more perplexing. Short and intermediate maturities provide limited return potential given the depressed interest rate landscape. Longer maturities - while having produced meaningfully higher returns in recent quarters - inherently have much greater interest rate risk. While our proverbial "guts" tell us that long term rates will be the same or lower by year end, we are unwilling to assume the potential downside risk of these securities given the historically low interest rate environment and the uncertainty surrounding it. Additionally, we remain cautious in the high yield space due to the incredible demand (and subsequent lower current yields) of the past several years - and are also concerned with potential liquidity "unknowns" stemming from recent legislation of the financial sector. Overall, we prefer a "higher credit, shorter duration" fixed income strategy which lends itself to preservation rather than chasing yield or return.
In summary, the risks - "risk" described as "uncertainty" - resulting from unknown outcomes of unprecedented monetary policy are too great to ignore. Whether or not the Fed is directly responsible for current asset prices, valuation levels on both stocks and bonds are historically elevated by many measures. That said, it is important to note that "unknown" does not necessarily mean "negative"- it is in fact possible that the Fed has managed the greatest monetary magic trick in the history of the world. Unfortunately, as always, we won't know for sure until well after the fact.
Finally, and most important, we thank you for your continued trust and confidence in Round Hill Wealth Management.
Sincerely,
Douglas Brymer - President & Wealth Advisor
David Swanson - Principal & Wealth Advisor
The opinions expressed 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 not guaranteed to continue in 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. The prices of small and mid-cap stocks are generally more volatile than large cap stocks. Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price. High yield / junk bonds (grade BB and below) are not investment grade securities and are subject to higher interest rate, credit, and liquidity risks than those graded BBB and above. They generally should be part of a diversified portfolio for sophisticated investors.