World Asset Class First Quarter 2016 Index Returns
The U.S. stock market recovered from the worst start to a year on record (down 10% by February 11th) and finished the first quarter up slightly (while the small cap Russell 2000 index was slightly negative, see chart below). It would have been a poor decision for a long term investor to sell out of stocks due to the negative volatility that reared its ugly head as the market bottomed on February 11, since world stock markets recovered prior to the end of the quarter.
The U.S. dollar weakened 4.2% against a basket of global currencies, which helps index returns in International Developed and Emerging Markets. Emerging Markets have rebounded from a challenging 2015 as the dollar strength of last year has reversed and commodity prices have recovered from a steep decline. Global Real Estate was the best performing asset class during the first quarter and bond markets around the world were positive due to a sizeable parallel shift down in the yield curve (all maturities except the one-month Treasury Bill saw interest rates decline, see chart below).
The S&P High Yield Index was also up but is still down 3.7% in the last year as high yield spreads spiked to 9% during February and have since declined back to 7% (more on this later).
A DEEPER LOOK
What caused the market to suffer such a drop, only to recover? Two actions in December created unintended consequences: The timing of The Federal Reserve increasing short term interest rates from 0% to 0.25% and China’s decision to un-peg its currency from the dollar and manage it to a basket of currencies, allowing it to weaken. Combined with already high stock valuations (as we have been pointing out for a very long time now in this blog), the ingredients seemed right for a correction. So the markets responded.
Then markets rallied back. There are three primary underlying justifications for the market rallying: 1) Federal Reserve Chair Janet Yellen’s comments; 2) The People’s Bank of China (PBOC) successfully exercising control over the exchange rate of their currency to the U.S. dollar; and 3) the slight improvement in the price of oil allayed bankruptcy fears in the high yield bond market.
Janet Yellen calmed markets by changing expectations around the glide path of interest rate increases throughout the year. The market responded to her comments by reducing expectations for the pace of interest rate increases. The expectation for a more prolonged period of lower rates gave a boost to risky assets. The comments also caused the dollar to weaken versus global currencies by 4%, boosting U.S. export businesses and, presumably, U.S. jobs.
The People’s Bank of China was able to maintain a stable exchange rate even though many economists and analysts believed China’s currency would weaken, perhaps substantially, causing a global disruption in international money movement and trade. Since January, however, the PBOC has been able to stabilize the Yuan, as evidenced in the chart below. At the end of last summer, the PBOC announced it would weaken the currency by 2% (notice the straight line up in July) up to 6.4 Renminbi (Yuan) per dollar. It appeared the PBOC has lost control of the exchange rate through December and January as the Yuan continued to weaken all the way to 6.6 per dollar by the end of January. Massive amounts of capital were fleeing China, which created uncertainty in their economy. As you can see in the chart below the exchange rate has moved back to 6.45 (Yuan strengthening against the dollar), about the same level as December of last year. News out of China has not been moving global stock markets in the last month.
The stabilization and slight increase in oil prices also calmed market fears that the low oil prices would cause a spike in bankruptcies, which would affect the loan portfolios of small and mid-sized banks serving the energy sector. This leads to a fear of all risky assets due to contagion. There is no question that the energy sector has been hit pretty hard, but other sectors in the economy are picking up the slack both in productivity and employment. The elevated, then alleviated concerns are illustrated in the one-year high yield bond spread chart below, although concerns are still obviously present, with a spread of 7%:
CONCLUSION
The first step in portfolio management is to try to achieve the target return for goal attainment with the lowest amount of risk possible. This is known as mean-variance optimization (mean return and the variance or standard deviation of that return). Dialing portfolios in along the “efficient frontier” helps us build financial plans that increase the probability of goal achievement over the long term. These portfolios are created with the knowledge that recessions and bear markets occur, therefore are expected; and we do not abandon the portfolio based on news, guesswork or prognostications as markets cannot be timed. We build portfolios to be robust and resilient through all market conditions (although negative volatility cannot be removed completely), including recessions and market corrections, based on a globally diversified asset allocation of stocks and bonds. The empirical evidence proves asset allocation explains 93.6% of variance of investment portfolio returns; so less than 7% of variance of investment returns are explained by market timing and active stock selection (see https://blogs.cfainstitute.org/investor/2012/02/16/setting-the-record-straight-on-asset-allocation/). Our globally diversified portfolios include global bonds, global large cap and small cap stocks, and emerging market and real estate stocks, further delineated amongst growth and value stocks. It is important to point out that the global stock and bond markets will not collapse to zero unless an absolute disaster occurred. Why? The markets represent the productive assets of the global economy and business transactions are a major part of society. The economy represents the daily decisions that consumers, like you, make on daily basis. As long as there is the buying and selling of goods, there is economic activity; and therefore there is profit earned by those productive assets of the economy.
On top of portfolio construction, we add additional value by using an active rebalancing strategy; allowing asset classes to drift 20% from their target before rebalancing back to target. This strategy can add up to an additional 80 basis points of annual return and is based on the white paper, “Opportunistic Rebalancing: A new Paradigm for Wealth Managers” by Gobind Daryanani that appeared in the Journal of Financial Planning in January, 2008. The white paper provides convincing empirical evidence that an asset drift of 20% and monitoring the portfolio for rebalancing every two weeks is superior than calendar based rebalancing based on quarter or year end. We would be happy to provide a copy of the white paper to you upon request. In addition to active rebalancing, our investment strategy includes analysis of macro-economic data in conjunction with valuation and yield curve analyses, which are discussed weekly at our investment committee meeting. This tactical overlay process could result in a decision to move target bond durations, or under or overweight asset classes, based on a prudent look at upside potential versus downside risk. Is there a high probability of all risky asset classes going down together (what is known as a black swan event) or an impending recovery from such an event? Black Swan events are rare but occur more often in stocks than they should as the assumption that stock returns are “normally distributed” (from a statistical viewpoint) is false. While the market cannot be timed, and we do not deviate from our core portfolio methodology often, we do exercise prudence and take measured actions when our triggers are activated.
However, what we believe to be more important than investment portfolio return is the ability to help answer the question, “What is the money there for?”. There is a purpose behind saving money; whether it is for education, retirement, to create a legacy, or any other dream one may have. We optimize the probability of achieving one’s financial goals using stochastic modeling of thousands of different investment return possibilities combined with one’s expected cash flows by identifying a prudent asset allocation; and also by helping with decision making on items under one’s control, such as saving and spending behaviors and tax decisions. Once a prudent asset allocation is identified, we create an investment policy statement for our client so they understand the process in written detail. We help our clients become successful investors that understand how their portfolio ties to their goals, that markets pull back at times, and that those times provide opportunity over the long run. We discussed more about successful investing in our previous blog here: http://www.laketahoewealthmanagement.com/blog/2015-08-24-putting-recent-market-volatility-perspective. It is important to adhere to strategies that are based on rigorous research and empirical evidence and maintain a long term focus. One cannot time markets and typically the short term is just noise. Here is a sample of how the world stock market responded to headline news, during the last quarter and the last year (notice the insert of the second graph that compares the last 12 months to the long term):
In short, the conclusion is this: investors should base actions on academically vetted research rooted in empirical evidence, understand one’s own psychology around money (behavioral finance), and maintain a rigorous discipline while avoiding reaction to the noise cycle, oops, news cycle, of the day. As always, we are here for you. Please call us any time with questions. We love this stuff, and love talking with you about it!
1. Standardized Performance Data and Disclosures
Russell data © Russell Investment Group 1995-2014, all rights reserved. Dow Jones data provided by Dow Jones Indexes. MSCI data copyright MSCI 2014, all rights reserved. S&P data provided by Standard & Poor’s Index Services Group. The BofA Merrill Lynch Indices are used with permission; © 2013 Merrill Lynch, Pierce, Fenner & Smith Inc.; all rights reserved. Citigroup bond indices copyright 2014 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.
Past performance is no guarantee of future results. This information is provided for educational purposes only and should not be considered investment advice or a solicitation to buy or sell securities. Diversification does not guarantee investment returns and does not eliminate the risk of loss.
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.
Lake Tahoe Wealth Management, LLC is an investment advisor registered in the States of Nevada, New York, North Carolina, South Carolina, and Texas.
Principal Risks:
The principal risks of investing may include one or more of the following: market risk, small companies risk, risk of concentrating in the real estate industry, foreign securities risk and currencies risk, emerging markets risk, banking concentration risk, foreign government debt risk, interest rate risk, risk of investing for inflation protection, credit risk, risk of municipal securities, derivatives risk, securities lending risk, call risk, liquidity risk, income risk. Value investment risk. Investing strategy risk. To more fully understand the risks related to investment in the funds, investors should read each fund’s prospectus.
Investments in foreign issuers are subject to certain considerations that are not associated with investment in US public companies. Investment in the International Equity, Emerging Markets Equity and the Global Fixed Income Portfolios and Indices will be denominated in foreign currencies. Changes in the relative value of these foreign currencies and the US dollar, therefore, will affect the value of investments in the Portfolios. However, the Global Fixed Income Portfolios and Indices may utilize forward currency contracts to attempt to protect against uncertainty in the level of future currency rates (if applicable), to hedge against fluctuations in currency exchange rates or to transfer balances from one currency to another. Foreign Securities prices may decline or fluctuate because of (a) economic or political actions of foreign governments, and/or (b) less regulated or liquid securities markets.
The Real Estate Indices are each concentrated in the real estate industry. The exclusive focus by Real Estate Securities Portfolios on the real estate industry will cause the Real Estate Securities Portfolios to be exposed to the general risks of direct real estate ownership. The value of securities in the real estate industry can be affected by changes in real estate values and rental income, property taxes, and tax and regulatory requirements. Also, the value of securities in the real estate industry may decline with changes in interest rate. Investing in REITS and REIT-like entities involves certain unique risks in addition to those risks associated with investing in the real estate industry in general. REITS and REIT-like entities are dependent upon management skill, may not be diversified, and are subject to heavy cash flow dependency and self-liquidations. REITS and REIT-like entities also are subject to the possibility of failing to qualify for tax free pass through of income. Also, many foreign REIT-like entities are deemed for tax purposes as passive foreign investment companies (PFICs), which could result in the receipt of taxable dividends to shareholders at an unfavorable tax rate. Also, because REITS and REIT-like entities typically are invested in a limited number of projects or in a particular market segment, these entities are more susceptible to adverse developments affecting a single project or market segment than more broadly diversified investments. The performance of Real Estate Securities Portfolios may be materially different from the broad equity market.
Fixed Income Portfolios:
The net asset value of a fund that invests in fixed income securities will fluctuate when interest rates rise. An investor can lose principal value investing in a fixed income fund during a rising interest rate environment. The Portfolio may also be affected by: call risk, which is the risk that during periods of falling interest rates, a bond issuer will call or repay a higher-yielding bond before its maturity date; credit risk, which is the risk that a bond issuer will fail to pay interest and principal in a timely manner.
Risk of Banking Concentration:
Focus on the banking industry would link the performance of the short term fixed income indices to changes in performance of the banking industry generally. For example, a change in the market’s perception of the riskiness of banks compared to non-banks would cause the Portfolio’s values to fluctuate.
The material is solely for informational purposes and shall not constitute an offer to sell or the solicitation to buy securities. The opinions expressed herein represent the current, good faith views of Lake Tahoe Wealth Management, LLC (LTWM) as of the date indicated and are provided for limited purposes, are not definitive investment advice, and should not be relied on as such. The information presented in this presentation has been developed internally and/or obtained from sources believed to be reliable; however, LTWM does not guarantee the accuracy, adequacy or completeness of such information.
Predictions, opinions, and other information contained in this presentation are subject to change continually and without notice of any kind and may no longer be true after the date indicated. Any forward-looking statements speak only as of the date they are made, and LTWM assumes no duty to and does not undertake to update forward-looking statements. Forward-looking statements are subject to numerous assumptions, risks and uncertainties, which change over time. Actual results could differ materially from those anticipated in forward looking statements. No investment strategy can guarantee performance results. All investments are subject to investment risk, including loss of principal invested.
Lake Tahoe Wealth Management, Inc. is an investment advisor registered in the States of Nevada, California, New York, North Carolina, South Carolina, and Texas.
