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January 2015
End of Year Newsletter
Diversification is considered, by most studies, to be the
best way to reduce overall investment risk; “risk” being
defined as a measure of portfolio volatility. In 2014, a
portfolio invested only in the S&P 500 would have had a
return of 13.7% with dividends included. On the other
extreme, a portfolio invested only in the Bloomberg
Commodity Index would have had a return of (-17.0%).
In between these two extremes is where the Total
Return of most asset classes fell last year. While there
are always diverging returns from various asset classes
in any given year, it was especially important to be
aware of your diversification when reviewing the impact
on one’s portfolio last year. Nearly all asset classes that
a portfolio would have held last year outside of large
U.S. companies greatly reduced portfolio return. The
one exception was the Real Estate Market, which was
up 28%, represented by the Nareit Equity REIT Index.
For example, note the following:
ASSET CLASS
REPRESENTED BY
how well the market did, and all the new highs the S&P
500 and Dow Jones Index set last year. As you can see
from the Chart #1 (below), asset class returns can vary
greatly from year to year, and you never know exactly
where any one of them will fall in a particular time
period.
CHART #1
2014 TOTAL RATE
OF RETURN
Small Stocks
Russell 2000 Index
4.9%
International
Stocks
MSCI EAFE Index
(-4.5%)
Emerging Market
Stocks
MSC Emerging Index
(-1.8%)
The same holds true for most of the fixed income
investments a portfolio may have held. The Barclays
Aggregate Index had a return of 6.0% and that return
was much better than short maturity bonds, floating
rate note investments or most of the broad fixedincome category referred to as unconstrained, or
flexible bond funds.
All of this illustrates the fact that a well-diversified
portfolio had a 2014 Total Return less than many
people might expect when the news outlets rave about
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A somewhat unusual aspect of 2014 asset returns was
that small cap stocks lagged the performance of large
cap stocks by more than 8.5 %. While not unprecedented, you have to go back to 2011 for another instance of
small underperforming large, and all the way back to
1998 to find a period where small underperformed by a
larger margin.
Of course, the big story in the markets for 2014 was the
collapse in oil prices. The price of West Texas
Intermediate crude has fallen by more than 50%, from a
high price of over $100 per barrel to less than $50 per
barrel in less than six months. This is only the sixth time
since 1980 that the price of oil declined by 50% or more.
It is, however, only the second time when the high was
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January 2015
End of Year Newsletter
making the decline seem even more dramatic.
CHART #2
The impact of the decline in oil has been felt in both
stocks and bonds. There has been the expected fall in
the prices of stocks from the major integrated companies
to the small exploration and production companies. The
spillover has been seen in the bond market as well.
A significant percentage of the high-yield bond market
consists of small and mid-size energy companies that
have borrowed to fund operations and expansion during
the growth of the shale oil boom. Concern is now
surfacing as to whether these companies will have the
cash flow to sustain their debt service payments if the
price of oil stays low for an extended time.
Consequently, the interest rate spreads between yields
of higher quality and lower quality debt has widened,
making it more difficult and more expensive for
companies to re-finance or issue new debt. This may
provide an explanation why small-cap stocks had such a
tough year versus their larger cap brethren.
While diversification reduced potential returns last year,
it also reduced the risk of picking the wrong market
segment. At Medallion Wealth Management, we have
always believed that diversification is an important
component for the long-term investor. As can be seen
from the wide dispersion of returns without being
diversified in 2014, reward can be high if you are
fortunate enough to select the right asset class, but a
high threshold for pain would be required if you only had
one or two of the losing asset classes.
With few exceptions, international markets and
economies underperformed the US in 2014. In spite of
verbal encouragements from European Central Bank
officials, most EU economies suffered from moribund
growth. ECB President Draghi has indicated on
several occasions that they would embark on a major
quantitative easing program, but thus far the central
bank’s balance sheet has not shown any expansion.
Please see the following chart (Chart #2) on central bank
balance sheets and note the lack of growth over the last
three years of the ECB. As a result, GDP growth in most
developed European economies has been barely above
stall speed. Another blow like Russia’s intervention in
Ukraine would probably be enough to drive most of
Europe into recession. Many of the Asian countries are
suffering from a similar malaise. Japan has made
attempts to stimulate growth by embarking on a
quantitative easing program of their own, but so far,
little is available to prove its worth.
To set the stage for 2015, most developed international
economies are trying to drive down the value of their
currencies relative to the US dollar. Growth in GDP
among the industrialized world may again be a scarce
commodity.
Creating a relatively cheaper currency has been a way
to stimulate trade. The US began efforts to lower the
value of the dollar and simultaneously drive down
interest rates in 2008 when it became clear that we were
in the throes of a major recession. Those stimulation
efforts, known as Quantitative Easing (QE), were
designed to lower interest rates, provide additional
liquidity and lower the value of the currency. Having
achieved a measure of success, QE in the US ended at
the end of 2014; it is, however, just beginning in most
other parts of the world.
Relative to the rest of the developed world, better GDP
growth, the end of QE, and more attractive interest rates
have made the US somewhat of a haven for capital
flows, creating a stronger currency. We believe the
dollar and the US equity markets are likely to continue
to be the most attractive markets, on a risk/reward basis,
of the developed world in 2015. International markets
do have considerable upside if things would go their
way, but still seem very questionable at this point.
The potential for continued cash inflows into the US,
coupled with a shrinking supply of available US shares
for purchase due to the enormous amount of buy-backs
that have occurred, could continue to provide a favorable
backdrop for our stock market.
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End of Year Newsletter
Of course, earnings growth, stock valuation and
alternative choices are always important considerations
when analyzing the stock market. Let’s briefly examine
these, with regard to earnings. S&P Capital IQ is
estimating an 8-9% growth rate for 2015 S&P 500
earnings. Due to the extreme weakness in the energy
sector, that estimate may get revised downward, but
should still show a reasonable increase for next year.
However, it is thought by many that 2015 will be the time
that workers finally share some of the corporate profits in
the form of slightly higher wages. This, along with the
severe drop in the price of gasoline would provide
additional spending power for the consumer. Corporate
profit margins should stay near record levels. So any
revenue growth should find its way to the bottom line of
many sectors of the market. Current valuation of the
S&P 500 looks fair, as measured by both the trailing 12month price/earnings ratio, which is 17.5, and the price/
earnings ratio based on next year’s estimated earnings,
which is 15.8. With regard to alternative choices versus
the stock market, you have extremely low interest rates
on Treasuries, and only slightly higher on US investment
grade corporate bonds.
The current psychology of the professional money
manager appears to be best described by saying they
are reluctantly and cautiously invested. Despite strong
returns from the S&P 500 in 5 of the last 6 years, there is
still significant doubt that the Bull Market should have
been this strong and will continue. This could provide a
nice environment for stocks if the economy continues to
improve and the lack of an alternative forces managers
to put more money into stocks. In addition, the average
retail investor still appears to be very cautious toward
stocks and continues to buy bonds even in this
extremely low rate environment. Chart #3 shows the
CHART #3
January 2015
enormous cash reduction in domestic stock mutual
funds over the last six years, while bond mutual funds
have had inflows more than twice that amount. Even a
slight reversal of this could provide some fuel for further
market gains.
In conclusion, our outlook is that the US economy is
on a fairly strong footing, stocks are not extremely
over-valued, and interest rates are not likely to be up
significantly The Bull Market trend for US stocks
appears to be intact. While International economies
are not nearly as strong as the US, they do have the
potential for financial and structural reform and
improvements which could lead to improved stock
market returns.
While US small stocks significantly under-performed US
large stocks in 2014, we feel they could show better
relative returns in 2015 due to a strong dollar, which
could put pressure on some of the foreign earnings in
large companies.
Regardless of the specific market, we feel 2015 will have
much more volatility, with a wider dispersion between the
winners and losers. As always, Medallion Wealth
Management will focus on building client portfolios that
are well diversified and have holdings that are well
researched, and --most importantly – fit with client
objectives and risk tolerances.
A potential major impact to both the equity and fixed
income markets around the world is the fact that so many
markets are more intertwined and linked because of all
the central bank action around the world in recent years.
This has, in effect, not allowed interest rates, currencies
and stock markets to find the levels they may have
otherwise reached.
This has greatly increased the volatility of many markets,
and set up the potential for unintended consequences as
various actions or non-actions are taken around the
world. These dislocations may cause extreme swings in
currencies, interest rates or stock markets.
Securities offered through Cambridge Investment Research, Inc., a brokerdealer, member FINRA/SIPC. Advisory services offered through Cambridge
Investment Research Advisors, Inc., a Registered Investment Adviser.
Cambridge and Medallion Wealth Management, Inc. are not affiliated. Asset
allocation and diversification strategies cannot assure profit or protect against
loss in a generally declining market, and past performance does not guarantee
future results. Indices mentioned are unmanaged, do not incur fees, and
cannot be invested into directly. Material discussed herewith is meant for
general illustration and/or informational purposes only. Please note that
individual situations can vary; therefore, the information should be relied upon
when coordinated with individual professional advice.
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