Looking forward, there are many good reasons that the bull market is likely to continue. The economy is back on track for growth. Yet there are many who are bracing for a down market and have low expectations for the equity market in 2014, due to last year’s extraordinary performance. We enter the New Year prepared for periodic pullbacks, yet we are optimistic for the year ahead.
We thought it would be helpful to reminisce about the equity markets of recent history in order to put recent returns in perspective and show that there is cause for optimism. If we are expecting the equity markets to return to “normal” it is important to reflect on what that might mean.
The financial landscape changed dramatically at the beginning of the 1970s. Prior to 1971, there were no money market funds, the U.S. dollar was backed by gold (and currency futures did not exist), you could not own gold, there were no discount brokerage firms (Charles Schwab started in 1971 after the Securities and Exchange Commission ended fixed rate commissions on stock transactions), and there were no adjustable mortgages—all mortgages had fixed interest rates. Banks had a ceiling of what they could pay on deposits (remember the good old 5% savings interest?).
The 1970s were a time of great tumult, including one of the steepest recessions of our lifetimes. During that decade, the equity market experienced three negative years.
Following the dismal 1970s, the S&P 500 had only one negative year in each of the next two decades, and three years in each with annual returns in excess of 30%. Those who remember the October 1987 market crash (during which the DJIA fell 508 points or 22.6% on October 19th) often forget that the year ended with a positive return. Please keep in mind that past performance is not a guarantee of future performance.
In the table above, we include the MSCI EAFE (Europe, Australasia and the Far East) for the 1980s since the MSCI All Country World ex-U.S. started in 1987. The MSCI ACWI ex-U.S. includes the emerging markets and is a much broader non-U.S. equity benchmark than the MSCI EAFE. The non-U.S. markets dominated during the 1980s; however much of this outperformance came from the bubble in Japan, which represented more than 50% of the MSCI EAFE at various points, and which collapsed in 1990.
As the table illustrates, a globally diversified portfolio has helped during most time periods. Since 2010, the U.S. markets have outperformed—however, this pattern is not expected to persist indefinitely. By continuing to invest when these non-U.S. markets are out of favor, we are poised to benefit when they rebound. Economic conditions and demographic trends will benefit companies that provide what global consumers want and need.
Investors in the 1980s experienced market turbulence fairly frequently: the failure of First Pennsylvania Bank (1980), the failure of Penn Square (1982), the default of Mexico (1982), the FDIC takeover of Continental Illinois (1984), and Alan Greenspan’s move to raise interest rates after replacing Paul Volcker as Fed chair in Au- gust 1987. The decade ended with the savings and loan crisis (1989) and the creation of The Resolution Trust.
The 1990s also provided challenges. They included the Mexican peso devaluation crisis (1994-1995), bankruptcy filing of Orange County, California (1995), revelation that the Foundation for New Era Philanthropy was a Ponzi scheme (1995), South East Asia currency crisis (1997), Russian ruble devaluation and moratorium on foreign debt payments (1998), and the collapse of Long Term Capital Management (1998).
Then came the “oughties” beginning in 2000—the decade with four double-digit negative years, and only one year in which the S&P 500 returned almost 30%. It was as if the market cycle was on steroids: technology bubble and bust, September 11, 2001 terrorist attacks and responses, accounting scandals (Enron, WorldCom etc.), housing bubble and collapse, subprime crisis, credit crisis, the “Great Recession” and the market lows of March 2009. When we look back at the past 14 years, should we view this period as “normal” or an “aberration”? Have investor expectations been too biased to the negative as a result of this most recent period, leaving them unprepared for a longer term bull market?
Could we have another double-digit year? We think it is possible. The global economy has been slowly recovering, which should result in rising revenues for businesses. U.S. auto sales in 2013 were the highest since 2007. Corporate stock buybacks are back to pre-financial crisis levels. Housing prices in many regions of the country have recovered, which spurs homeowners to renovate, expand and/or move.
In 2013, initial public offerings were 30% higher than in 2012. New home construction was up 18% in 2013. Manufacturing is up, and on December 20th, the Bureau of Economic Statistics released a revised 4.1% annualized growth in U.S. GDP for the third quarter, up from its prior estimate of 2.8%. For the fiscal year that ended September 30th, the budget deficit was the lowest since 2008, and was down to 4.1% of GDP, from a peak of 10.1% in 2009. On many fronts, economic and fiscal conditions have been improving.
There are other tailwinds that may drive markets higher. Our domestic energy production is one of the game- changers. Natural gas production is enabling new energy efficiencies, with expanding uses for cleaner power generation and transportation. Also, if U.S. law is changed to allow the exporting of crude oil, we have another significant revenue source that reduces our trade deficit, creates new jobs and does not compromise our energy independence. The current ban on crude oil exports was prompted by the Arab Oil embargo in 1973, in order to make sure we maintained supply for domestic consumption. The situation has so dramatically reversed itself, making this law an example of how difficult it is for government to adapt to the new realities.
The markets are likely to be bumpy in 2014. While we are optimistic about the long-term prospects for global equities, we remain very disciplined with our annual rebalancing to ensure that equity allocations remain in target ranges. Our introduction of several alternative investment strategies was motivated by the objective of having additional defensive positioning for market turbulence; these new strategies are “buffers” in times of stress, and will have less upside during strong bull markets.
As we have often stated, the next severe bear market appears headed for the bond market. During the 1980s, the yield on the 10 year Treasury was over 10% for the first five years, and kept falling from a range of 14% in 1981 to 8.5% in 1989. During the 1990s, the 10 year yield fell steadily from 8.6% in 1990 to 5.7% in 1999. Yields continued to fall in the 2000s, from 6% to 3.3% in 2009.
At year-end 2013, this benchmark yield was a paltry 2.35%. As yields rise, bond prices fall. And as inflation creeps up, the net real return gets further squeezed. It has been over 30 years since bond investors have experienced the impact of persistently higher interest rates; in 2013 we saw just the first inning.
During the Credit Crisis, the Fed signaled its willingness to be proactive before disaster strikes. Incoming Fed Chair Janet Yellen is an extremely bright and competent person to lead the Fed. Of all the many challenges that the Fed is likely to face, the most insidious would be a “Crisis of Confidence” in the Fed itself. Tapering is only the first phase of what it must do. Its ability to gradually divest itself of the massive amount of fixed income securities it has accumulated during its quantitative easing programs, without creating system-wide shocks, will largely depend on how long it can suppress interest rates.
Yellen has done extensive work on the dynamics of unemployment, and brings this expertise to the Fed as it also grapples with the dual mandate (unemployment and inflation) imposed upon it by Congress. Of the triple tasks of maintaining a low interest rate environment, lowering unemployment and managing inflation, a stronger economy may make the unemployment goal the easiest to achieve, at the possible risk of triggering inflation. Under that scenario, the real returns to bond investors will be further compromised.
Recommended Reading:
Next Time Will Be Different, Why Economists Can’t Predict Financial Panics and Crises, Brendan Moynihan 2013. Moynihan is a member of the management team for MainStay Marketfield.
An original article authored by the Investment Research Group of Wescott Financial Advisory Group LLC
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https://www.wescott.com/documents/resources/Wescott_1Q_2015_Market_Perspective_and_Outlook_for_20151.pdf
