Q4 2015 Client Letter
“Pressure, pushing down on me, pressing down on you…”
-- Under Pressure, David Bowie & Queen
I begin this letter with a brief comment on the recent stock market decline. In the first two weeks of 2016, the global equity markets began right where they left off in 2015…focused on oil and China and under pressure.
The good news is that stocks are nearing several oversold indications and last Friday’s employment report showed that a recession in the U.S. is not on the horizon. But with global equities now over 6% lower since the first interest rate hike, maybe the Fed will tamp down their excitement to raise rates in 2016. Indeed, we could be in for low interest rates and low oil prices for much longer than most people expect.
Global Capital Markets in Review: “The Man Who Sold the World”
As we look back on the financial markets in 2015, what really stands out is how poor returns were across the globe and across asset classes (stocks, bonds, commodities, etc.). Among the major global stock markets, the United States was the best performer, but that’s faint praise. What’s more, it was a market in which a handful of large tech/Internet companies (e.g., Facebook, Amazon.com, Netflix, and Google) generated huge gains, while the equal-weighted S&P 500 index actually fell 2.2% for the year. Thankfully, our U.S. portfolios were overweight with these growth-oriented companies.
One striking feature of last year’s investment environment was the difference in the direction of the U.S. economy and U.S. monetary policy versus other major global economies. In December, the U.S. Federal Reserve was sufficiently comfortable with the outlook for economic growth and the potential for inflation to eventually normalize that it made its first increase in rates in nearly a decade. Outside the United States, regaining more normal economic growth and inflation has remained more challenging in the face of downward pressures such as sharply lower commodity prices (most notably oil), Middle East tensions, and China’s slower economic growth. Year-end foreign stock returns reflect this bifurcation, with developed international stocks and emerging-markets stocks falling. As in 2014, the strength of the dollar exacerbated foreign markets’ under-performance, detracting 9% from emerging-markets stocks and 6% from developed international stocks compared to their local-currency returns. Our hedge against the falling Euro helped us limit some of the currency damage.
The worst-performing areas of the markets were commodity-related asset classes. Commodity indexes were crushed, down on the order of 25%–30% as oil prices hit an 11-year low in December and fell 30% for the year, after plunging 50% in 2014. Energy MLPs, an increasingly popular vehicle for yield seekers (and yield chasers), dropped 35%–40%, wiping out the previous four years’ worth of gains. Not to worry, we didn’t own any MLPs last year.
Bond investments offered little relief. High-yield bonds (junk bonds) were smashed, down close to 5% (we didn’t own any junk, either). Investment-grade municipal bonds were a relative bright spot, with the national municipal bond index up nearly 3% on the year.
Overall, 2015 was a challenging year for the financial markets, and for our globally diversified portfolios as well. The major headwind to our performance was our allocation away from U.S. stocks in favor of European and emerging-markets stocks.
Portfolio Review and Positioning: “Rebel, Rebel”
Given the challenges of the past year, we think it is particularly important to reiterate our positive outlook for our portfolio positions and review how we arrive at our assessments.
Our positions in foreign stocks are not based on a short-term view of the market, or a prediction that a drop in U.S. stocks is imminent, or even that U.S. stocks will necessarily trail non-U.S. stocks in 2016 (although it is very tempting to say they are due!). Financial market history is a history of cycles (or like the swings of a pendulum), moving from one extreme to another. Market history teaches us that undervalued assets can fall further, and overvalued markets can overshoot even further on the upside. We need only look back to the tech bubble or real estate bubble to see recent examples of this. It is simply the reality that comes with being a long-term equity investor.
Our investment philosophy is based on the belief that fundamentals ultimately drive investment returns. Specifically, whether we’re evaluating stocks, bonds, real estate, or another asset class, the value of an investment is generally determined by the cash flows the investment or investment market generates over time. This type of valuation, unfortunately, is a very poor short-term market indicator. But over the longer term and over full market cycles (five to 10 years), history has shown that valuation is a powerful driver of returns. Buying undervalued assets pays off over time, but you need to withstand the discomfort that typically accompanies it as you wait for markets to turn in your favor.
The U.S. equity market has had a very strong run over the past few years and by most valuation measures is stretched. After six years of generally rising stock prices, investors may be complacent about the potential risk. Those risks may or may not be imminent, but we believe the reversal of this current cycle may not be long in coming given the relative attractiveness of foreign stock market valuations and the potential for foreign company earnings to improve from currently depressed levels.
We are confident we will be rewarded (with outsize returns) for our current allocations to European and emerging-markets stocks. But we also know that we don’t know precisely when those markets will turn around. As the old saying goes, “They don’t ring a bell at the bottom of the market” (or the top for that matter). It requires patience—another core element of our investment philosophy—to hold onto (and potentially add more to) these longer-term return generators during the periods when they seem only to be downside-risk generators.
On the bond side, with interest rates having begun what the Fed has said will be a gradual upward climb (maybe even more gradual than originally thought), we view our fixed income allocation as primarily a risk-reducer. And while our core bonds should mitigate some of the shorter-term downside risk from stocks in our portfolios, the degree to which they can do so is more limited in the current environment. This past year was a good example of this, with core bonds registering negative results along with global equities.
Finally, given our sub-par outlook for U.S. stocks and bonds, we continue to find value in owning alternative strategies that can generate attractive long-term returns and provide powerful portfolio diversification benefits.
Looking Ahead in 2016: “Modern Love”
We live in a modern capital markets world that is becoming more intricately connected all the time. We believe our portfolios are well positioned to generate solid returns over our five-year horizon, but we think it is prudent to be prepared for potentially increased market volatility and downside risk (as well as positive returns) over the shorter-term. We may even get the opportunity to add to our undervalued positions or establish some others before this market cycle turns. In other words, we believe the key to successful investing in this environment is to maintain the healthy patience, perspective, and discipline necessary for long-term investment and financial success. Remember, discipline trumps conviction every time.
One thing is for certain, the global capital markets will always be undergoing ch-ch-ch-ch-changes. And we will continue to monitor events and adapt to opportunities here at Ground Control.
As always, we appreciate your trust and confidence.