January 2015 Market Commentary

Scott Russell |

The New Year is off to an inauspicious start with the stock markets around the world selling off 4% since the end of 2014, and to add insult to injury (no pun intended), I suffered a severely torn ligament in my left ankle from a minor skiing accident on New Year’s.  As I'm confident my ankle will heal, so too will the markets.  


2014 Review

Last year the stock markets experienced sharp & quick selloffs of 4%-7% multiple times throughout the year (e.g. Russia/Ukraine concerns, Ebola outbreak, Crude oil crash…) only to make just as quick a recovery. Trying to time such moves is a fool’s game, and often causes concern for investors with weak stomachs (I received several calls from clients asking me if we should sell stocks due to the Ebola outbreak- we didn't).


2014 was a great example of the short term pro's & con's of maintaining a diversified portfolio of asset classes (e.g. stocks, bonds , REITS…) and asset class segments ( e.g. U.S. Large Cap, U.S. Small Cap, Europe, Japan,  & Emerging Markets….).


In 2013, U.S. Small Cap stocks significantly outperformed U.S. Large Cap stocks by over 7.0%, and REITs were the worst performing asset classes.  So what happened in 2014? REITS were the best performing asset class (+21.5%),  Commodities were the worst (-17.0%), International stocks were weak (-4.5%),  and  U.S. Large Cap Stocks (+13.7%) significantly outperformed U.S. Small Cap stocks (+4.9%).


Why not make big shifts in the portfolio to capture the performance of the best asset classes? If investors owned a mixture of asset classes for even a relatively short period (e.g. 3-5 years), they likely have significant capital gains in most of their holdings (see chart below of Large cap stocks vs. Small cap stocks). Paying combined Federal & State long-term capital gains taxes of 30% today to make major shifts in allocations to try to capture annual performance in different asset classes is a losing proposition, and is why 95% of most mutual funds don't beat the markets on a 3, 5, 10 year basis.


Speaking of assets classes and significant underperformance, you probably missed this Sept 2014 headline- “ Calpers, Nation’s Biggest Pension Fund, to End Hedge Fund Investments”. It turns out even CalPers, one of the most sophisticated institutional investors with  $300 billion in assets and legions of high paid investment consultants, decided it’s hedge fund investments are “too complicated and expensive….,  and will eliminate all of its hedge fund investments over the next year”. “Too complicated and expensive" is a euphemism for bad performance.  Now they just want to go back to owning various asset classes using low-cost index type products.  Wow- what a novel and interesting concept.


A similar but slightly better approach  is to regularly rebalance portfolios to maintain proper risk exposure and capture relative long-term outperformance and underperformance of various asset classes without paying significant capital gains taxes along the way.  This is what Kennicott Capital strives to provide its clients.


2015 Forecasts

The 2015 consensus from leading Wall Street economists is for U.S. Large cap stocks to continue to outperform all the other equity markets including U.S. Small Cap, International Developed & Emerging markets due to a faster growing U.S. economy and a rising  U.S. dollar.


However, keep in mind, this consensus forecast is from the same group of “leading” Wall Street economists who predicted in 2014 the 10 year U.S. Treasury bond would rise in yield from 3.00% to 4.00% based on a growing U.S. economy and a gradual  removal of easy money policy from the U.S. Federal Reserve.  They got the economy and the Federal Reserve action correct, but oops, the 10 year U.S. Treasury bond actually dropped to 1.98% from 3.00% instead of rising to 4.00% due to demand for U.S. bonds from foreign buyers .


FYI- mortgage rates track the 10 year U.S. Treasury bond rate, so if you haven't refinanced your mortgage lately, you might want to give your mortgage broker a call. If you a need a referral for a  good mortgage broker, call me- I have a few since I finally bought a house in Marin (yeah!!)  and instead of paying cash I used a mortgage to finance a significant portion of the purchase. I got a 3.50% 30 year fixed rate mortgage. So, my after-tax cost to finance my debt is closer to 2.00% and I'm using the proceeds from the mortgage to invest in the markets. I like to think if I have a long-term investment horizon I should be able to beat 2.0% cost of debt.


In case you missed it (and you probably did because you pay me to watch this kind of stuff), in the last 12 months the US dollar has climbed 8% against the Euro. 8% is a BIG move for reserve currencies like the US dollar and the Euro. So, as I just mentioned, the “leading” Wall Street economists think U.S. Large Cap will continue their strong performance in 2015, but is it possible large U.S. company sales to non-U.S. markets will be hurt with a stronger U.S. dollar because U.S. product costs more for international consumers and businesses?


Alternatively,  will U.S. Small cap stocks, which lagged US large cap stocks in 2014 but outperformed in 2013, outperform US large cap stocks in 2015 because U.S. small caps stocks are better insulated from a rising U.S. dollar due to their lack of significant international sales?  Or does it even matter?


Not if you are a long term investor- U.S. Small cap stocks historically outperform U.S. Large cap by 2.0% per year over long term investment horizons, but U.S. Small caps are much more volatile (see chart below) especially over a 1-3 year horizon. If you can tolerate the added volatility, then you should have exposure to U.S. Small cap stocks and reap the benefits of higher returns over the long term.








On a relative P/E basis (i.e. Price to Earnings ratio) European & Emerging stock prices are at the cheapest prices to U.S. stocks in the last 20 years. Will they get even cheaper? Is this the bottom?  Will the European Central Bank's latest aggressive monetary policy in 2015 jump start Europe's economy and create another worldwide "pile-on" into risky assets (i.e. stocks, commodities, REITs…) as the U.S. Federal Reserve's aggressive monetary policy did in 2009-2014?  Or is this the end of the benefits of easy money monetary policy as PIMCO's Bill "the Bond King" Gross suggest in his latest market musings?


Another question to ask yourself- did you believe during the height of the Credit Crisis in 2009 the U.S. Central bank's unprecedented action to expand its balance sheet from $870 billion to $4.400T (that's trillion!) by buying up almost every single U.S. Treasury bond and U.S. government mortgage backed security in circulation would result in the stock market rising  200% from its low on March 9,2009? My guess is most of you were skeptical and may have sat out a large portion of the rally thinking that printing money to buy up our own debt sounds kind of silly and somewhat irresponsible. Now what do you think if the European Central Bank does the same thing? You probably think it's still an irresponsible idea, but “get me invested because I don't want to miss out again in the worldwide rally in stocks and real estate!”.




Crude Oil

I'm sure all of you have noticed the significant decline in oil prices. Even the wealthy who drive fancy cars seem to have a smile on their faces when they fill up their gas tanks. Who benefits more from plunging worldwide oil prices- U.S., Europe, Japan,  or China…? Oil prices are denominated in U.S. dollars,  so a stronger U.S. dollar hurts foreign buyers of oil but the 40% drop in oil prices is still a net positive all countries which import oil. A back of the envelope estimate based on worldwide consumption of 90mm barrels of oil a day results in approximately $1.5 billion savings per day from the recent fall in oil prices. Wonder where that is going to get spent?  On the flip side, if you’re an exporter (e.g. Russia, Iran, Venezuela… )- falling oil prices are a big problem.


Will investors finally give up on Europe and send stock prices even lower? Will Russia's Putin start a war with the West to deflect the Russian population's attention away from the deep recession they just entered due to economic sanctions and plunging oil prices? Which hedge funds or banks are massively leveraged to oil prices and will implode from falling crude oil prices causing a contagion effect through the capital markets?


Time for a market correction?

These types of concerns are worth noting and are necessary for markets to move higher. Markets dislike uncertainty since it makes it harder to forecast future earnings. The more uncertainty, the more discounting of future earnings is required. After the uncertainty clears, markets typically resume their upward trajectory. The real danger is when everything is rosy- that's when markets are most likely to have a significant correction. It doesn't feel very rosy to me right now, but then again we haven't had a significant correction greater than 10%  since Oct 2011.


Over the last 75 years, equity markets have averaged at least one 10%-20% decline every 2 1/2 years.  Statistically we are due for a correction, but we've never had major central banks flood the markets with this much easy money for such a long period of time.  This party will end, but falling crude prices might just be the catalyst to unlock consumer spending in the U.S. and help struggling developed countries (e.g. Japan, Europe, China...) jump start their economies.   But will Russia spoil the party?



Below is one of my favorite charts- it shows the annual performance of every major asset class by color for the last 10 years with the best performing asset class for each year at the top and the worst at the bottom. Notice how there is no pattern to the color?  



So, what’s the moral of the story? Stay diversified according to your risk tolerance using low cost index funds, be a long-term  investor to capture the cycles for each asset class,  and don't pay capital gains taxes until you need the funds for retirement or to make a significant purchase. All the academic research shows even actively managed mutual funds (i.e. stock pickers)  can't consistently beat the market, especially on an after-tax basis.


Hope you enjoyed reading this as much as I enjoyed writing it.