8 Wealth Issues: Investment Strategies

Why Globally Diversified Portfolios have (& should have) Lagged the S&P 500

Those who have heard me speak about the media’s influence on investor’s decision-making know that I believe in a phenomenon I call “The Creation of Crisis”—whereby 24-hour news outlets fill airtime by making “vital” news stories out of non-stories. These crises can have impact on investor behavior, which in turn has potential impact on investor’ process. This can also work the other way, and is why I believe many investors have felt frustration with portfolio performance throughout 2014.

In this month’s 8 Wealth Issues blog entry, I thought it would be a good idea to look at why continuing to emphasize the institutional process of investing is still a better idea than benchmarking against the S&P 500.

Diversification is essential, yet it comes with trade-offs. Investors are repeatedly urged to allocate portfolio assets across a variety of investment classes. This is fundamental; market shocks and month-to-month volatility may bring big losses to portfolios weighted too heavily in one or two classes.

Just as there is a potential upside to diversification, there is also a potential downside. It can expose a percentage of the portfolio to underperforming sectors of the market. Last year, that kind of exposure affected the returns of some prudent investors.

The media insists on reporting on about 1.5 asset classes: The Dow Jones Industrial Average & S&P 500 are both Large Cap US-based indices, and NASDAQ is a US technology-based index which has many Large Cap companies in it. It is a POOR comparison to any risk-based managed investment strategy.

Sometimes diversification hinders overall performance. The stock market has performed well of late, but very few portfolios have 100% allocation to stocks for sensible reasons. At times investors take a quick glance at stock index performance and forget that their return reflects the performance of multiple market segments. While the S&P 500 rose +11.39% in 2014, other asset classes saw minor returns or losses last year.1

As an example, Morningstar assessed fixed-income managers for 2014 and found a median return of just +2.35% for domestic high yield strategies. The Barclays U.S. Aggregate Bond Index advanced +5.97% in 2014 (that encompasses coupon payments and capital appreciation), while the Citigroup Non-U.S. World Government Bond index lost -2.68%.1,2

Turning to some very conservative options, the 10-year Treasury had a +2.17% yield on December 31, 2014; & Bankrate found the annual percentage yield for a 1-year CD averaged +0.27% nationally, with the yields on 5-year CDs averaging +0.87%; last year’s average yields were similar.3,4

Oil’s poor 2014 affected numerous portfolios. Light sweet crude ended 2014 at just $53.27 on the NYMEX, going -45.42% on the year. (In 2008, prices peaked at $147 a barrel). Correspondingly, the Thomson Reuters/CRB Commodities Index, which tracks the 19 most watched commodity futures, dropped 17.9% in 2014 after slips of 5.0% in 2013, 3.4% in 2012 and 8.3% in 2011. At the end of last year, it was at the same level it had been at the end of 2008.5,6

The longstanding MSCI EAFE Index (an International index tracking Europe and the Asia Pacific region) lost -7.35% for 2014. At the end of last year, it had returned an average of +2.34% across 2010-2014. So on the whole, equity indices in the emerging markets and the eurozone have not performed exceptionally well last year or over the past few years.7

Why favor an Institutional Process? I sometimes get the question “Why wasn’t I allocated more” to the best performing asset class? Active investment management with an institutional risk-managed process is about both tilting portfolios TOWARD perceived opportunities and AWAY from too much risk—given the client’s comfort with a particular level of risk. For most people an over-allocation to the Large Cap Domestic asset class may have shown to be an unnecessary amount of risk. History tells us that a patient, well considered investment process tied to goals based in a financial plan gives us the best probability of long-term financial success. It also gives the investor a better, more consistent experience. The downside to employing this process is the myopic view: In a year like 2014 when the S&P 500 does well and everything else doesn’t, your diversified portfolio also doesn’t.

In most year’s I do not hear complaints about why managed portfolio’s didn’t beat the best performing asset class. But when the best performing asset class is the only index the media tracks, I understand why it could become a question.

Perspectives from Above the Noise – Week of March 23, 2015

Last Wednesday's highly anticipated Fed policy statement managed to send an unambiguously dovish message despite the removal of the word "patient" in describing when rate hikes will begin. The removal of the patient reference opens the door for a rate hike as early as June and was telegraphed by the Fed. However, what most observers did not anticipate was a sharp ratcheting down of forecasts for inflation, growth and interest rates, along with Fed Chair Yellen emphasizing that policy will remain highly accommodative even after tightening begins.

With the Fed statement out of the way, a lull in major economic reports, and earnings season still several weeks away, market volatility may subside somewhat in the near-term. Globally, the outlook for a new bailout package for Greece is likely to remain a key driver of volatility in equity and currency markets. German Chancellor Angela Merkel made it clear on Friday that Greece would receive cash to ease its liquidity crisis if creditors are able to approve a list of its reforms.

For the week, the S&P 500 added +2.66%, the Dow Jones Industrial Average rose +2.13%, and the MSCI EAFE (developed international) grew 4.02%.

Here are the 3 stories this week that rose above the noise:

Yellen Is Watching These Four Indicators for Signals on When to Raise Rates

A recent Bloomberg article highlights the four key indicators that Federal Reserve Chair Janet Yellen is monitoring for signals on when to raise interest rates. The U.S. Federal Reserve has maintained a zero interest-rate policy since December 2008 and appears likely to raise interest rates in the second half of the year. According to Yellen, the Federal Reserve will raise interest rates when it is “reasonably confident” that inflation is about to rise towards its 2 percent target.

The indicators the Fed is monitoring for signals on when to raise interest rates include a continuation of the declining unemployment rate, signs of an uptick in wage growth, stabilization of core inflation, and a rise in inflation expectations from households and investors.

Sales of New U.S. Homes Unexpectedly Climb to 7-Year High

Purchases of new homes in the U.S. unexpectedly rose in February to a seven-year high as stronger job gains helped bolster industry activity amid severe weather. Sales climbed 7.8% to a 539,000 annualized pace, the most since February 2008, Commerce Department data showed Tuesday. The reading exceeded even the most optimistic forecast of economists.

The median sales price of a new home increased 2.6 percent from February 2014 to $275,500 the report showed. The supply of homes dropped to 4.7 months at the current sales pace, the lowest since June 2013, from 5.1 months in January. As a point of reference, a six-month inventory is generally considered a balanced market. The positive new home sales news was encouraging amid a spate of softer U.S. economic data recently.

U.S. Consumer Prices Rebound, Underlying Inflation Firming

The latest report on U.S. consumer prices showed a modest but broad uptick in inflationary pressures. The latest reading on the Consumer Price Index (CPI) showed prices increased 0.2 percent last month after showing declines for three straight months. Importantly, core CPI, which removes the impact of food and energy, increased 1.7 percent vs. a year earlier. This was the largest year-over-year increase in core CPI since November and a continued move toward the Fed’s 2 percent target would increase the odds of an interest rate hike by September.

Articles chosen and summarized by the First Allied Asset Management, Inc. investment management team. First Allied Asset Management provides investment management and advisory services to a number of programs sponsored by First Allied Securities and First Allied Advisory Services. First Allied Asset Management individuals who provide investment management services are not associated persons with any broker-dealer.

International investing involves additional risk, including currency fluctuations, political or economic conditions affecting the foreign country, and differences in accounting standards and foreign regulations. These risks are magnified in emerging markets. Investing in companies involved in one specified sector may be more risky and volatile than an investment with greater diversification.

Perspectives from Above the Noise – Week of March 16, 2015

The past week featured relatively few significant data releases, with perhaps the most notable being Thursday's report on monthly retail sales. U.S. retail sales fell for the third straight month, declining 0.6% in February, after also falling in January and December. The weakness in February was broad-based with spending falling at restaurants, auto dealers and department stores. However, spending at gas stations actually increased for the first time since May 2014, as prices at the pump nudged modestly higher. For perspective, though, retail sales were still up 1.7% vs. a year earlier and harsh winter weather in the Northeast likely contributed to some of the sluggish report. Retail sales data can also be very volatile and the weakness of the past three months does follow a very strong period in the second half of 2014.

For the week, the S&P 500 lost -0.86%, the Dow Jones Industrial Average fell -0.60%, and the MSCI EAFE (developed international) dropped -1.72%.

Here are the 3 stories this week that rose above the noise:

Hot Topic - Can Stocks Rise When Dollar Is Strong?

The financial markets are eagerly awaiting this week's Federal Reserve policy meeting looking for clues as to the possible timing of any changes to interest-rate policy and how this might impact the currency markets. Can U.S. equity markets rally further if the U.S. dollar continues to strengthen?

While individual companies and sectors can potentially be significantly impacted, a recent Goldman Sachs study found that the S&P 500 index is indifferent to currency moves. "Since 1981, the median annualized return of the index was nearly identical in both strong and weak U.S. dollar cycles." Also, hikes in interest rates do not necessary portend a stock market selloff. Following the last 15 Federal Reserve interest-rate increases, the S&P 500 has actually risen, on average, 0.8% one month after the first hike.

First Rate Hike now Likely in August: CNBC

Fed Survey Investors will find out tomorrow if the U.S. Federal Reserve drops its use of the word "patient" from its policy statement. The word has been used by the central bank to signal no rate hike for at least two meetings. According to a recent CNBC poll, economists, analysts and money managers now see the first rate hike coming in August, a month ahead of the prior survey. However, rates are still forecast to rise gently, peaking at 3.04% in this cycle by the fourth quarter of 2017. According to one strategist, it will take the Fed years to normalize rates, suggesting the bull market still has room to run.

For some global perspective, the number of central banks that are currently in a monetary easing cycle reached 24 following an interest-rate cut by South Korea last week. Low inflation and weak economic growth are the main catalysts for the rising number of central banks that are implementing interest-rate cuts. Oil prices have declined dramatically since last June, which has put downward pressure on inflation rates. The United States, however, is expected to raise interest rates this year despite dealing with low inflation. The expected divergence in monetary policy between the United States (tightening) and many central banks globally (easing) has helped contribute to the U.S. Dollar index reaching a 12-year high.

Surprise: U.S. Economic Data Have Been the World's Most Disappointing

As the Federal Open Market Committee (FOMC) gets set for a highly anticipated two-day meeting that may see them set the stage for raising interest rates as early as June, recent economic data in the United States has been generally disappointing. In fact, relative to consensus expectations, U.S. economic data has been the most disappointing in the world.

This doesn't necessarily mean a period of prolonged economic weakness is at hand, as high expectations and harsh weather have likely played some role in the disappointing data. However, if the Fed continues to emphasize that rate hikes will be dependent on incoming data, a continuation of disappointing economic reports in the coming weeks would likely reduce the probability that the Fed initiates its rate hikes before September.

Articles chosen and summarized by the First Allied Asset Management, Inc. investment management team. First Allied Asset Management provides investment management and advisory services to a number of programs sponsored by First Allied Securities and First Allied Advisory Services. First Allied Asset Management individuals who provide investment management services are not associated persons with any broker-dealer.

International investing involves additional risk, including currency fluctuations, political or economic conditions affecting the foreign country, and differences in accounting standards and foreign regulations. These risks are magnified in emerging markets. Investing in companies involved in one specified sector may be more risky and volatile than an investment with greater diversification.

Perspectives from Above the Noise – Week of March 9, 2015

As expected, the European Central Bank (ECB) announced on Thursday morning that it was holding rates steady at record lows and preparing to launch its quantitative easing program on March 9. Despite raising his forecasts for European growth, ECB President Mario Draghi managed to exceed already dovish expectations with details of the quantitative easing plan first announced back in January. Notably, Draghi explained that bonds will be bought at yields at least as much as the ECB’s deposit rate of -0.2%. That means sizable quantities of bonds with negative yields could be purchased.

The U.S. jobs report on Friday was surprisingly strong. Nonfarm payrolls increased by 295,000 in February, blowing past consensus expectations for an increase of 240,000. Aided by rounding, the headline unemployment rate plunged to 5.5%, which is the lowest reading since May 2008.

For the week, the S&P 500 fell -1.58%, the Dow Jones Industrial Average dropped -1.52%, and the MSCI EAFE (developed international) lost -1.84%.

Here are the 3 stories this week that rose above the noise:

Inflation Outlook 2015: The Fed vs. the Market

Is 2015 the year that U.S. inflation finally surfaces? PIMCO authored this article which provides their 2015 inflation outlook along with the two opposing viewpoints: the reflation side supported by the Federal Reserve Open Market Committee (FOMC) and the disinflation camp supported by the global fixed income markets. PIMCO expects core U.S. inflation (as measured by CPI) to increase modestly year-over-year in 2015.

“Transitory forces like lower energy prices and a stronger dollar are keeping inflation below target at the moment, but lower energy prices are ultimately good for the consumer, and we anticipate wage inflation picking up over the cyclical horizon.” As such, PIMCO prefers holding U.S. interest rate duration in inflation-protected form and views a Treasury Inflation-Protected Securities (TIPS) overweight as one of their highest-conviction positions.

The Biggest Threat to Stocks Now: A Fed Rate Hike

The current bull market just reached its sixth anniversary and has gained over 200 percent as measured by the S&P 500. The biggest threat to the bull market over the next year is a Fed interest rate hike, according to this article. The Federal Reserve is likely to hike interest rates between June and October and the rise in interest rates will have several implications.

A rate hike will officially end the era of easy money, which helped fuel the bull market following the Fed’s policy of near zero rates since 2008. Additionally, the stock market historically has been weak around the start of a Fed tightening cycle. It’s possible that a Fed rate hike could cause a market correction, but it’s unlikely that it would trigger a bear market this year because the U.S. economy remains healthy, corporate earnings are still growing and U.S. stocks remain attractive compared to many investment alternatives.

Investors Are Buying Stocks and Bond from Energy Producers Amid Oil Price Drop 

Earlier this year, concerns of widespread defaults on below-investment-grade bonds in the energy sector caused the entire high-yield bond market to drop precipitously. Equity markets were also rattled in January as investors wondered if looming energy defaults could become equivalent to another sub-prime housing debt crisis. Fast forward to March 2015 and junk-rated energy bonds are actually up 4.5 percent year-to-date.

A recent Wall Street Journal article highlights the reasons investors are buying oil and gas bonds amid the crude oil price drop. According to Dealogic, oil and gas exploration and production firms have been able to sell about $4.7 billion of bonds in the United States so far this year, up from $2.7 billion at this time last year. The resilience of the energy high-yield bond market is a potentially encouraging sign since it suggests investors are voting that the crude oil sell-off represents a buying opportunity and that energy sector defaults, should they occur, will not be on par with the sub-prime crisis of 2007-09.

Articles chosen and summarized by the First Allied Asset Management, Inc. investment management team. First Allied Asset Management provides investment management and advisory services to a number of programs sponsored by First Allied Securities and First Allied Advisory Services. First Allied Asset Management individuals who provide investment management services are not associated persons with any broker-dealer. 

International investing involves additional risk, including currency fluctuations, political or economic conditions affecting the foreign country, and differences in accounting standards and foreign regulations. These risks are magnified in emerging markets. Investing in companies involved in one specified sector may be more risky and volatile than an investment with greater diversification.

Perspectives from Above the Noise – Week of March 2, 2015

The past week was a relatively uneventful one for equity markets, with a light economic calendar and temporary resolution to the Greek debt drama allowing markets to consolidate February's gains. On Friday, the already soft, advanced estimate for fourth quarter GDP of 2.6% annual growth was revised to an even lower 2.2%. However, consensus expectations were for a sharper downward revision to 2.0% and as a result, the news had little market impact.

For the week, the S&P 500 fell -0.27%, the Dow Jones Industrial Average dropped -0.04%, and the MSCI EAFE (developed international) gained +1.09%.

Here are the 3 stories this week that rose above the noise:

We’re at our Lowest Level of Misery in 56 Years, Thanks to Gas Prices

The Misery Index, which is the sum of the unemployment rate and the annual change in the consumer price index, is at its lowest level since the late 1950s. The Misery Index captures the economic anxiety of the time and has dropped considerably since its multi-decade peak in September 2011, when the unemployment rate was 9 percent and inflation was 3.8 percent. At present, the unemployment rate is 5.7 percent and inflation is -0.1 percent.

A low Misery Index is positive for consumer confidence and it places our current economic state in perspective compared to periods of high unemployment and elevated inflation. However, the Misery Index doesn’t capture some of the weakness in the labor market that is not captured in the unemployment rate, including the high level of part-time workers who would like to work full-time along with discouraged workers who have given up their job search.

Next Curveball for Oil: an Iran Nuclear Deal

With crude oil inventories sitting at record high levels, additional supply could be soon brought to the market. There is growing discussion that a deal on Iran's nuclear program could see a complete removal or easing of sanctions on Iranian oil exports to the U.S. and Europe. This topic will be in focus this week as Israeli Prime Minister Benjamin Netanyahu addresses the U.S. Congress. The magnitude of sanction relief would determine the potential impact on crude prices. However, there is debate over how much oil Iran could produce and how quickly additional capacity could be brought to market.

Europe Is the Market to Watch Now: David Rosenberg on the Outlook for Oil, the Loonie, Stocks and Bonds

Economist David Rosenberg, who became well-known for his bearish views on equities and bullish stance on bonds for most of the past two decades, has become much more optimistic on the global economy and equities in recent years. In his recent article he details his current outlook, which is notable for a generally bullish call on Europe. Rosenberg makes an important point, that the monetary base in Europe has already stopped contracting and is now growing at a solid pace just as a large quantitative easing program is set to begin. This suggests that the risk of a nasty deflationary episode is diminishing which creates the potential for a reversal higher in global bond yields later this year.

Articles chosen and summarized by the First Allied Asset Management, Inc. investment management team. First Allied Asset Management provides investment management and advisory services to a number of programs sponsored by First Allied Securities and First Allied Advisory Services. First Allied Asset Management individuals who provide investment management services are not associated persons with any broker-dealer.

International investing involves additional risk, including currency fluctuations, political or economic conditions affecting the foreign country, and differences in accounting standards and foreign regulations. These risks are magnified in emerging markets. Investing in companies involved in one specified sector may be more risky and volatile than an investment with greater diversification.