Markets got off to a rocky start this year, with a major selloff dominating the news in the first half of the quarter. While they have regained a good deal of ground, stocks remain skittish, with small companies and international developed markets continuing to trail U.S. large cap stocks. Emerging markets were the strongest performer this quarter although they have still not fully recovered from last year’s poor performance.
Acting on short-term performance rarely behooves the investor, and this quarter has provided ample testament to that. Those assessing the damage wrought in the first two months of the year might conclude that exiting markets altogether was advisable, but in just a few short weeks markets have rebounded significantly.
The S&P 500 Index of US large cap companies lost more than 5 percent year-to-date through February, but managed to end the quarter up 1.3%. US small company stocks had lost about 8.8% through February but pared that to -1.5% through the end of March, based on the Russell 2000 Index. The same story played out in markets globally. In international developed markets, stocks lost 8.9% through February but had trimmed the loss to 2.9% based on the MSCI EAFE Index as of quarter end. While emerging markets were hardest hit in 2015, they have fared better than developed markets thus far in 2016, losing 6.6% through February but rebounding from that loss to a gain of 5.8% through the end of March based on the MSCI Emerging Markets Index. The MSCI All Country World Index, a globally weighted amalgam of large company stocks, is up 0.4% this year thus far, coming back from a 6.6 percent loss through February1.
Markets also got a boost in mid-March, when the Federal Open Market Committee left the Fed Funds rate unchanged at a target of 0.25% to 0.50%. When Fed officials met in December they had originally signaled steadily rising rates in 2016, with four increases possible. The likelihood of that is now all but zero, as weakness in economic conditions and the stinging market volatility have stayed the Fed’s hand. Recent outlook implies that June could be the month for the next rate increases; however, officials have made clear that they plan to move gradually. “Caution is appropriate,” stated Federal Reserve Chairwoman Janet Yellen. To which investors breathed a collective sigh of relief2.
Meanwhile internationally, we have begun to witness the spectacle of negative interest rates, a proposition wherein central banks actually charge in order to keep money on deposit. The effectiveness of this extreme form of loosening monetary policy is debatable3 and it also gives rise to the question of how it will impact U.S. investors. An academic concept known as “uncovered interest rate parity,” states that the difference in interest rates between two countries will be equivalent to the expected change in the exchange rates between those countries. In English, this suggests that when U.S. interest rates are higher than those in other nations, the value of the dollar is likely to depreciate. In reality, this theory has not tended to hold true. Rising rates are expected by many to result in an appreciating dollar, which would hurt U.S. investors in overseas markets4.
Currency movements were a significant detractor to US investor performance in 2015. Whereas the return of the MSCI EAFE index was a positive 5.8 percent last year when measured in those stocks’ own currencies, U.S. investors lost 0.4% when that same investment is translated back to U.S. dollars. That is because if the U.S. dollar climbs vis-à-vis other currencies, it costs the US investor in overseas stocks more of the other currencies to buy back into the dollar. This impact was even more painful in the emerging markets space, where a -5.4% local return became -14.6% in U.S. dollar terms last year.
This year, however, currency has worked in our favor thus far. The MSCI EAFE has lost 6.4% through the end of March in local terms but that loss actually shrunk to only 2.9% in U.S. dollar terms. Likewise, the MSCI Emerging Markets Index gained 2.8 percent in local terms but performed considerably better in U.S. dollar terms up 5.8% for the quarter 5.
The relatively positive performance of emerging markets in 2016 has been one bright spot in the investing landscape, coming as it does off the heels of a very difficult 2015. Of course it is far too early to tell how emerging economies will play out through the rest of the year, but as long-term, strategic investors, we would suggest that this is beside the point. As with every market or asset class, it will have up periods and down periods. That volatility tends to be more pronounced in developing economies and therefore losses are unfortunately par for the course. Standard deviation is a measure of the variation in returns that can be used to get a sense of how rocky the ride will be in a given asset class. The higher the number, the bigger the ups and downs. By way of comparison, consider that the standard deviation of the S&P 500 Index of U.S. large stocks has been about 14 percent from January 1988 through March 2016. The MSCI Emerging Markets Index, on the other hand, has a standard deviation of about 23 percent over the same period6.
So why even own such a volatile asset class? Well, for starters, it diversifies our other investments because it behaves differently than them. When U.S. or international developed stocks are down, emerging may be up, or at least not down as much. We try to encourage investors to view their portfolios as a whole as opposed to falling into the behavioral trap known as “mental accounting,” wherein they segment off different pieces and judge them separately. We believe a good investment portfolio will mix a variety of different assets that play off of each other to create a long-term better experience when viewed together.
Okay, but what if you are prone to judge each asset separately? Emerging stocks have had significant losses and you may be inclined not to want such an investment in your portfolio. That is fair, but we would caution you about how you might be timing this sort of a decision. An analysis looking at the rolling one-year returns of the MSCI Emerging Markets Index back to January 1988 and ranking those returns provides some evidence that the rally after the drop can be worth waiting for. The four worst one-year periods were followed by fairly substantial gains a year later (The worst four one-year periods when excluding other one-year periods within four months of original).
Add to that that the long-term performance of emerging markets is quite good. Over the period mentioned above (January 1988–March 2016), the return of the emerging index is slightly higher than that of the S&P 500, at 10.6 percent, compared with 10.2 percent7. We would expect a decent long-term return on a volatile asset class because rationally, investors expect payment for taking risk. While that adage will not work out in every time period, we expect it to generally hold true over the long-term. The volatility of emerging markets is risky, and investors should be compensated for bearing that risk.
Something similar can be said about value stocks vs. growth stocks. Year-to-date, value has outperformed growth in the United States and in emerging markets, but underperformed in international developed markets8. Value stocks are equities of companies for which the market price has been bid down. While their standard deviation has not tended to be higher than growth firms, their relatively lower price suggests that they may be distressed. These stocks contrast with growth stocks: these are firms with higher stock prices that can be thought of as excellent companies. We overweight value stocks relative to growth stocks in our portfolios in large part because we believe the market perceives a risk in those stocks, hence their lower prices. While that risk may manifest in various periods – 2015 was particularly difficult for value stocks – the long-run expectation is one of higher return to pay investors for bearing that risk. Studies show that value stocks have tended to outperform growth over the long haul9.
Sometimes it can be very difficult to keep your eye on that long haul when negative news and market gyrations are reverberating in our brains. We are, as a species, not hardwired to look sublimely at our investment fortunes whipsawing in value. As a result, we tend to cry uncle at the worst possible times, cutting our losses for sure, but also compromising our ability to earn the higher returns that may be coming. We believe that successful investing in stock markets relies on accepting this unnatural state of affairs by preparing oneself in advance for the inevitable market pain in the hopes of gaining the higher long-run return. Thus, we emphasize the importance of being in a model portfolio appropriate to your tolerance for risk. This will allow you to ride out the difficult times and to realize the rewards of being a long-term investor.
1 All returns are according to Morningstar as of March 31, 2016.
2 Hilsenrath, Jon. Torry, Harriet. “Fed Dials Back Pace of Rate Hikes..” The Wall Street Journal. March 16, 2016.
3 Schulze, Elizabeth. “Wall Street fears NIRP: CNBC Fed Survey.” CNBC. March 15, 2016.
4 Kaletsky, Anatole. “What a US interest rate rise really means for the dollar.” The Guardian. November 17, 2015.
5 Returns according to Morningstar as of March 31, 2016.
6 Source: Zephyr StyleADVISOR
7 Source: Morningstar as of March 31, 2016.
8 Source: Morningstar, based on the Russell 1000 Value/Russell 1000 Growth, MSCI EAFE Value/MSCI EAFE Growth and MSCI Emerging Value/MSCI Emerging Growth Indexes as of March 31, 2016.
9 Fama, Eugene and Ken French. “Common Risk Factors in the Returns on Stocks and Bonds.” Journal of Financial Economics, 33, (1993), 3-56.
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Investors cannot invest directly in an index. Indexes have no fees. Historical performance results for investment indexes do not reflect the deduction of transaction and/or custodial charges or the deduction of an investment management fee, the occurrence of which would have the effect of decreasing historical performance results. Actual performance for client accounts will differ from index performance.
S&P 500 Index represents the 500 leading U.S. companies, approximately 80% of the total U.S. market capitalization.
MSCI ACWI (All Country World Index) Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets.
MSCI EAFE Index is a free float-adjusted market capitalization index that is designed to measure the developed equity market (as defined by MSCI) equity performance, excluding the U.S. and Canada.
MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets (as defined by MSCI). The index consists of the 25 emerging market country indexes.
Russell 2000 Index measures the performance of the small-cap segment of the U.S. equity universe. The Russell 2000 Index is a subset of the Russell 3000® Index representing approximately 10% of the total market capitalization of that index. It includes approximately 2000 of the smallest securities based on a combination of their market cap and current index membership.
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