Market Commentary: 4Q 2015

As we look back on the financial markets in 2015, returns were poor across the globe and across asset classes (stocks, bonds, commodities, etc.). Among the major global stock markets, the United States was the best performer. Unfortunately, the S&P 500’s whopping 1.4% return was driven by a handful of large tech/Internet companies (e.g., Facebook, Amazon.com, Netflix, and Google) which generated huge gains and helped propel the index into positive territory. The equal-weighted S&P 500 index actually fell 2.2% for the year.

The difference in the U.S. economy and monetary policy versus other major global economies was one striking feature of last year’s investment environment. In December, the U.S. Federal Reserve was so comfortable with the outlook for economic growth and the potential for inflation to eventually normalize that it made its first increase in interest rates in nearly a decade. Outside the United States, regaining more normal economic growth and inflation has remained more challenging due to sharply lower commodity prices (most notably oil), Middle East tensions, and China’s slower economic growth. Year-end foreign stock prices ended lower, reflecting this bifurcation. As in 2014, the strength of the dollar exacerbated foreign markets’ underperformance for dollar-based investors, detracting 9% from emerging-markets stocks and 6% from developed international stocks Ccompared to their local-currency returns. Commodity indexes were down on the order of 25% as oil prices hit an 11-year low in December and fell 30% for the year.

Fixed-income offered little respite. The core bond index gained just 0.6%, high-yield bonds were down close to 5% and floating-rate loans lost 0.7%.

Here are the broad index returns through the Fourth Quarter of 2015:

U.S. Large Cap Stocks 1.4% Emerging Market Stocks -14.6%
U.S. Small Cap Stocks -4.4% Commodities -24.7%
U.S. Real Estate 3.2% U.S. Aggregate Bonds 0.6%
Overseas Stocks -0.4% International Bonds -5.3%

Economic Outlook

The investment thesis for European and emerging-markets stocks has not changed materially over the last few months. Analysis suggests both markets are undervalued relative to their normalized earnings potential looking out five or so years. Those investments should benefit from stronger-than-expected earnings growth and the current allocations to European and emerging-markets stocks should yield outsized returns over a reasonable time frame.

Conversely, when it comes to U.S. stocks, the tactical outlook over the coming five years is much less positive compared to emerging-markets stocks and European stocks. Analysis suggests that U.S. valuations are still high and with U.S. corporate profit margins also well above normal, there is the potential for disappointing earnings growth and slow growth in stock prices over the next few years.

Effective portfolio allocation is based on a long-term view of the market. Financial market history is a history of cycles, like the swings of a pendulum, moving from one extreme to another. Market history teaches that undervalued assets can fall further and overvalued markets can overshoot on the upside. The tech bubble of the late 1990’s is one recent example of this. This type of volatility is simply the reality that comes with being a long-term equity investor.

Nevertheless, sound investment philosophy is based on the belief that fundamentals ultimately drive investment returns. The value of an investment is generally determined by the cash flows the investment generates over time. This type of valuation is a very poor short-term market indicator. But over the longer term and over full market cycles (five to 10-plus years), history has shown that valuation is a powerful driver of returns. Simply enough, studies show that if you buy an investment when it is relatively expensive, your returns will likely be lower over time. Alternatively, if you buy an investment when it is relatively inexpensive, your returns will likely be higher. Buying undervalued assets pays off, but it may take a little while for the markets to turn in their favor. To be successful, one must be disciplined and patient.

Financial Planning (Not Investment Returns) Insures Retirement Success

After mediocre (or negative) returns like the markets have produced over the last couple of years, investors often begin to question the underlying assumptions and the expected returns for their portfolios. Retirees often begin to fret over the viability of their long-term goals, fearing that they will eventually run out of money.

It is the helplessness created by the seemingly random series of returns that creates worries. However, there is a solution: At the intersection of “What Matters” and “What You Can Control” is the area where you should spend your energy. We all know what matters: living comfortably through retirement, giving to those in need, having peace of mind, etc., but what can we control? We know that we cannot control when the market goes up or down or what our return will be in the next few years. However, there are a number of things you can control to insure you are able to achieve what matters:

1) minimizing income taxes

2) consistently rebalancing to insure you are buying when stocks are cheaper

3) maintaining a long-term perspective

4) controlling spending and the timing of expenses relative to the portfolio value

5) lowering portfolio costs

6) diversifying the portfolio to mitigate risk, etc.

Take the worry out of the portfolio volatility by allowing BFA to assist you in developing your financial plan and staying focused on the things you can control. This is how you can insure that you are successful in the long run.

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