OK – let’s get right to it. I was incorrect in my projection of the 4th quarter of 2015. I believed that domestic stocks would continue their decline and bonds would be the benefactor. Instead the opposite happened. However, as you have probably seen in this first month of 2016, my suspicions have been confirmed as we are experiencing a slight correction. Luckily I felt the same way on January 1 as I did on October 1, and our discretionary portfolios at Interactive Brokers have outperformed the benchmark portfolio. Of course, outperformance does not always mean positive returns but limiting losses is just as beneficial. Anyone can make money when the market is thriving. How a manager performs in stressful times is a better gauge of his or her acumen. What follows is a review of the 4th quarter as well as 2015 as a whole.
Domestic blue chips rallied after a weak 3rd quarter to end the year up 0.8%. Employment figures again improved, with the unemployment rate falling 0.1% in Q4 to end the year at 5.0%. (1). For the full year, US employers added 2.7 million jobs and the unemployment fell to 5.0% from 5.6% at the end of 2014. Home prices strengthened over the year rising nearly 6% (2). However, corporate earnings are showing continued weakness as the energy sector struggles and a stronger dollar continues to hurt the earnings related to international operations. The estimated earnings per share of the S&P 500 for the full year 2015 was over $131 per share on December 31, 2014. Today, estimated earnings for the full year are only $107 (3).
While Greece dominated headlines in the first half of 2015, China stole the spotlight in second half. China makes up nearly 30% of our emerging market ETF benchmark. The country faces uncertainty over whether it can continue its growth. The chart below shows China’s GDP growth for the past 8 years as well as estimates for 2015 and 2016 (5).
Investment grade bonds were the best performer in 2015 out of the 14 asset categories we track, despite deep anxiety about the Fed raising interest rates. As interest rates rise, generally bond prices suffer. However, as we saw this past year it is the expectation of rates that shapes the performance of bonds, not the actual increase itself. Rates were initially expected to rise earlier in 2015 but as we saw, the Fed kept delaying until finally deciding to pull the trigger in December. As the market came back to reality, bond prices stabilized. See the chart below from Deutsche Bank Research (6), which posed the following question at the beginning of 2015 as to whether the market would be correct and that rates would start to rise in the first half of 2015:
The black dotted lines are the market’s future expectations of the federal funds rate while the solid red line represents the actual federal funds rate. The answer to the chart’s question was a resounding “NO” in first 11 months of 2015. The market was wrong as usual. The Fed did not raise rates until December and only to 0.25%. But fear is a powerful force not only in the stock market but in the bond market as well. The bond market misjudged the timing of the interest rate rise and thus the steepness of the rise in rates. Instead things were more calm and gradual than expected. Bond prices were not hurt but instead again justified their value in any portfolio.
As far as the next rate increase goes, the Fed recently met yesterday on Wednesday the 27th and decided to hold rates steady for the time being. The probability of a rate hike at their next meeting in March is only 26%. In fact, the first time a rate increase’s likelihood is more than 50% is at their September meeting (4).
A stronger dollar hurt foreign bonds last year. The economies in foreign countries continue to show signs of weakness, especially compared to the United States. As such, many foreign central banks are pursuing monetary policies aimed at stimulating their economies. As the US Fed is now moving towards a less friendly policy by beginning a series of gradual rate hikes, our dollar has strengthened versus our foreign counterparts.
Outlook for 2016
The outlook for 2016 remains cautious, similar to our outlook for 2015. Volatility has increased as uncertainty has crept back into the market. The end of quantitative easing, suspicious foreign economies, hints of war, mixed domestic economic indicators, and one of the more puzzling Presidential elections in some time has investors polarized. Our discretionary portfolios at Interactive Brokers are adjusted quarterly for perceived strength or weakness seen across the various asset classes that we track. We compare performance versus a moderately allocated benchmark portfolio. The purpose of this portfolio is for growth and trading profits obtained through investments in ETFs according to a moderate risk profile. This portfolio is not meant for retirement and as such does not have the same risk profile of such accounts.
The current portfolio versus the benchmark portfolio is shown below. As you can see, the biggest shift in our current allocation for Q1 is from domestic equities (-11.0%) into cash (+7.5%). As I mentioned, I saw weakness in domestic equities in Q1 and thus moved our portfolio towards a more conservative allocation.
Please see below for the inception to date performance of the discretionary accounts at Interactive Brokers.
1 – “Labor Force Statistics from the Current Population Survey.” Bureau of Labor Statistics – US Department of Labor.
2 – “S&P/Case-Shiller 20-City Composite Home Price Index©.” St. Louis Federal Reserve.
3 – “S&P 500 Earnings and Estimate Report.” S&P Dow Jones Indices.
4 – “Countdown to the FOMC”. CME Group.
5 – “World Economic Outlook: Adjusting to Lower Commodity Prices (October 2015)” International Monetary Fund.
6 – “Investors Keep Guessing Wrong about the Fed’s Rate Moves”. Bloomberg Business.
None of the information or data presented herein constitutes a recommendation by Composed Financial Management, LLC (“the Firm”) or a solicitation of any offer to buy or sell any securities. Information presented is general information that does not take into account your individual circumstances, financial situation or needs, nor does it present a personalized recommendation to you. Although information has been obtained from and is based upon sources the Firm believes to be reliable, we do not guarantee its accuracy and the information may be incomplete or condensed. All expressions of opinion reflect the judgment of the authors as of the date of publication and are subject to change. Past performance is no guarantee of future results.
1 – The discretionary investment portfolio and associated benchmark portfolio are assumed to be rebalanced at the same time (every 3 to 4 months).
2 – The inception starting balance is set to $10,000 and performance is tracked as if no additional contributions or withdrawals are made to the portfolio. This is known as the time-weighted return.
3 – Fees are applied only to the discretionary portfolio managed by the Firm. No fees are applied to the benchmark portfolio. The assumed fees applied to the discretionary portfolio are 1.0%, based on current fee pricing. All fees are negotiable and not every client is charged a fee of 1.0%. No clients are charged more than 1.0%. For a complete view on the pricing of the Firm, please visit www.composedfinancial.com/pricing.
4 – Risk Disclosure:
Investing in securities involves risk of loss that clients should be prepared to bear. No investment process is free of risk; no strategy or risk management technique can guarantee returns or eliminate risk in any market environment. There is no guarantee that our investment processes will be profitable. Past performance is no guarantee of future results. The value of investments, as well any investment income, is not guaranteed and can fluctuate based on market conditions. Diversification does not assure a profit or protect against loss.
Our discretionary investment management style invests in ETFs that are exposed to a variety of different asset classes which may be subject to some or all of the following risks.
Equity Securities Risk – Equity securities include common stocks, preferred stocks, convertible securities, ETFs, and mutual funds that invest in these securities. Equity markets can be volatile. Stock prices rise and fall based on changes in an individual company’s financial condition and overall market conditions. Stock prices can decline significantly in response to adverse market conditions, company-specific events, and other domestic and international political and economic developments.
Risk Related to Company Size –Investing in mid, small and micro capitalization companies generally involves greater risks than investing in larger companies. The market may value companies according to size or market capitalization rather than financial performance. As a result, if mid-cap, small cap or micro-cap investing is out of favor, these holdings may decline in price even though their fundamentals are sound. They may be more difficult to buy and sell, subject to greater business risks, and more sensitive to market changes, than larger capitalization securities.
Fixed Income Securities Risk – Fixed income securities include corporate bonds, municipal bonds, other debt instruments and mutual funds that invest in these securities. Issuers generally pay a fixed, variable, or floating interest rate, and must repay the amount borrowed at maturity. Some debt instruments, such as zero-coupon bonds, do not pay current interest, but are sold at a discount from their face value. Prices of fixed income securities generally decline when interest rates rise, and rise when interest rates fall. Longer-term debt and zero-coupon bonds are more sensitive to interest rate changes than debt instruments with shorter maturities. Fixed income securities are also subject to credit risk, which is the chance that an issuer will fail to pay interest or principal on time. Many fixed income securities receive credit ratings from Nationally Recognized Statistical Rating Organizations (NRSROs). These NRSROs assign ratings to securities by assessing the likelihood of issuer default. Changes in the credit strength of an issuer may reduce the credit rating of its debt investments and may affect their value. High-quality debt instruments are rated at least AA or its equivalent by any NRSRO or are unrated debt instruments of equivalent quality. Issuers of high-grade debt instruments are considered to have a very strong capacity to pay principal and interest. Investment grade debt instruments are rated at least Baa or its equivalent by any NRSRO or are unrated debt instruments of equivalent quality. Baa rated securities are considered to have adequate capacity to pay principal and interest, although they also have speculative characteristics. Lower rated debt securities are more likely to be adversely affected by changes in economic conditions than higher rated debt securities.
U.S. Government securities include securities issued or guaranteed by the U.S. Treasury; issued by a U.S.
Government agency; or issued by a Government-Sponsored Enterprise (GSE). U.S. Treasury securities include direct obligations of the U.S. Treasury, (i.e., Treasury bills, notes and bonds). U.S. Government agency bonds are backed by the full faith and credit of the U.S. Government or guaranteed by the U.S. Treasury (such as securities of the Government National Mortgage Association (GNMA or Ginnie Mae)). GSE bonds are issued by certain federally-chartered but privately-owned corporations, but are neither direct obligations of, nor backed by the full faith and credit of, the U.S. Government. GSE bonds include: bonds issued by Federal Home Loan Banks (FHLB), Federal Farm Credit Banks (FCS), Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac) and the Federal National Mortgage Association (FNMA or Fannie Mae).
Foreign Securities Risk – Investments in foreign securities involve certain risks that differ from the risks of investing in domestic securities. Adverse political, economic, social or other conditions in a foreign country may make the stocks of that country difficult or impossible to sell. It is more difficult to obtain reliable information about some foreign securities. The costs of investing in some foreign markets may be higher than investing in domestic markets. Investments in foreign securities also are subject to currency fluctuations.
Exchange-Traded Fund Risk – ETFs are open-end investment companies, unit investment trusts or depository receipts that hold portfolios of stocks, commodities and/or currencies that commonly are designed, before expenses, to closely track the performance and dividend yield of (i) a specific index, (ii) a basket of securities, commodities or currencies, or (iii) a particular commodity or currency. Recently, the SEC has authorized the creation of actively managed ETFs. Currently, the types of indices sought to be replicated by ETFs most often include domestic equity indices, fixed income indices, sector indices and foreign or international indices. ETF shares are traded on exchanges and are traded and priced throughout the trading day. ETFs permit an investor to purchase a selling interest in a portfolio of stocks throughout the trading day. Because ETFs trade on an exchange, they may not trade at NAV. Sometimes, the prices of ETFs may vary significantly from the NAVs of the ETFs’ underlying securities. Additionally, if an investor decides to redeem ETF shares rather than selling them on a secondary market, the investor may receive the underlying securities which must be sold in order to obtain cash.
Liquidity Risk – Trading opportunities are more limited for fixed income securities that have not received any credit ratings, have received ratings below investment grade, or for fixed income and equity securities that are not widely held. Liquidity risk also refers to the possibility a security cannot be sold at an ideal time. If this happens, a client account may be required to continue to hold the security and losses could be incurred.
Investment Management Style Risk – We take an active management approach to investing. There is no guarantee that our strategies will produce their intended results. There is a risk that a particular type of investment on which an account focuses (such as small cap value stocks) may underperform other asset classes or the overall market. Individual market segments tend to go through cycles of performing better or worse than other types of securities. These periods may last as long as several years. Additionally, a particular market segment could fall out of favor with investors, causing a strategy that focuses on that market segment to underperform those that favor other types of securities.
Value Investing Risk – A value-oriented investment approach involves the risk that value stocks may remain undervalued, or may not appreciate in value as anticipated. Value stocks can perform differently from the market as a whole or from other types of stocks and may be out of favor with investors for varying periods of time.
Focused Investing Risk – With a focused portfolio there is the risk that a material event, which negatively impacts one or more of the securities, could have a meaningful negative impact on portfolio performance.