My F&M

Market Commentary 4th Quarter 2015

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2015 was a disappointing year for investors.  The best of the stock indexes was the S&P 500, which fell 0.7% for the year, its worst return since 2008.  Including dividends, its total return in 2015 was a slightly positive 1.4%.  Returns of U.S. small stocks were -4.4% in 2015 (the Russell 2000), while returns on established and emerging international stocks in 2015 were -0.8% and -14.9%, respectively.  The total return of our blended equity index was -1.4% for the year (60% large U.S., 15% small U.S., 15% established international, and 10% emerging market stocks).  High initial valuations (as we have pointed out previously), concerns about the Fed’s December increase in short-term interest rates, weak earnings growth, China, and commodity prices all likely contributed to these returns.  Additionally, U.S. markets were unusually “narrow” and hostile to dividends in 2015.   On average, the 74 non-dividend paying members of the S&P 500 rose 3.9%, while its 426 dividend paying members, on average, fell 5.2% for the year (in the long run, dividend paying stocks have outperformed non-payers by nearly 2% per year).  

Taxable bonds returned 0.6% for the year.  REITs returned 2.8% (with private real estate holdings doing much better). Considering some specific investments, market risk hedge strategy holdings were generally slightly positive.  Inflation hedges were the worst of all, generally in the -14% to -17% range for the year for the year while inflation was +0.8%.  A modestly bright spot in portfolios was insurance linked securities, with the relatively more conservative Swiss Re Cat Bond Total Return Index returning 4.5% in the year and more aggressive “quota share” mutual funds returning 7.9% and 9.9%.  

Inflation hedges merit special comment.  Gold, diversified commodities, pipeline master limited partnerships (MLPs), and energy royalty trusts each contributed to losses, while managed futures produced modest gains.  Inflation has been all but absent recently but history says this period is an aberration.  We have no opinion as to when inflation may return, but we believe that when meaningful inflation does return, it will pose a significant (and greatly unappreciated!) risk to your portfolio.  You own these holdings as an insurance policy for the rest of the portfolio, and we continue with a standard allocation to these assets of just under 5% of portfolios.  

The other really poor performer was emerging market stocks.  The MSCI Emerging Market index represents riskier, less developed countries but offers faster earnings growth.  It has outperformed the S&P 500 Index over the past 15 years, and we expect it to outperform the S&P 500 in the long run going forward as well.  However, last year it lagged the S&P 500 by 16.3%.  More significantly, over the past 5 years, it has lagged the S&P 500 by 17.4% per year!  Emerging Market stocks also lagged the S&P 500 massively for 5 years ending in 1998 and then outperformed significantly over the next 12 years.  Offering materially better valuations at this point, we consider emerging markets an attractive opportunity.

Unfortunately, valuations for most other equities (including REITs) are not compelling now.  Despite the much discussed interest rate hike by the Fed, bond yields remain very low while money market yields are still near zero.  As opportunities are few and risks remain elevated, we continue to emphasize broad diversification, including allocations to truly diversifying investments such as insurance linked securities.