2015 Fourth Quarter
After an October that brought us back to breakeven, November and most of December were flat. And then the last two days of the year took us into the red for 2015. As I write this, the downward pressure has continued into the new year as stocks declined in the first few trading days of 2016. Obviously I don't like to lose money - especially my client's hard earned savings. As you all know the portion of your portfolio invested in the stock market is not going to go straight up year-in and year-out. I am confident, however, that the stock portion of our portfolios will reward the risk we are taking over the long-term. Over the short-term, it is impossible to predict what will happen. Nevertheless, after a brief review of the different asset class returns in my model portfolio, I would like to devote some space to some short and long-term outlooks I have been reading and hearing about.
Fixed Income: Breaking down the asset classes, our fixed income did relatively well. High yield was not a fun category to be in during 2015 and we avoided that area. PIMCO Short-Term and Vanguard Short-Term Investment Grade were up over 1% in 2016 while two out of three intermediate-term bond funds we use were up over 2%. The average effective duration - a measure of the fund's interest-rate sensitivity - for PIMCO Short-Term right now is 0.01 years. Thus - in theory - if the Federal Reserve increased rates by a full 1% this year (which I highly doubt will happen) this fund would go down 0.01% - almost nothing. This serves as a reminder that just because we are purchasing mutual funds that look boring on the outside, that doesn't mean there isn't something going on under the hood. The management teams we have hired are some of the best in the business.
Large-Cap Domestic Equities: With the exception of Berkshire Hathaway and Oakmark Equity & Income, our domestic large-cap stocks were positive in 2016. During the year I sold an under-performing First Eagle U.S. Value and purchased Vanguard Dividend Growth with the proceeds during the August and September market swoons. For the most part, that paid off. While I am extremely comfortable with Vanguard Dividend Growth for the foreseeable future, eventually we will need to look at that position once rates climb to levels where CD's and treasuries become more attractive. However, with the global slowdown, I doubt the Federal Reserve will be able to raise interest rates as quickly as they said there were going to and, therefore, I believe Vanguard Dividend Growth has some room to grow. Berkshire has struggled as the price of oil has declined and Oakmark Equity & Income was hurt for the same reasons as the Royce funds (see below).
Mid and Small-Cap Equities: As for our medium and small company stocks, I was extremely disappointed with how the Royce funds performed. They have been preaching that "quality" companies (i.e. corporations with little to no debt and strong financial statements) are not getting the respect that they deserve while interest rates have hovered near historic lows. Charles Dreifus (Royce Special Equity fund manager) and Chuck Royce (Royce Total Return fund manager) have both said that as rates rise, high quality companies will outshine the higher debt-laden companies due to the higher cost of carrying that debt. As the first quarter-point interest rate increase and any subsequent rate increases work their way through the economy, we will have to watch and see how the Royce funds do. Our Schwab U.S. Small-Cap ETF, Schwab U.S. Mid-Cap ETF and the Vanguard Selected Value have done a nice job of holding their own in 2015.
Foreign Equities: Last but not least, I'd like to address our foreign stock funds. First Eagle Overseas was up 2.27% in 2015. That doesn't sound like much until you realize they beat their benchmark by 7.94% last year - enough to finish in the top 10% of all funds within that category. I'm glad we have half of our foreign equity allocation invested in First Eagle Overseas. IVA International was up 1.19% while Oakmark International was down 3.83%, but still beat its benchmark by almost 2%. I had to sell Oakmark International for many of you with taxable accounts as it continued to show losses I could harvest to match up against any 2015 realized capital gains.
Near-Term Outlook: As I watch the stock markets react to the first few days of 2016, I am amazed at how the markets are following the price of oil. As oil goes up, the U.S. stock indexes follow and vice versa. What are consumers doing with all of that gas savings? I always thought low oil prices were going to be a boon for the economy. It turns out after experiencing the Great Recession, I believe many consumers are paying down their debts and saving more. With 292,000 jobs created in December and unemployment at 5%, the U.S. seems to be doing well in certain areas. Obviously, the strong U.S. dollar is weighing down the larger U.S. corporations as their goods and services look more expensive to overseas consumers. The strong dollar could be a detriment to corporate earnings in the months to come. The question on a lot of investors' minds as we begin 2016 is the following: Will a global slowdown - as signaled by a deflating Chinese stock market - draw the U.S. down with it? During a global slowdown, I believe it would be very difficult for the Federal Reserve to continue to raise rates as the sliding price of oil, a slower global economy and the stronger U.S. dollar weigh in on markets.
Long-Term Outlook: My Vanguard representative called me a few days ago. Vanguard is expecting 6-9% average annual returns from the stock market over the next ten years. They also believe we will see 2 to 2.5% average annual returns from the 10-year treasury and 2 to 2.5% for inflation expectations. On a separate note, I asked him how often returns actually meet the historical average (10.24% for stocks; 5.45% for bonds), he quickly pointed out: Almost never. In fact, since 1926-2014, stock "returns fell within 2 percentage points of the annualized return of 10.24% in only 6 out of 89 years." So, when you hear that the average return for stocks is 10%, the chance that the return will hit exactly that 10% is pretty slim as stock returns are extremely volatile. Average bond returns more often fell in the +/-2% band around the annual average return of 5.45% (27 out of 89 years). Note that going forward, return expectations are much smaller, but still respectable. After all, what other asset class are you potentially going to receive a 6-9% average annual return over the next 10 years?