From an early age, we are instinctively driven to ask “Why?” Likewise, we have all been taught that "you can't judge a book by its cover."
Through further training, we learn to research and analyze situations to find the root cause. However, too often we skip the research and analysis and just take things for face value. The 24-hour news stations don’t help, as they provide a daily one-liner on why the market rose or fell.
We don't deserve all of the blame though. Economics and financial markets are fraught with circular references and feedback loops. It's not as simple as one cause and one effect. There are literally thousands of potential inputs into a financial model, so we are left to pick certain ones and go from there.
Performance: A Book’s Cover
Potentially due to the overwhelming amount of information available, investors often fall on the most straightforward and readily available piece of information on an investment—recent performance. We would equate making decisions primarily based off of recent performance to judging a book by its cover.
If judging primarily based off of recent performance, it would be easy to overweight U.S. stocks and underweight international stocks and other diversifiers. U.S. stocks have outperformed international stocks in the last one, three and five years by a significant margin. That is like five straight world championships—hard to bet against that at face value.
In this article, we will explore two root causes for recent disappointment in diversified portfolios and frame some thoughts for decisions going forward. We will focus on:
- The strong U.S. dollar
- Historically low oil prices
Are You An Investor Or Speculator?
Many investors would agree that speculating on short-term currency and oil prices is a loser’s ballgame. However, we see investors reducing exposure to many asset classes that have underperformed importantly due to the strengthening in the U.S. dollar and significant drop in the price of oil.
This leads us to ask, "Are you an investor or speculator?”
5-Year Trailing Results
Diversified portfolios have trailed the S&P 500 for several years. Understandably, investors are questioning diversified exposure.
However, all else being equal, if currencies would have stayed stable over the last five years, diversified portfolios would be largely in line with domestic results.
Source: Data through 9/30/2015. Bloomberg.
We recognize that weak currencies may have helped underlying international economies disproportionately to the negative impact of the strong dollar on S&P 500 companies. However, we are simply pointing to an impactful observation of a root cause.
Trying To Predict Commodity Prices
As investors have found in the last few years, predicting interest rates is incredibly difficult. If losing at predicting interest rates isn’t challenging enough, try predicting commodity prices.
A survey by Reuters of 27 top energy analysts at the end of 2013 predicted that the price of Brent crude oil would average $104.10 for 2014. Brent finished the year at about $65 a barrel and was below $60 a barrel a week later.
Prices for Brent are down more than 50 percent in the past 12 months. The drop in oil prices has had several byproducts. Obviously, natural resources stocks have been negatively impacted. However, low oil prices have also had a significant impact on emerging markets stocks and ETFs such as the Vanguard FTSE Emerging Markets (VWO | C-88) and the iShares MSCI Emerging Markets (EEM | B-100).
Many analysts would agree that a main driver of the oil price decline is a current supply glut. While overall demand is not down significantly, global demand is trailing supply growth. Particularly impactful to emerging markets, however, is that their biggest customer (China) is slowing. China is the 800-pound gorilla of commodities markets.
Source: VisualCapitalist.com
Strong Dollar & Cheap Oil Impact Returns
How do you explain to clients that a strong dollar and lower oil prices are costing them returns? When we hear the term “strong dollar,” we picture Uncle Sam holding a greenback high in the air in a pose representing American spirit and dominance. What an encouraging image. How could that be a bad thing?
Many global investors have lost exponentially more money in their investment accounts—due to the 50 percent-plus drop in oil prices in the last year—than they have saved at the pump from lower fuel costs. Likewise, many global investors have lost more money recently in their investment accounts—due to the strong U.S. dollar—than they have gained in other ways.
It is important for investors to remember that their short-term expenses typically pale in comparison to the impact that efficient-market global forces can have on their life savings. This is a difficult thing for many of us to digest: Lower gas prices and cheaper European vacations are simple bird-in-hand rewards.
Risk & Performance
Let's say that you are considering two different investments that have long-term expected return distributions in the following ranges. For technical purposes, let's say these ranges represent two standard deviations:
- Investment A: -5% to +5%
- Investment B: -10% to +10%
Investment A would be considered by most to be a less risky investment since the standard deviation would be lower than Investment B.
Let's assume that, in a given year, oil drops significantly, causing Investment A to perform toward the bottom of its range, with a return of -4 percent.
Investment B was less sensitive to oil, and returned 1 percent for the year.
What now changes? Do the long-term expected return distributions change? Not likely, and if they do, they would likely be adjusted upward for Investment A, given the low valuation for oil.
Investment A is still inherently a less risky investment than Investment B. Likewise, the fact that the combination of Investments A and B are not 100 percent correlated can have diversification benefits for a portfolio made up of Investment A and Investment B.
We would argue that a decision to reduce exposure to Investment A based on recent performance would be a speculation.
What Should Investors Do?
While adjustments may be necessary to reflect current market environment, it is important not to be surprised and overreact when an investment performs within its expected range.
In investing for longer-term cycles, it is important not to spend each day playing the role of judge and executioner, presiding over your portfolio like a small-town sheriff in the Old West.
We would remind investors to not be surprised when things happen that are statistically normal. If you understand the cause-and-effect relationship, and don’t purport to be able to predict the cause, don’t be surprised by the effect.
Most investors don’t have a strong conviction on the direction of oil prices or currencies. We suggest sticking to a well-thought-out strategic allocation, designed to perform over multiple market cycles.
Taking a shorter-term viewpoint without short-term conviction can leave investors disappointed, and leaves the door open to making several mistakes within the same shorter-term cycle. - etf.com
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