What To Do When Nothing Is Working

Last week we saw everything sell off…US stocks, foreign stocks, REITs, US bonds, commodities, gold.  You name it, and it lost money last week.  There are times when diversification just doesn’t work as expected.  As a long-term investor it is important we handle this appropriately:

  1. Get some perspective- there are periods where nothing seems to work.  It doesn’t mean you should change your strategy, just realize going in, this will happen time-to-time.
  2. Check your emotions- losing money is emotional.  If you are wanting to make changes to your portfolio, ask yourself honestly, “Do I want to make this change because I am afraid of losing more money or do I really believe my strategy is not effective anymore?”
  3. Realize you will look stupid- most good investment strategies require you to look and feel stupid in many instances.  In times like these doing nothing while the market goes down is agonizing.  Even still, adding money to an asset class that has lost value, only to see it continue to drop takes tremendous courage.  A good investment strategy will have you making incorrect short-term investment decisions since no one knows how the market will react day-to-day.
  4. Stick to your guns- if your strategy calls for buying when assets drop below a certain target weighting, make sure you do this.  Rebalancing portfolios (especially in times of market turmoil), is one of the best ways to react.  Don’t be afraid to stick to your guns, as this is one of the hardest things to do during these periods.
  5. Focus on long-term results- in the fall of 2011, the market had taken quite a beating.  Europe was a complete mess and the perception was the US government was completely inept.  Global markets had lost more than 20% of their value in just a couple months.  At that time, we wrote this to clients:

Greenspring continues to manage client portfolios using a disciplined process. Because of that strategy, we are close to repositioning some of our bond positions into stocks. If the stock market were to fall another 5 percent, our strategic allocation to equities for most clients would drop below our acceptable threshold and prompt a buy. While we don’t know if this would mark the ultimate bottom, we have found that this strategy tends to work well during market declines, as we are able to pick up quality holdings at cheaper prices. While it may seem counterintuitive to buy when everyone else is selling, we have found that following the herd tends to lead to herd-like returns, which unfortunately have been dismal.

When you focus on long-term results and try to block out the short-term noise, things seem to be a little more clear.  Those of us who believe in markets, know that 10, 20 and 30 years from now, there is a very good chance of higher stock prices.  When we view the market in this type of context, these times of trouble, actually end up as times of opportunity.

Emerging Markets Divergence Continues

Emerging market stocks have continued to sell off, even in the face of an improving US economy.  The chart below shows the performance of emerging market equities (blue line) versus US equities (green line) over the past six months:

Chart foriShares MSCI Emerging Markets Index (EEM)

So what is going on with these markets and why are they trailing so significantly?  While no one ever knows for sure why the market does what it does over short periods, we can make a few educated guesses:

  1. Commodity prices have fallen- many of the companies in these countries are dependent on commodity prices (oil producers, miners, etc).  Year-to-date most commodity indices are showing negative returns, which is weighing on these markets.
  2. Exports are slowing- Europe, which is a large trading partner with many emerging markets, is still reeling from the austerity measures put on them.  Since most emerging market companies are dependent upon exports to foreign developed countries, this has certainly hurt their revenue and profit growth.
  3. Rising rates in the US- as interest rates have risen in the US, it is feasible that funds will flow back to the US to take advantage of higher yields.  This can have a real drag on equity and bond prices of emerging markets.

Emerging markets have always been volatile.  We would urge investors to continue to hold a portion of their equity exposure in emerging markets and if prices continue to fall, consider increasing that percentage, as valuations could become very compelling.

 

Emerging Markets in Your Portfolio

I have found that emerging market stocks is an area of new client portfolios that typically has a very small weighting .  Unfortunately, these portfolios are divorced from the reality that emerging markets are becoming a huge force in the global economy.  Listed below is a chart from the Economist that shows the trend that has been occurring for a long time:

Today, emerging markets account for 40% of our world’s gross domestic product and make up 80% of  the total population.  In addition, most of the population in these countries have annual incomes that would be well below the poverty line in the United States. With just small increases in the standard of living of these populations, there could be massive opportunities for wealth creation for companies around the world.  

In a slightly different take, look at this fascinating map of the world:

http://www.thereformedbroker.com/wp-content/uploads/2013/05/the-world.jpg

Emerging markets still have major issues to deal with (volatile currencies, dependence on exports, heavily tied to commodities, stability of governments, etc) and will most likely be a volatile asset class, but as an equity investor, they warrant consideration.  This is a trend that is most likely here to stay for quite some time.

Bonds-Return-Free Risk?

I have heard a few commentators talk about bonds as return-free risk.  On the surface, when you look at traditional Treasury Bonds, this is pretty accurate.  As of this morning, a 10 year Treasury Bond would generate 1.82% per year if you were to purchase it.  With inflation running over 2%, investors who are buying these bonds are knowingly locking in a return less than the expected inflation rate for the next 10 years.  So on the surface, this seems like an asset class investors should completely avoid. 

We would differ in our opinion, as we still believe that bonds offer some compelling reasons for ownership (in the context of a broader, diversified portfolio).  First, bonds historically offer risk mitigation to a portfolio.  In periods like 2008 when everything was cratering, bonds saw appreciation.  Now, you may want to weight the bond component of your portfolio less than normal given their high prices and low yields, but they certainly should not be ousted.  Second, not all bonds are created equal.  While traditional bonds have seen yields shrink in recent years, other “non-traditional” bonds still have some solid yields.  The chart below shows some of these areas of the market that have higher yields.

http://www.thereformedbroker.com/wp-content/uploads/2013/04/bond-sectors.png

Don’t get me wrong, these bonds have different risk characteristics than their traditional counterparts, but they are certainly worth considering in a portfolio.  Our clients have exposure to both emerging markets debt and high yield, which has aided in boosting the overall return of the bond allocation within their portfolio.

US Markets Are Pulling Away

Since the beginning of the year, US stock market has handily outperformed their emerging markets counterparts.  These markets have been highly correlated over the past five years, but it seems as if their correlations are starting to break down.  Here is a snapshot of the S&P 500 ETF against the Emerging Market ETF.

Chart forSPDR S&P 500 (SPY)

What is causing this divergence?  In the short term it is always hard to know, but Emerging Markets tend to be highly correlated to Commodities (since that is a big source of revenue for them).  Commodity prices have struggled lately which could be a cause.  In addition, economic data from the US has been positive causing some investors to rotate more of their investment dollars to US equities.  Greenspring continues to maintain a balanced approach.  While there are factors favoring US equities right now, Emerging Markets also have their advantages.  Mainly, they are cheaper.  You have to pay 1/3 more for a dollar of US earnings than a dollar of emerging markets earnings. 

Information contained herein has been obtained from sources considered reliable, but its accuracy and completeness are not guaranteed. It is not intended as the primary basis for financial planning or investment decisions and should not be construed as advice meeting the particular investment needs of any investor. This material has been prepared for information purposes only and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Past performance is no guarantee of future results.