Gerstein Fisher, an independent investment advisory firm based in New York City, has released its latest Market Perspective Winter 2014 Letter by Gregg Fisher, founder and CIO of the firm.
Fisher starts by looking back at 2013′s bull run, pointing out that despite the myriad of challenges investors faced (tax increases, budget sequester, government shutdown, rising rates), the S&P “shot up 32.4% in 2013, the best calendar year gain since 1997.”
He also notes Europe’s outperformance, but also the underperformance of emerging markets, warning that the “interplay between trade, the cost of global capital, and potential currency instability in emerging markets bears watching in 2014.”
Fisher moves on to discuss preparing for a market correction and while “the fact that markets have reached record highs doesn’t particularly concern [him],” he does “want our clients to prepare psychologically for a market correction of 20% or more, whether it happens in 2014 or not.”
He goes on to discuss the importance of alternative asset classes in a well-diversified portfolio, mentioning global real estate and energy as two asset classes that have particular appeal.
Letter from Gregg S. Fisher, Gerstein Fisher
Dear Clients and Friends,
2013 was a busy and successful year for us at Gerstein Fisher, and we extend our thanks to you for helping make it possible. We greatly appreciate the trust and confidence you have placed in us as we continue to invest on your behalf.
Our goal at Gerstein Fisher is to deliver an exceptional investment experience for our clients. As part of this, we conduct ongoing research to help us identify ideas that can be beneficial to investors. Our team works to explore these ideas, test them with rigor, and consider their application in thoughtfully implemented investment strategies. We believe that our research gains much of its value through transparency and communication, and that our clients’ investment experience is improved by understanding what we at Gerstein Fisher have been thinking about and working on with respect to your investments, and by sharing our views on some key market and economic trends.
After a highly eventful year for markets, where record highs were smashed and indices finally returned to pre-2007 levels, we think it’s important to discuss some of the broader, more strategic issues facing our clients. Just as it can be difficult to stay focused on the long term in the midst of a crisis, it can be helpful during times of relative market calm to discuss the preparations we’ve made and will continue to make for the next market correction. Although we don’t know when it will occur or what will be the instigating cause, our portfolio strategies are all built around the understanding that markets can’t rise (or fall) indefinitely. Accordingly, they are designed to mitigate this unavoidable volatility through diversification, active risk management, and diligent planning. As we enter a new year together, I would like all of our clients to know that our focus is not just on the next 12 months, but on the bigger trends and risks which will impact their financial lives for years or decades to come.
Gerstein Fisher: Bull Run
Let’s begin with a quick look back at 2013. The fourth quarter of 2013 capped a phenomenal year for US stocks. The S&P 500 INDEX (INDEXCBOE:SPX), which ended the year at a new high, shot up 32.4% in 2013, the best calendar year gain since 1997. The index rose almost relentlessly throughout the year, with no intra-year decline of more than 5.6% and volatility (measured by the Chicago Board of Options Exchange Volatility or VIX Index) falling to its lowest level since early 2007 (see Exhibit 1). Small cap stocks performed even better, with the Russell 2000 (INDEXRUSSELL:RUT) Index jumping 38.8%.
It’s not as though investors didn’t have a variety of issues to contend with – tax increases, the budget sequester, a federal government shutdown, rising interest rates – and few market observers predicted such a banner year for US stocks. Investors appeared more willing to embrace risk, seen in the rise of the price the market was willing to pay for the book value of the S&P 500 (the P/B ratio), which increased 22% from 2.14 at the beginning of the year to 2.62 as of December 31st, 2013. The positive sentiment was also fed by economic growth picking up in the second half of the year as the employment picture improved, the Federal Reserve’s accommodative monetary policies continued, and memories of the 2008 financial crisis receded (the first estimate of fourth-quarter US economic growth from the Department of Commerce was 3.2% – slightly better than consensus but slower than in the third quarter.) The price of gold, often viewed as a gauge of fear, plunged 28%, the worst performance since 1981 for the precious metal.
Abroad, the iShares MSCI EAFE Index Fund (ETF) (NYSEARCA:EFA) Index of developed country stocks logged a gain of 23.6% in 2013, despite mixed economic news overseas. The eurozone economy was stagnant and unemployment remained at an alarming 12.1% as of the end of October, but the World Bank is forecasting modest GDP expansion of 1.1% in 2014, amid signs that Europe’s doubledip recession may be coming to an end. With major gains in US and developed market stocks, the global odd man out in 2013 was emerging markets, with theiShares MSCI Emerging Markets Indx (ETF) (NYSEARCA:EEM) slipping by 2.3% after indications of weakness in a number of the largest emerging markets. Weak commodity prices pinched major resource exporters such as Brazil, South Africa and Russia, while political unrest affected countries such as Turkey and Thailand. The prospect of a reduction in Fed tapering and rising US interest rates also raises concerns over raising the cost of borrowing for developing countries with large current account deficits and heavy reliance on capital inflows, including India and Indonesia. This interplay between trade, the cost of global capital, and potential currency instability in emerging markets vbears watching in 2014.
Gerstein Fisher: Prepare for a Correction
With US markets near a record high, let’s consider some recent market history for a moment. Last year was the fifth consecutive year of gains for the S&P 500 Index, and investors who stayed the course after the market collapse of 2008 have been amply rewarded for their patience and discipline. From March 1, 2009 to December 31, 2013, the S&P 500 returned 179%, or 23.6% annualized, and more than recouped losses from the Financial Crisis crash of late 2007 to early 2009. In other words, investors who panicked, exited stocks during the market crisis of 2008, and stayed out, have missed one of the best five-year bull market runs in US history.
Other than to state the obvious – that 2013’s major gains will not determine whatever happens in the market in 2014 – we make no market predictions. The fact that markets have reached record highs doesn’t particularly concern me. After all, stocks rise in most years (historically, 3 out of every 4 years has generated positive stock returns in the US), inflation and interest rates remain low, the federal deficit is shrinking, the US economy and corporate earnings continue to expand, and consensus growth forecasts are more bullish for 2014 than for 2013.
But I do want our clients to prepare psychologically for a market correction of 20% or more, whether it happens in 2014 or not (and keep in mind that the S&P Index dropping nearly 6% in late January and early February and 2.6% year to date through February 7 is not an indication, positive or negative, of anything beyond normal market fluctuation). Just as we strenuously advised our clients to avoid making fear-based decisions about their investment strategies when the Dow Jones Industrial Average (INDEXDJX:.DJI) was at 6,500, we do not want them lulled into complacency by a 10,000-point rise. Historically, stocks drop by 10% or more once a year on average (since 1945 the average decline has been 13.3%), and from 1980 to 2013 the S&P 500 Index fell by at least 20% six times, including during several major recessions. Always remember that corrections are a normal, and even healthy, aspect of embracing risky assets such as stocks; without them, investors wouldn’t collect the risk premium available in stocks. After every one of those pullbacks, the markets eventually returned to record new highs. The people who lose money in the long term are not those who endure the painful market turndowns, but those who panic and sell when the market is down.
Market declines are often triggered by surprises, which are by definition unpredictable. Perhaps earnings disappoint, or long-term bond yields surge, or China’s banking system melts down, or deflation breaks out in the ailing eurozone.
Whatever the immediate cause for a future correction, rest assured that we follow the markets very carefully, and if clients believe that their financial situations have changed, we encourage them to contact us. To this end, throughout the last year, we have been aggressive (as always) in mitigating any potential change in risk profile in our portfolios through the rise of the equity markets or through the outperformance of any sub-sectors or underlying risk factors, as well as continuing to expand our research efforts on our investment processes and strategies, with the view that a sound investment starts with identifying the risks worth taking and minimizing the risks that don’t come with expected reward.
Gerstein Fisher: The Role of Alternative Asset Classes
One key to remaining prepared for a correction is to resist the urge to tamper with a well-diversified global portfolio, even when short-term trends can feel more relevant than long-term potential benefits. Remember, if one asset class is performing extremely well, then by definition another asset with a low or negative correlation should behave quite differently, and consequently is likely to underperform. For example, in 2013 while US stocks soared, investment-grade bonds declined in value – the iShares Barclays Aggregate Bond Fund (NYSEARCA:AGG) shed 2% in 2013 – which is precisely what one might expect to happen in a bull market fueled by a (generally) improving economy.
Some clients have inquired about the role in portfolios of alternative asset classes (which we usually define as investments other than stocks, bonds and cash), which have been notable in the last year for not sharing in the broad gains in the global equity markets. In addition to the losses in gold prices noted earlier, the Dow Jones-UBS Commodity Index (INDEXDJX:DJUBS) shed 9.5%, and the Dow Jones Select Real Estate Securities Index gained a relatively modest 3.5% in 2013. All of these asset classes play an important role in a well-diversified global portfolio, and as counter-intuitive as it can seem, we would likely be more concerned if they had risen comparably to the S&P 500, given that the primary reason that we allocate to these alternative assets is that they move in distinctly different ways from the general market.
Let’s take the case of real estate investment trusts, or REITs. These are publicly traded real estate companies that own (and often operate) diversified portfolios of properties such as shopping malls, office buildings and industrial space. These commercial real estate holdings offer some diversification benefits by being somewhat uncorrelated with not only the rest of an investor’s portfolio, but also any residential real estate they may own, such as their home. While REITs and equities have earned similarly attractive returns over time (from January 1, 1994 to December 31, 2013, the S&P Global REIT Index returned 9.7% annualized, compared to 9.2% for the S&P 500 Index), there is a substantial difference in how they earn those returns (see Exhibit 2). The bulk of equities’ return comes in the form of capital appreciation, while significantly more of REITs’ value to investors comes from income generated by the underlying properties. During the same 20-year period, the correlation between the US market and global REITs was 0.62 (compared, for instance, with 0.83 between the MSCI EAFE and S&P 500 indices), and it makes fundamental sense that global real estate – along with other alternative asset classes – will continue to provide significant diversification benefits to investors.
In addition to the purely quantitative logic behind the diversification benefits of multiple asset classes that are not perfectly correlated, we at Gerstein Fisher are also proponents of owning some exposure to alternative asset classes simply because their returns are driven by fundamentally different economic logic than equities. As an example of these sorts of macroeconomic trends, the United States has experienced a dramatic shift in terms of energy production and trade over the last decade (see Exhibit 3), and as technology, market, and political pressures continue to evolve, changes such as these will continue to have major impacts on the global economy. In our lifetime, the US may become energy independent, with important implications for our economy; for competition with areas with higher energy costs, such as Europe and Japan; and for foreign relations with the Middle East. We are of the firm belief that investors should have direct exposure to such economic trends, in order to take advantage of the rise and fall of prices not directly tied to the averages listed on the evening news. In the weeks ahead, we plan to communicate more about America’s rapidly changing energy picture.
Conclusion
At Gerstein Fisher, our highest priority is your long-term financial security and success. After a year with gains as dramatic as in 2013, our goal is to keep our focus on exactly that: managing risk and working hand-in-hand with you to ensure that we understand your ever-changing situation and continue to manage your investments accordingly. We also aim to periodically remind you, as in communications like this, of the greater historical context surrounding today’s markets, and of some of the longer-term “laws of gravity” of investing that bear repeating in the midst of near-term market noise. In our view, recent market volatility represents an opportunity to allow us as portfolio managers to add incremental value by rebalancing back to long-term targets or by investing periodic savings into the market at a lower average price. Remember: volatility can work to our advantage as long as investors have sufficient liquidity, fortitude and patience.
If you have any questions about your portfolio, please know that we are eager to speak with you, and to continue to provide a window into our process and our results.
Sincerely,
Gregg S. Fisher, CFA
Founder & Chief Investment Officer
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