Second Quarter 2014 Letter to Clients

It was in this space just over a year ago that we addressed the rather distressing fact that the Dow Jones Industrial Average had just busted through the 14,164 record high it had achieved way back in 2007.

Wait…distressing? What’s so distressing about a record high in the stock market?

It seems quaint now, but many investors in early 2013 were ready to sell out of stocks at Dow 14,000 and move to bonds and cash, or at least reduce their stock exposure. Like gamblers who have dug themselves out of a huge hole and are desperately hugging the pile of chips in front of them, investors at that time were both relieved that stocks had finally regained their pre-2008 highs and convinced that we were due for a big downturn on the other side. The talking heads in the media were all too happy to feed this mentality, peppering investors with data about how the market had once again “gotten ahead of itself” and was due for a plunge.

We heard these concerns so frequently in early 2013 that we felt compelled to address the subject in our First Quarter 2013 client letter. We agreed that the market had surged for several years running and that, historically speaking, a downturn would not be unusual. But we also pointed out that bull markets often run much longer than people expect, and getting out based on guesses that a downturn was “overdue” could result in missing out on continued gains that stocks were poised to deliver.

We pause here, then, to consider the total returns of some of the major stock indices since March 31, 2013 compared to bonds and cash:

There’s no sugar-coating the reality: Investors who bailed out on stocks or reduced their stock exposure after the Dow regained its record high in early 2013 made a major strategic error. By any measure, stocks around the world have achieved huge gains since that time, ranging from almost 19% to more than 27%. An investor with $500,000 invested in the Dow would have gained about $94,000 in his portfolio since that time. An investor who fled to bonds would have gained about $9,500*.

And now we bring into focus another point we made in that same client letter that seems especially relevant today:

…an investor who gets out of the market in fear that it is “too high” faces a philosophical dilemma. If stocks historically always climb,
when will the investor ever feel comfortable that it is not too high?
At 20,000?At 50,000?At 100,000?

That is the exact dilemma anyone who bailed out of the market in early 2013 faces today at Dow 17,000 – the terrible quandary of not wanting to miss out on further gains but not wanting to invest at an even higher point than when you fled the market and then catch a downturn.

All of which goes to emphasize the underlying point of all this: The only way to be 100% sure you are invested for all of the unexpected upturns in the market is to be invested all the time. To do anything else is to court disaster.

* * * * *

“Why are we investing in other asset classes when everything else is underperforming the Dow? There’s no benefit to diversification!”

That is a common refrain we hear when Blue Chip stocks are leading the market, which most recently occurred in 2012. It can indeed be frustrating to hear about the Dow’s record high on the nightly stock report and not see an equivalent performance in your portfolio.

The answer we give during those times is the same one we give at all times, no matter which asset class is leading the market: Concentrating your portfolio in one asset class is risky, and it is a risk that doesn’t need to be taken in order to achieve long-term, stock market returns.

Never has this been more evident than looking at the 15-year performance of the S&P 500 index (which, like the Dow, invests in Blue Chip stocks) as of 6/30/14. Over the past decade-and-a-half, the S&P has averaged a paltry 4.35% return, one of the lowest returns for that length of time going back to the Great Depression.

The conventional wisdom in the media, therefore, is that “stocks” have delivered lousy returns for the past fifteen years. But that isn’t the whole story. Many other asset classes, such as small stocks, emerging markets stocks and REIT (real estate) stocks delivered returns over that same time period ranging from good to great:
A reasonably diversified portfolio combining those asset classes might look something like this:

• 40% US Large Stock (S&P 500)
• 20% US Small Stock (Russell 2000)
• 20% Foreign Large Stock (MSCI EAFE)
• 10% Emerging Markets Stock (MSCI EM)
• 10% REIT (DJ US Select REIT)

For that same 15-year time frame, the above portfolio would have returned 6.63% per year, more than 2% per year higher than the all-S&P 500 portfolio*. And over that period of time, a $100,000 investment in the diversified portfolio would have fared substantially better:

Certainly a 6.63% rate of return for an all-stock portfolio is low by historical standards, but it is much closer to historical norms than the 4.35% return that S&P 500 investors have experienced over the past 15 years. Also keep in mind this is just a hypothetical portfolio that we constructed without much forethought to illustrate the benefits of diversification. A thoughtfully constructed portfolio combining specifically targeted asset classes in accordance with the principles of Modern Portfolio Theory could have yielded even better results over that time frame.

The bottom line is that every asset class has its day in the sun – from Blue Chips to emerging markets and everything in between – and every asset class has a commensurate period of poor performance. Modern Portfolio Theory, which we implement at Capital Directions, is all about investing in multiple asset classes to smooth these extremes and provide a much more stable investment experience for our clients.

* * * * *

It seems only yesterday that investors were swooning over hedge funds. Unlike mutual funds, hedge funds are allowed to take both long and short positions in stocks. This allows hedge funds to bet either on a stock’s rise or fall, as their research dictates.

It all sounds great on paper, and many of those hedge fund managers looked like geniuses in 2008 and 2009, when their short positions made huge gains in the midst of an historic market downturn. Since that time, however, it has been rough sledding. The hedge fund industry as a whole has trailed the S&P 500 for the past five years, and 2013 saw the industry post a paltry 7.4% return compared to the S&P 500’s gain of 30% -- a whopping 23% underperformance!

The standard hedge fund fee is known as “two and twenty”; for the uninitiated, that’s a 2% annual management fee and 20% of the profits. Not surprisingly, after five straight years of underperforming the market while still gouging clients with this ridiculous fee structure, hedge fund managers are seeing billions of dollars in assets flow out of their funds. And, suffice it to say, they are getting a bit desperate (those yachts don’t run themselves, don’t you know?)

It was therefore no surprise to see a recent article in the Wall Street Journal highlighting the news that one of the largest hedge funds in the country is opening a new fund in which it will take huge positions in a concentrated portfolio of just a handful of stocks – sometimes as few as four or five stocks in the entire fund. This is the industry equivalent of swinging for the fences in the bottom of the ninth when you’ve got nothing to lose. And it is illustrative of why investors should avoid hedge funds like the plague. Hedge fund managers don’t have a lot of disincentive to make huge bets, and they conversely have a huge disincentive to just be patient and let the market work for them.

Not exactly a case of having your interests aligned with your clients’ interests!

* Please note: Diversification does not eliminate the risk of market loss. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is no guarantee of future results. Investing involves risks, including fluctuating values and potential loss of principal. Index data provided by Morningstar Direct.