2015 Playbook: Diversification, Divergence and Defense

Looking back on 2014, history will show that it was a “pretty good” year to be an investor—in the United States.  No one will remember the three minor corrections during the year that spooked the markets or the fact that no professional investor in January 2014 felt “really good” about being in either the bond or the stock market.

Outside the United States, things played out much differently.  Civil war in Ukraine, a slowing Chinese economy, a stagnant Europe worried about potential deflation, a return to recession in Japan, the threat of a Russian economic meltdown triggered by plummeting oil prices–it all made an improving situation at home look even brighter by comparison.

Despite troubles overseas, the United States by almost any measure was stronger than it has been in years.  The labor and housing markets improved, corporate profits were solid, Congress managed to avert another government shutdown, and the Ebola threat had little impact domestically.  It proved to be a Goldilocks economy: not too hot, which could have brought on higher interest rates from the Federal Reserve, and not too cold, which let the Fed end the QE3 bond purchases begun in the wake of the 2008 Great Recession.

From an investment perspective, the strength of the U.S. recovery is so significant that many have called into question the theory of diversification.  Why should we invest in anything beyond U.S. large capitalization stocks when all they do is drag down returns?  The reason we still diversify is because the future is unknown and change occurs quickly.  Bubbles happen, whether it is tech stocks, or gold or real estate.  We still diversify because surging asset classes eventually come down to earth and the dogs of today can become stars of tomorrow.  Some of the most storied names in money management like Bill Nygren, Wally Weitz and Bruce Berkowitz, suffered serious bruises to their reputations in 2009 because they were only in a handful of stocks with an over-emphasis on financials.

The point is no one knows what the future holds so it’s prudent to take a balanced approach and spread your risk.  Diversification helps you avoid the major setbacks in your portfolio while still participating in most of the upside.

Moving Forward

So where do we go from here?  We see a couple of things driving the markets in 2015.  The first will be a return to normal market volatility.  While it may not feel like it, we’ve lived in a relatively calm world since the Fed stepped in with QE and zero interest rates over the last five years.  Janet Yellen knows that the U.S. needs to buck the trend and be the first to raise rates, but middling employment numbers and indexes, cheap gasoline keeping a lid on inflation, and an international community that is worse off, have allowed her to kick that can down the road possibly into 2016.  The result will probably create a return to increased volatility in the stock and bond markets as they try and “guess” the speed and magnitude of future moves.  Any surprises, positive or negative, could upset the apple cart so the Fed will need to clearly telegraph what they’re going to do, as they have been, before taking any actions.

Furthermore, the divergence between major world central banks may create more uncertainty around the world’s fragile global economic health.  After all, no man is an island and central bankers will need to coordinate their plans and actions to insure the global economy gets back on track.

We will avoid oil for now.  The duration of this respite that we have been given is unknown and could last for quite some time, possibly even years, particularly if the dollar continues to climb like it did 11% this year.  This is great news for consumers and transports, which should receive noticeable earnings boosts with such cost reductions.  But as an investment, oil could be flat for a decade as gold has often been.

We will keep an eye on Europe who is attempting to emulate our recovery with quantitative easing.  Hopefully, this will represent opportunities akin to what we have experienced here over the last five years.  Nevertheless, the global markets will take time to heal given their disinflation pressures and tepid growth outlook for 2015.  Until growth returns overseas, commodities should remain weak.

The latest survey shows that foreign investors think the U.S. will be the best place to put their money to work in both the equity and fixed income markets, with the added lever of a potentially strengthening currency.  On the equity side, we will remain diversified, but acknowledge that U.S. large caps should continue to perform well given our position in the business cycle and foreign investor interest.  On the bond side, U.S. Government bonds should continue to remain favorable as foreign investors seek yield and safety.  With continued U.S. growth in our mindset, we can say with almost 100% certainty that there will be bumps along the way whenever the market decides to look up and glance abroad as it did in 2014.

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