The Diversification Obituary

Stocks Mixed As Jobs Disappoint

Equity markets were mixed last week, as investors tried to assess a likely reduction of quantitative easing in 2014. Minutes from December’s Federal Open Market Committee meeting showed that only one member – Eric Rosengren – objected to a reduction in asset purchases. With labor market conditions improving, committee members judged it an appropriate time to start stepping back from the quantitative easing program that had been in place since the fall of 2012. The S&P 500 gained 0.6%, while the Dow Jones Industrial Average declined 0.2%.

A poor government jobs report on Friday, however, led to gains in the S&P as some speculated this could delay the Fed’s plans to reduce QE. Although the unemployment rate fell to 6.7%, a recovery low, payrolls added just 74,000 jobs in December. That was the lowest monthly figure since January 2011. Some observers noted poor weather may have caused distortions in this month’s data.

The improvement in the unemployment rate was a low quality one as the labor force participation rate dropped by 0.2%. Over the course of 2013, the labor force participation rate dropped by an astounding 0.8%. Outside of 2009, during the depths of the employment contraction, this metric had not declined by that magnitude since 1961. For an economy supposedly starting to gain traction, this is certainly a disturbing development.

A closer look at nonfarm payrolls was equally troubling. Goods-producing industries were essentially flat in December, shedding 3,000 positions. This was led by construction, which lost 16,000 jobs. Gains were of the low quality variety, including 40,000 in temporary help services, 14,000 in accommodation & food services, and 12,000 apiece in clothing stores and food & beverage stores. It is worth noting that November’s job figure was revised significantly upward; the initial reading of 203,000 was updated to 241,000.



December’s labor report was a bit at odds with other recent economic data, which has started to show signs of improvement. These trends were noted in the Fed’s recent policy meeting.

The only other major piece of economic news during the week was the Institute for Supply Management’s Non-Manufacturing index. The report, released on Monday, disappointed consensus with a 53.0 reading. After a slowdown in November, economists had expected the series to rebound to 54.8. Seven of the index’s 10 underlying components weakened during the month, led by a stunning plunge in new orders. After a seven-point drop, ISM’s measure of new orders for the service industry fell into contractionary territory. As reported by the economic research firm Econoday, this is the first contractionary reading for new orders since July 2009.

Earnings season got off to an inauspicious start, with Alcoa reporting disappointing results on Thursday. While no longer a part of the Dow index, most observers still view this report as the unofficial start of the period. The company reported a severe loss in the quarter owing to an impairment charge connected with M&A activity. Excluding extraordinary items, the firm’s profit was still lower, as was revenue.

The diversification obituary

According to some major media outlets, 2013 was the year diversification died. With the S&P 500 racing to a more than 30% gain (the largest since the late ‘90s), it seemed as though no other asset class truly mattered last year. While it is true domestic equities had a banner year, one-asset class portfolios will never be robust, and there is reason to believe 2013 is a prime example of why diversification is incredibly important.

Last year offered a stark dichotomy to investors, with numerous asset classes disappointing, and only a handful offering truly stellar returns. For example, high yield corporate bonds gained 7.4%, REITs were up slightly more than 1%, and municipal bonds finished roughly flat. In the negative, the broad aggregate bond index lost 2% and commodities were down 9.5%.

For many investors it felt like a rare outcome that the S&P finished up with so many asset classes struggling. In 2011, however, the S&P finished slightly positive in a period when emerging markets, international stocks and commodities were sharply negative. For the myopically focused, it would also be easy to forget that emerging market stocks were the top performing equity sector in 2012.

Source: J.P. Morgan Asset Management

What might be most surprising about 2013, is bonds finishing in negative territory. The last time the BarCap Aggregate Bond Index lost money was in 1999, during the peak of the tech bubble. Bonds have pushed on a proverbial string for some time now, and that string finally snapped in 2013. The move was not extreme, however interest rates did rise enough to overwhelm the broader fixed income market.

But, the longer-term story remains somewhat consistent. For the past ten years, the S&P is up 7.4% annualized, identical to the 7.4% return for international stocks, and well behind the 11.5% gain in emerging markets stocks. At the same time, commodities are virtually flat at 0.9% annualized, while bonds are annualizing at 4.5%.

For investors that simply bought and held the S&P 500, their annual return for the past ten years was 7.4%. A simple nine-asset class portfolio would have generated a 7.2% return over that time, but with lower risk, lower loss of capital and a smoother point-to-point client experience.

But, the average investor was highly unlikely to keep pace with the S&P in 2013. According to J.P. Morgan, investors allocated $1.3 trillion to fixed income mutual funds and ETFs between 2007 and the end of 2013. Over the same time, equity funds and ETFs added $498 billion, but with most of that new money arriving in 2013. Increased exposure to fixed income was a drag on 2013 performance after several years of being quite beneficial.

Source: J.P. Morgan Asset Management

The ultimate goal of diversification is rather simple – some assets do well when others struggle. This is supposed to lead to a more robust portfolio that does not subject investors to excessive risk, volatility or impairment of capital. Prior to 2013, the S&P was never higher than the fourth best performing asset class from 2004 onward. Last year was a perfect reminder why diversification in fact works and remains a staple tenet for solid portfolio construction.

The week ahead

Earnings season should take center stage this week, with bellwethers including Wells Fargo, J.P. Morgan, Intel, Morgan Stanley, Citi, Goldman Sachs, American Express, and General Electric reporting.

Several important economic indicators are also due, including retail sales, inflation data, housing starts, and industrial production. The Fed’s Beige Book should provide further insight into the US economy on Wednesday. The less heralded Job Openings & Labor Turnover Survey is also scheduled from the Labor Department for Friday.

Central bank activity is limited this week with Brazil, Egypt, and Serbia scheduled to make policy rate decisions. Brazil is forecasted to increase its benchmark Selic rate by 25 bps.

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