A Year of Transition for Financial AssetsLearn more about this firm
- The rocky start to the year corroborates our belief that 2015 marked a transition in the investment environment. We expect low returns and high volatility to continue in 2016.
- Two factors that help explain market outcomes in 2015 remain relevant in 2016: 1) financial assets aren’t cheap and 2) Fed tightening eliminates one of the greatest tailwinds for financial markets.
- Even in this new and challenging environment, we strongly believe that positive returns are achievable with the appropriate investment strategy. Active strategies deserve higher prominence.
The outcomes of 2015 suggest an important transition for financial markets. Specifically, we believe that the era of asset price reflation, fueled by both post-crisis undervaluation and aggressive central bank easing, is over. It was fun while it lasted, as the recovery of financial asset prices from the nadir of the great financial crisis has been dramatic, one of history’s most fruitful periods for investors. But 2015 returns were rather different, and the early experiences of 2016 only reinforce the likelihood of a new investment climate.
Last month, Bloomberg published the aptly titled article, “The Year Nothing Worked: Stocks, Bonds, Cash Go Nowhere”. It summarized the year in financial markets succinctly enough to render optional the actual reading of the piece. Just as well. The details are not for the faint of heart. Exhibit 1 arrays full year 2015 returns for a variety of asset classes. For U.S. dollar-based investors, one feature of the year missing from the Bloomberg headline presents itself in this chart. Note that beyond the simpleabsence of high returning asset classes, 2015 also offered the presence of material losers. For investors who owned a simple portfolio of U.S. large cap stocks and investment-grade bonds, returns were positive though close to zero. For investors diversified into categories like emerging market equity and commodities, results were far worse.
Exhibit 1: 2015 - A paucity of winners, a plethora of losers
Two factors that help explain the market outcomes of 2015 also remain relevant in 2016. The first is that following a long expansion of significant magnitude, financial assets are not cheap. No longer can we count on our returns being flattered by valuation recovery dynamics. The second factor, of course, is that the U.S. Federal Reserve has embarked upon a tightening of policy. The removal of extraordinary stimulus eliminates one of the greatest tailwinds for financial markets. Our base case for 2016, then, is a continuation of the environment of 2015: lower returns, higher volatility, market prices that fluctuate significantly but proceed in a mostly sideways pattern. We strongly believe, though, that positive returns are achievable, even in this new environment, with the appropriate investment strategy.
We see two ways to approach the challenge of profiting in a low trajectory, volatile market. The first seeks tactical opportunities in a time series sense. If we expect asset classes or securities to fluctuate in performance throughout the year, linking bursts of strong performance with periods of offsetting losses, then we might look for opportunities to anticipate these ebbs and flows, and vary our positioning accordingly. Yes, cynics would call this “market timing” and dismiss the exercise as hopeless and foolhardy. We believe, though, that tools and insights exist that provide adequate basis for attempting to capture time series opportunities. For example, our recommendation to underweight equity exposure has been in place since the early winter, and we are monitoring closely the same tools that suggested weaker markets for an indication that equity risk is again attractive1.
The second approach to profiting in a sideways market explores opportunities from a cross-sectional perspective. If we can identify a strong relative preference between two investments, then we can pair them off, one against the other, and extract returns from their relative performance. In a market environment that features heavy influence from macro factors, like central bank tightening, and a preponderance of index-based trading, the likelihood of individual securities becoming mispriced rises. If the patterns of 2015 persist, then we believe that these time series and cross-sectional techniques should be cultivated as an increasingly prominent component of overall investment strategy.
Our contention from an investment strategy perspective simplifies to this: In a low-return, high-volatility environment, active strategies deserve higher prominence.
1 At the moment, our indicators point to continued caution. We are watching for stability in oil prices, credit spreads, and currency markets (China in particular) before we will regard this volatility storm to have passed. Please see our latest Investment Strategy Outlook for a more detailed discussion.