Review of 1st Quarter
The first quarter of 2015 was a good, but not great, three months for most capital markets:
U.S. large company stocks increased in value by 1%, mainly because of steady economic results. Corporate profits remain high, and that is the most important driver of equity values. However, unlike 2014, large company stocks were the worst performing of the major asset classes – in particular, small company stocks, developed market international stocks, and emerging market stocks all outperformed the S&P 500. International stocks did well because of an improved outlook on the world economy. Bonds again had good quarter – interest rates declined once again.
Below is a table showing key economic and market indicators (as of April 9, 2015)*:
**Sources: Bureau of Economic Analysis, Bureau of Labor Statistics, JP Morgan, Federal Reserve Board
These data (along with most other indicators) suggest that the U.S. economy is continuing the steady progress that it’s had since the recovery from the 2009 recession – persistent if unspectacular growth, increasing employment, and low inflation. The consistency in the economy explains the low past and current market volatility. We agree with the market consensus and remain bullish on the U.S. economy.
U.S. Stock Market Outlook
Unfortunately, we cannot be as bullish about the U.S. stock market, mainly because most investors have a similar positive view about the economy, and current valuations reflect that perspective. While prices of U.S. stocks are far from the “bubble” type levels of the late 1990s, it’s unlikely that average price-earnings ratios will keep rising. That means the only growth in values will come from earnings growth, and in turn, that suggests a limited upside return potential. Moreover, any disappointment in corporate earnings will impact stocks negatively. Consequently, investors should have more modest expectations for U.S. stock returns compared to what has occurred over the past five years. We’re slightly more bullish on international stocks, because their valuation levels are not as high.
Here we go again – our quarterly warning about bonds. There will be an increase in interest rates, and for a short period of time, bonds, particularly long-term Treasury bonds, will decline in value. While we can’t predict precisely when that interest rate increase will occur, and how much rates will rise, it will happen. So our recommended strategy remains the same. Investors should diversify much of their portfolio away from Treasury bonds and indexed bond funds, and include other types of bonds such as investment grade corporate, high yield, and emerging market debt. We also recommend staying away from long-term bonds, which are more sensitive to interest rate increases.
Importance of Diversification
Because of the remarkable performance of the S&P 500 over the past five years, a few clients have asked us if our philosophy of broad diversification has changed – it hasn’t. Indeed, history continually has taught us that the most important times to remain diversified have been after spectacular performance – either on the upside (such as the late 1990s) or downside (such as 2009). Indeed, over the past three months a broadly diversified portfolio has outperformed the S&P 500 – but the advantages of diversification thus far in 2015 are a drop in the bucket compared to the potential benefits if we have a market correction in the next few years.
We believe that current market valuations are consistent with a favorable outlook on the U.S. economy. With those high valuations, the stock market may have a limited upside, and returns are not likely to be as high in the near future as they have been over the past few years. Interest rates have remained low, but we expect them to rise over the next few years. We continue to recommended broad diversification across domestic stocks, international stocks, and bonds.