Equity markets soar as economy expands
The final few trading days of 2013 brought additional gains for equity investors, pushing the S&P 500 Index to a 32.3% gain for the year, and leaving the MSCI EAFE Index up 23.2%.
Investors were increasingly optimistic about the prospects for economic recovery throughout the year, leading to the impressive final tally. All asset classes did not perform equally, however, with bonds, emerging markets, commodities and TIPS closing in the negative.
The final week of the year brought further optimism for the economy, carrying strong momentum right into 2014. A mix of economic releases on manufacturing, construction, housing prices and consumer sentiment were encouraging.
In the manufacturing sector, the ISM Manufacturing PMI finished at 57.0 in December. Readings above 50 are representative of expansion in manufacturing. Despite being a slightly lower reading than November, the components of the headline index were strong. New orders and employment were both higher in December, while inventories shrank. Comments from the survey were telling, as respondents indicated, “largest backlog ever”, “very, very busy”, and “meaningful increases in our sales in nearly all segments and regions.”
Source: Institute for Supply Management
Data on housing also confirmed that improvement is happening. The S&P/Case-Shiller Home Price Index rose 1.0% in October and is now up 13.6% in the past 12 months. The yearly gain is the strongest since February 2006 according to S&P.
Source: S&P Dow Jones Indices
Following a mixed holiday shopping season, we learned late in the week that consumer confidence increased in December. The consumer confidence index rose from 72.0 in November to 78.1 in December. According to the survey, consumers were more optimistic about their current and future outlook.
Source: Haver Analytics
With equity markets posting such healthy gains in 2013, the question now turns to whether that performance can be repeated. By most major measures, the S&P 500 is currently at fair value and slowly creeping into overvalued territory. That does not mean the S&P will tread water, though, as it has historically shown an ability to move deep into overvalued territory before normalizing. As an example, the equity valuation model from BCA Research showed that markets moved well into overvalued territory during the late 1990s and in the mid-2000s. 2014 likely represents a year where equity multiples expand, leading to further gains for markets, but probably not to the same degree as 2013.
Source: BCA Research
Is 2014 the year that alternatives matter again?
In the wake of the financial crisis of 2008, investors piled into alternative investments en masse to help insulate their portfolios from another dramatic market decline. For those who had not yet bought into the idea of improving portfolio risk-adjusted returns, the 50% drawdown in the S&P 500 provided all the convincing needed.
Since then, however, alternative investments – broadly defined – have generally disappointed those new entrants. After compounding at 7.5% between 1990 and 2008, the HFRI FOF: Diversified Index has posted a 4.8% annualized return from 2009 to present. While not terrible in a vacuum, compared to equity markets these returns have obviously been far inferior. The S&P 500 saw comparable returns of 7.3% for the 1990-2008 period, but a 17.7% annualized average return since 2009.
A confluence of developments hurt alternatives in the latter period on a relative basis. These ranged from unprecedented central bank intervention, investor behavioral dynamics, a foreign sovereign economic crisis, and various regulatory changes. All in all, these created a market less dominated by fundamentals than most hedge fund managers would have ever envisioned. For active investment managers – particularly those who try to control risk by hedging out market sensitivity – 2009-2013 was a challenging market environment for alpha generation.
The million-dollar question for many investors at this juncture is whether their recent foray into alternative investments is worth sticking to. With the S&P 500 up 180% from trough levels five years ago, the need for diversification is slowly fading from the minds of many market participants.
From a historical perspective, the current five-year streak of positive performance is already past the S&P 500’s average bull market length of 3.76 years (based on calendar year data). In fact, prior to the current cycle there were only three instances in which calendar year performance reached a positive streak of at least five years. History suggests that the power of mean reversion may win out at some point.
With the Fed also signaling that it intends to withdraw its aggressive bond purchasing, one of the pillars of market support may also be eroding. The impact of such programs was exceedingly evident in 2013 when the four best performing global markets (US, UK, Japan, and European Union) were each aggressively pursuing easy money policies. This is now changing, and global markets are arguably becoming less synchronized.
On the other hand, there are certainly reasons why a bull market could continue. Economic growth is starting to show signs of life, with growth in the US recently accelerating to 4.1% annualized. Europe and Japan are also experiencing expansions following periods of stagnation. Sustainability of this trend could propel the market further, as “easy money” gains give way to greater organic growth.
For investors, the decision on whether to stick with, or to allocate more to, alternative investments should not necessarily hinge on the prospective direction of equity markets. Far more important are the normalization of market dynamics and the increasing impact of fundamentals. The most straightforward way to evaluate this phenomenon is through cross-market correlations, which recently sank to a near-term low in late 2013.
More recent research suggests another important metric on this front centers not just on correlations, but on dispersion (between stocks and between asset classes). A study by Standard & Poor’s notes that certain flaws exist with correlation measures, including inability to capture complexities such as non-linear relationships, dependencies between combinations of assets, and variable sensitivities. The S&P research indicates that periods of high dispersion (or rather, cross-sectional portfolio volatility) may provide a better estimate of periods when active management has a greater opportunity to add or subtract value relative to passive approaches. The implication is that skilled managers may find such environments more conducive to their strategies.
The calculations made by S&P across recent markets indicates that equity dispersion is currently quite low – indeed, near the low end of its historical range. Research by Goldman Sachs supports this notion, as current sector dispersion of 10% is well below its 30-year average of 17%. Six of the 10 sectors, in fact, are at or near their historical extremes.
Source: Goldman Sachs Research
While the S&P series has exhibited autocorrelation in the short-term, it has been mean reverting over time. And from an asset class perspective, S&P’s calculations indicate that dispersion is rising from trough levels in early 2013.
Source: Standard & Poor’s
The pivotal question for investors moving forward is whether increasing discretion by market participants based on fundamentals, and therefore higher dispersion in markets, will take hold. While a backward looking view supports a continued beta trade, there are reasons to believe that this could change – most notably: the withdrawal of monetary support, green shoots of economic growth, and/or simply market exhaustion after a multi-year rally. A broader range of returns for market securities should provide a more fertile environment for active managers, including alternative investment managers, to produce attractive returns.
For any variety of reasons, maintaining exposure to alternative investing should prove more productive in 2014 (and beyond) than it has over recent years. It is important to look forward and not backward. Investors would be myopic to throw the towel in on alternatives at this point of the cycle.
The Week Ahead
As traders return from vacation, they will be greeted with a number of important economic indicators.
Monday brings the Non-Manufacturing PMI, released at the same time as factory orders for November. Later in the week, markets will closely watch nonfarm payrolls for December, which have trended stronger in recent months.
After the close on Monday, the Senate is expected to vote on Janet Yellen’s confirmation as Federal Reserve Chair. On Wednesday, minutes from the December FOMC meeting are released. Participants will closely analyze comments behind the decision to taper and what it may mean for future asset purchases by the Fed.
Outside the U.S., central bank meetings are happening in the UK, Eurozone, Indonesia, Romania, Poland, Peru, and South Korea.
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