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First Quarter 2015 Newsletter

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When Cycling, Don't Forget Your Helmet!

According to Hindu cosmology, and the ancient Sanskrit text The Bhagavad Gita, the lifetime of Lord Brahma is 311 trillion, 40 billion years. That’s a long cycle. The entire lifetime of some species of mayflies lasts only a few hours. That’s a short cycle. Most of us deal with cycles lasting somewhere between those two. Nonetheless, it is obvious that cycles are an extremely important part of life’s structure. When we wake up, eat breakfast, check our email, etc., all are based on cyclical activity which aids us in surviving in our world.

Investors are no strangers to cycles. Seasons of the year, business cycles, presidential cycles, tax seasons, holiday shopping, and military engagements are all examples of cyclical types of behavior that are often predictable and definitely influence the markets. What time of the year does the most money flow into retirement plans? What quarter do toy companies earn 70%+ of their profits? What political party is most likely responsible for deficit spending or tax legislation? Do new versions of the iPhone really affect the price of Apple stock? Does the sale of pickup trucks really give us a hint of the direction of the economy? All these answers relate to certain cycles and their influence on different aspects of the markets.

As long term investors, it only makes sense to review and use cycles that will give the greatest benefit to our long term performance. Too often, investors allow short term cycles to pull attention away from this fact. Let’s look at a real life example of taking short term cycles too seriously.

Chart of the Day

Above are some asset class returns for 2013. A couple things jump out at you. First, Large and Small US asset classes did great, with Value beating Growth. But Real Estate was terrible. Upon viewing this information, many investors jump at the chance to go with the recent winning formula, and eschew the ugly performer, in this case Real Estate.

Let’s fast forward to 2014’s numbers.

Chart of the Day

Wow! It seems like the big winners of 2013 cooled off in exactly the opposite degree compared to 2013. Of the big four 2013 winners, the top performer Small Value came in last at 3.48%, and the “laggard” Large Growth was the winner in 2014 with 13.51% The biggest dog (Real Estate) of 2013 became the darling of 2014.

How many investors do you think tried to take advantage of these short term trends, either via individual stocks or asset classes? It is a loser’s game, as it is nearly impossible to be on the right side of the short term trend, and by the time you think you have the puzzle solved and jump into the current cycle darling, the cycle changes and you are left holding something less than great.

DHG Wealth Advisors believes that the important cycles to focus on are those that over time have proven to add value to a portfolio WITHOUT jumping in and out of investments year after year. Those long term cycles are size and style based. The charts below show that by analyzing rolling periods of 5, 10, 15, 20 and 25 years, an investor is virtually certain to outperform the overall market averages by modestly overweighting their portfolio with smaller and more value oriented asset classes.

Chart of the Day

Just to remind you why we tilt our portfolios towards Small and Value, see the chart below. 

Chart of the Day

As you can see, it does not matter whether we are talking about Domestic, Developed Foreign or Emerging Markets equity asset classes -- Small and Value have been the leading asset classes in the long term cycles of the markets.

Last year, the S&P 500, which is neither a Small nor Value asset class, had a great year and outperformed all other non-Real Estate asset classes. Even though the data above clearly shows that Small and Value will win over the long term cycle, last year was a great example of a short term cycle going against the norm. The only real problem with this is that some investors may be fooled into thinking they don’t need a diversified equity portfolio and can simplify their life by merely owning an S&P 500 index fund. Review the above chart to see how the S&P 500 performed during the long term “cycles.”

Modern Portfolio Theory takes these long term cycles into consideration. By modestly overweighting your portfolio towards those factors that outperform over time, and then rebalancing when necessary, we are taking advantage of proven catalysts in performance – all without the need of wearing protective headgear and mussing our hair.

DFA Proxy Vote
Shareholders of DFA funds have started to receive proxy voting notices. It is the first time in several years that DFA Inc. has gone through this process. The voting issues are rather innocuous, with no major issues needing much debate. Your first reaction may be to just toss or delete this notice, thinking your shares’ votes won’t mean much. The problem is that DFA needs a quorum in order to have a valid vote, and if enough shareholders do not vote, they must spend ever increasing amounts of money to reach that quorum, which ultimately can increase the administrative costs of the funds. So take a minute and either check off a box or two, or click your mouse a few times, and vote for the management’s recommendations.

First Quarter 2015 Asset Class Returns


Chart of the Day

Some equilibrium came back to the global equity markets during this past quarter. After being a top performer in 2014, Large Cap US stocks came back down to earth, averaging a fraction of a percent. Modest performers of last year started the year much stronger. US Small Caps and just about all Foreign Developed and Emerging Markets were able to offset their weaker currencies with meaningfully better equity gains to average a 3%-4% quarterly gain. No one can know if this is the start of a cyclical change, where Foreign starts beating Domestic and Small takes the lead from Large, but it does point to the futility of attempting to piggyback recent trends (cycles) of asset classes. Usually, by the time the trend is recognizable, it is too late to jump on and ride it to further glory.

Bond performance continues to thumb its nose at all the Fed-watching Nervous Nellies. Rates trended slightly down during the quarter, allowing all durations of government bonds to generate quarterly capital gains that surpassed their annual yields. Not even Fed Chairwoman Janet Yellen’s discussion of potential timeframes for rate increases seemed to phase the bond market. Could it be that there is simply not enough inflation in the global economy to raise rates too much higher than current levels? Over the next several months we’ll see these high stake moves by the Federal Reserve play out in real time.

The first quarter of 2015 marked the sixth year anniversary of the current bull market. That is clearly not the longest on record, but it is no spring chicken either. Other than interest rates, the potential bottoming of foreign currency valuations and increasing economic growth of those same countries will be the real factor in determining when or if the US stock market will be overtaken by both Foreign Developed and Emerging Markets’ stock prices. During this six year period, the US markets have nearly tripled, while both the developed International Markets as well as Emerging Markets have “merely” doubled. There is definitely room for their valuations to catch up with the current US market valuation. All of this points to the necessity of employing sophisticated diversification strategies used in Modern Portfolio Theory. Asset class cycles can march to different beats within full market cycles, and having a properly implemented, monitored and rebalanced diversification program assures our clients will be “selling high and buying low” without ever having to make a market-timing decision. We simply rebalance back to your portfolio’s original risk/reward parameters, and in the process, buy the underperforming asset classes with capital from your outperforming asset classes.

The Federal Reserve’s interest rate moves, the heating up of the 2016 Presidential election, the rate of growth of both domestic and global economies and even the new drafts of tax bills floating around Capitol Hill all point to areas that will undoubtedly bring some excitement to the markets as the year progresses. How these topics interplay with each other during the year will be fun to watch.

Lastly, the weatherman certainly owes us some really nice weather after the craziness of the first quarter. As artic freezes give way to warmer spring temperatures, make sure you get outside and enjoy the beauty this season provides.

Sincerely,

Frederick F. Kramer IV, JD
Chief Investment Officer
Dixon Hughes Goodman Wealth Advisors LLC