February 3, 2015
February 3, 2015
The calendar year of 2014 marked the sixth consecutive year of positive returns for U.S. stocks (as measured by the S&P 500). The length of this winning streak is unusual. Since 1926, winning streaks for stocks have averaged about four years before coming to an end.
As we look to the current year, it is natural to wonder whether this extended bull market sheds any light on the prospects for this year’s stock returns. In other words, does the current six-year winning streak suggest that stocks are likely to fall or, conversely, that a seventh year of gains is in store? The short answer to both questions is “no.” Because so many factors affect stock prices, no single metric offers much predictive value. In fact, given the complexity of investment markets, even models using thousands of variables are unable to generate reliable market forecasts.
This observation leads to a key implication for investment strategy – a strategy’s success should not be based on “getting the forecast right.” Instead, investment strategy should consider multiple potential scenarios. This more robust approach facilitates the development of strategies designed to do well in rising markets while limiting the losses that can derail a long-term investment plan when markets are falling.
In this article, we consider this “scenario analysis” approach for the year ahead. We examine three scenarios that we believe capture the primary range of outcomes U.S. investors may encounter.
1) Stronger U.S. Growth Drives Trends – This scenario was the consensus among economists entering 2015. In this scenario, the U.S. economy maintains its momentum from the second half of 2014 as lower gas prices and better job prospects provide American households with the wherewithal to spend more on discretionary items. While weakness overseas remains a concern, problems in areas such as the Eurozone do not significantly hold back growth in the U.S. In response to this economic strength and tighter labor markets, the Federal Reserve begins raising interest rates.
Investment implications: Somewhat counterintuitively, this scenario could prove challenging for both stocks and bonds. While stocks generally benefit from stronger economic growth, a Fed rate increase could reverse a narrative that has helped propel stock prices during the current bull market – by committing to keeping rates low, the Fed has encouraged investors searching for higher returns to invest in riskier assets such as stocks. As the Fed begins reversing this process, stocks could suffer. Bonds could also struggle in this scenario as the potential for rising rates becomes a reality.
2) U.S. Growth Disappoints – Again – While not the consensus, this scenario also has a reasonable chance of occurring. Since the Great Recession, U.S. economic growth has consistently disappointed. At the beginning of each year, the Federal Reserve has predicted solid economic growth in the 3%+ range for the upcoming year and each time, growth has fallen short. Economic growth has been held back by various “headwinds” including negligible real wage growth and low levels of corporate investment. These headwinds have not fully abated and may again hold back growth this year. This “slow growth” scenario would be similar to the environment during the past several years. The Fed would likely postpone its plans to begin raising interest rates.
Investment implications: With the Fed on hold, this scenario would provide the same positive backdrop for U.S. stocks and bonds that we’ve witnessed over the past few years. Both stocks and bonds could do well in this scenario.
3) External Shock Triggers Major Stock Market Decline – In any given year, it is relatively easy to identify potential catalysts for a major stock market sell-off of 30% or more. In a complex and interconnected world, there is no shortage of potential flashpoints. Developments in Europe at the beginning of this year warrant particular attention. Elections in Greece have rekindled fears of a Eurozone breakup and a surprise move by the Swiss central bank triggered insolvency for some foreign exchange brokers and large losses for some banks. In a worst case scenario, uncertainty caused by developments in Europe could trigger the kind of panic selling that typifies major stock market declines.
Thankfully, markets manage to avoid these severe scenarios most of the time. Cooler heads generally prevail (or cans are kicked down the road) and the worst case scenarios come and go, replaced by others. The performance of the S&P 500 supports this – over the past eighty-eight years, the S&P 500 has recorded losses greater than 30% in just four of those years.
Investment implications: We believe this scenario has the lowest probability of occurring of the three scenarios considered. However, this scenario also has the most severe impact on portfolio values if it were to occur. For this reason, we believe it is essential to incorporate this scenario into investment strategy.
In this scenario, the decline in stocks would likely be accompanied by losses in other risky assets such as high yield and emerging market bonds. High-quality bonds, particularly U.S. Treasuries, would likely gain in value as investors seek safe, liquid assets.
Key Takeaway – Balance Works Best
It would be nice if specific asset classes performed well in all three scenarios. Alas, this is not the case. Instead, asset class performance would likely be very different depending upon which scenario occurs. For example, stocks should do well in the slow growth scenario that keeps the Federal Reserve on the sidelines while stocks could suffer losses if economic growth remains firm and the Fed begins raising rates. Stocks would also be hit in a financial crisis.
Without knowing which of these scenarios will occur, we conclude that a balanced strategy that includes a meaningful allocation to both stocks and high-quality bonds provides most investors with the highest likelihood of achieving long-term investment success.
After six consecutive years of stock market gains, maintaining discipline and sticking with a balanced strategy can be difficult. It is times such as these when investment discipline is most important.