Lessons Learned in 2015
by Seth Masters, CIO, Bernstein
After a number of years of strong stock market returns with little volatility, in 2015 the stock market swooned and risk rocketed skyward. As investors brace themselves for a more uncertain future, here are some key takeaways from 2015:
1. Don’t expect a repeat of past returns
Over the last five years, the S&P 500 Index has returned 13% annually—well above historical norms. We expect returns to be just half that much over the coming five years because the overall stock market is no longer cheap, and we expect corporate earnings growth to be modest.
When the broad market indexes were delivering double-digit returns, investors just needed to stay invested to do well. But with stock indexes now poised to deliver lackluster results, investors will need to select the right stocks in the environment we see ahead.
Fortunately, we think that the coming years will be a promising environment for stock picking. Consider the Display below, which shows the relative performance of active US large-cap equity managers in environments with different return patterns and changes in valuation.
As you can see, active managers historically underperformed when markets were rising on the back of expanding P/E ratios—precisely the environment we just experienced. But active managers handily outperformed when markets were weak, as shown in the bottom two quadrants. Active management also held its own when the market was up but P/E ratios compressed (top left quadrant). Based on our analysis, the coming years will likely land somewhere in the three quadrants where active managers tend to thrive—and where investing in the index disappoints.
2. Risk is back
After an extended period of market calm, volatility has returned with a vengeance. One measure of this shift is the frequency of large market moves. In 2014 and the first half of 2015, the S&P 500 Index rarely moved more than 2% over the course of a day. Then, starting in August, 2% swings began to occur far more frequently, as the next Display shows.
Note that the new, higher level of risk is actually close to the long-term average. What was truly abnormal was the very low level of volatility we were seeing until August. So why did that happen, and what’s changed?
In our view, the answer lies largely with central banks. We just came through an extended period in which the Federal Reserve and other central banks pulled out all the stops to suppress risk, by slashing interest rates and buying massive amounts of bonds. These actions helped rescue the global financial system and get the economy growing again, particularly in the US. And they made markets unusually tranquil.
Now, however, monetary policies are beginning to diverge. The Fed has begun to tighten, because the US economy is nearing full employment. By contrast, persistent economic weakness in Europe and in Japan is forcing their central banks to ramp up monetary stimulus. This policy divergence is provoking many anxious questions: Is the Fed moving too soon or too late? Will the European Central Bank and the Bank of Japan stimulus work? What unintended side effects will ensue? We think concerns like these will continue to simmer, keeping risk high.
3. Plan, diversify, and be flexible
What should investors do when facing the prospect of lower returns and higher risk?
The first line of defense is to update your financial plan. Even if you’ve made a plan in the past, it may require some fine-tuning, given the more challenging capital-markets environment. Lower returns from both bonds and stocks tighten the margin of error for plans. That’s why Bernstein helps clients to craft plans that would meet their goals even if markets are very weak. Our goal is to give clients the confidence needed to stay the course come what may.
The second line of defense is to diversify. As part of a well-diversified portfolio, bonds will continue to play a protective role, even with yields low and likely to rise. For instance, for taxable bonds, we think it makes sense to go global: to diversify interest-rate risk from exposure only to the US bond market and US policy regime. It’s equally important to avoid stock concentrations. That’s why our equity portfolios span the globe, and we seek attractive stocks with differing characteristics and market capitalizations.
Finally, staying nimble is another way to manage risk. Choose the right long-term allocation in line with your goals, but also recognize that over the medium and shorter-term, markets can be fickle. Adjusting your exposures dynamically can help keep risk closer to your original long-term target.
4. Buyer beware
2015 marked a turning point in many respects, yet one old saw seemed to persist: If something looks too good to be true, it probably is. Whether with exchange-traded funds (ETFs) or structured notes, investors learned this lesson in spades this year.
Take ETFs. When used appropriately, some ETFs can be an effective and efficient way to get a market exposure. But they’re far from flawless. A case in point was the plunge in global equity markets on August 24. Many ETFs continued to trade even though there was no good pricing information on their underlying securities. As a result, 10 of the largest equity ETFs fell to steep discounts. Had you sold them during that period, you would have suffered significant losses. We think that ETFs should come with a warning label, so that investors who buy them know what they’re signing up for.
The same can be said of structured notes. While structured notes have gained in popularity, they should also come with warning labels, in our view. Some of these complex instruments promise participation in rising markets but protection from falling markets. Others offer appetizing yields with little apparent risk. It’s only by studying the fine print and running sophisticated models that we were able to assess the likely results of these structured notes. In our analysis, structured notes tend to be illiquid and inefficient, far from the benefits they claim.
As investors prepare to greet a new year filled with fresh risks and rewards, keep in mind that some things never change. The next time someone tempts you with a “risk-free” product that will solve all your problems, remember the warning: “caveat emptor.”
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.
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