2014 Investment Outlook

As we enter the New Year, many investors are feeling like they are at a cross roads.  After two major melt-downs and two big melt-ups over the last 13 years, U.S. stocks have reached new all-time highs and you may be wondering if it’s time to get off the roller coaster.

Not yet, but you should locate the exits.

Here, our Investment Team has summarized our approach for 2014.  We’ve taken a step back from today’s complex landscape and attempted to provide a more general overview of what we are expecting over the next twelve months.  Most importantly, we want to explain how we are thinking about the future.

There are an abundance of risks and opportunities for investors today.  Savers are being squeezed by negative real interest rates and low yields from safer asset classes.  On the other hand, risk assets have the potential of providing 20, 30 or 40% returns.  This is truly an interesting time to be an investor and an even more interesting time to be an investment manager.

US Stocks: Timing is critical.

While domestic stocks are expensive and probably significantly overvalued, that doesn’t mean the rally is over.  It never makes sense to fight bullish momentum; however, you should have a process in place now for how and when you will sell your stocks because a correction is coming.

It’s worth emphasizing that wanting to sell when stocks begin to decline and planning to sell are two very different things.  To draw a sports analogy, wanting to win the game is very different from implementing a game plan.  With US stock prices at their all-time highs, if you don’t have a game plan, you deserve whatever result you get because you’re gambling.

There are plenty of analysts that will explain why the stock market is going to go up or down.  They will cite various fundamental measures, GDP, dividend yields, earnings reports, profit margins and others.  But research shows that these metrics have had little or no correlation with future stock returns.

Popular_Stock_Metrics

Forecasting the stock returns is a fool’s errand.  John Kenneth Galbraith said, “There are only two kinds of forecasters – those who don’t know, and those who don’t know they don’t know.”

Stocks rise and fall for reasons we don’t understand.  As an investor (or an investment manager), the sooner you recognize this the better.  One methodology we believe does work is momentum or trend following.  Own stocks when the trend is up and sell them when the trend is down.  It’s not perfect, but it does seem to work over time.

Last summer we published a research paper that showed that a simple 12-month moving average could effectively capture market momentum in a number of asset classes and outperform a balanced portfolio, providing both higher returns and less risk than its passively managed counterpart.

Our trend-following approach, because it is active, may seem like forecasting, but it’s not.  Trend-followers make no attempt to predict future prices.  Instead, our investment process moves into and out of assets classes based on current market conditions.  I describe it as, “recognize and react.”  We measure current and past market data and re-align our client portfolios based on today’s environment.  Our goal is to participate in markets that are trending higher and avoid markets that are trending lower.

For now, we are cautiously bullish on U.S. stocks and we will maintain our allocations until our indicators tell us that the trend has changed. 

Historical norms suggest a significant correction in the range of 10-20% at some point next year.  The question is what happens from there?  Will stocks re-rally or will they sink more?  Your game plan should allow you to adjust accordingly.

The famous investor John Templeton said, “Bull-markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.”  It’s not exactly clear what phase we’re in, but it could be that we’re only somewhere between skepticism and optimism.

In some ways, the biggest risk may be in being either too bullish or bearish.  A well-conceived, flexible approach seems most prudent at this time.

Opportunities Beyond Traditional Asset Classes

Investing beyond domestic stocks and bonds is a good way to diversify against many of the risks we’ve discussed above and in other commentaries, but it’s no silver bullet.  Owning too many asset classes at the same time results in low/average returns and owning too few is too risky.

Investing in the right areas at the right time is the key, and using multiple investment styles within your overall portfolio can add diversification.

For most of our clients, we recommend a core allocation to a domestic stock strategy and/or a global asset class rotation strategy.  We may also recommend complementary investments.  Here are some of our best investment ideas for 2014, in no particular order:

Global Asset Class Rotation

It’s hard to find any single asset class or market that has consistently out-performed all others for an extended period of time.  There certainly have been exceptional periods of abnormally high returns that have been the equivalent of shooting fish in a barrel, such as the US equities markets in the late 1990’s and global real estate market in the mid-2000’s.

Since it is nearly impossible to predict which asset class will be the top performer in a given year, it makes sense to hold a diversified portfolio of different asset classes.  The trick is not to hold too many asset classes and to hold the right assets at the right time.  By using a trend-following process that measures momentum in the various asset classes, (like stocks, bonds, real estate, commodities and currencies) we seek to shift assets to the strongest areas of the global economy while avoiding the weak ones.

International Stock Rotation

The U.S. stock market has been a great source of returns for investors for many decades.  It hasn’t been an easy ride, but domestic stocks have provided a few generations of investors with positive returns.  The U.S. stock market is mature and doesn’t offer the same growth potential as some emerging markets.  Especially now, with domestic stocks at all-time highs, it may make sense to diversify your stock portfolio outside the country.

By using momentum to shift assets to the strongest countries of the global economy, investors can seek to capture outsized returns – and avoid markets that are in decline.  Currently, our international portfolios are fully invested.  We own diversified stock funds in the following countries: Australia, France, Germany, Japan, Netherlands, Singapore, Sweden, Switzerland, and the United Kingdom.

Volatility Harvest

Change is the only certainty in investing.  With the introduction of volatility ETNs, now you can invest in volatility.  If you think volatility is going to increase, you can buy the iPath S&P 500 VIX ETN (ticker: VXX) or, if you think volatility is going to decrease, you can buy the VelocityShares Inverse VIX ETN (ticker: XIV).  Investing in volatility isn’t easy, because changes in market volatility happen overnight, literally.  And the swings can be dramatic.  So, while volatility offers the opportunity for attractive returns, it must be managed effectively.  In 2012, we launched one of the country’s first volatility trading strategies, called, “Long/Short Volatility,” which may be a good complement to a well-diversified portfolio.

Absolute Return Strategies

A few weeks ago we wrote a piece called, “Tactical Alpha: Our ‘Absolute Return’ Strategy.”  It explained that with the stock market near its all-time high, some investors are looking to diversify their investments into strategies that don’t rely on an upward trending stock market to generate investment returns.

Absolute return strategies may be a good way to add another layer of diversification to your portfolio.  During periods of market weakness, like in 2000-2002 and 2008, absolute return strategies may help protect your assets from the full effect of a bear market.

As 2014 unfolds, we will continue to closely monitor the global asset markets and apply our disciplined investment process.  Don’t pay attention to market analysts on TV or in print.  And forget about trying to react to individual news stories.  Instead, listen to what the market is telling you.  Analysts are right only about half the time.  Actually, the gurus are wrong more than they are right!  And contrary to what you might think, very few individual news stories have a significant effect on stocks.  Ironic isn’t it?  Given the fact that the news media spends every day dissecting stories as if they matter.

Ned Davis Research examined the impact of 28 major crises on the Dow Jones Industrial Average over the last sixty years. The results of the study showed a remarkably consistent pattern.  The market lost ground initially, but repeatedly re-established its previous trend within a matter of days or weeks.

Even more fascinating was the fact that the markets frequently made huge moves, in both directions, seemingly for no known reason whatsoever!  The most notable one was the devastating one-day decline on October 19, 1987, when the market crashed 22%.  Even now, twenty-six years later, the cause of the ’87 crash is unknown.

We have never allowed news stories or analysts to directly influence our decision-making.  There is simply too much evidence that shows that it’s dangerous and fruitless.  In today’s markets, the news is almost immediately reflected in the prices of assets.  This is why we form our investment decisions using disciplined, quantitative analysis of market prices.

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