The year 2014 will be remembered as another great year to be a stock market investor, both in the US and abroad. Of course, as is usually the case, the year-end results give us a limited perspective on the actual events of the year.
It’s been said that you know your portfolio is well diversified if you’re always unhappy with some part of the portfolio. It makes sense. A diversified portfolio consists of different asset classes that move in a dissimilar fashion. When one part zigs, another zags. If everything in your portfolio moved up or down at the same time, you don’t have a diversified portfolio. You just own the same thing multiple ways. Think of late 90s investors who owned several technology funds, or spread their portfolio out across a “diversified” portfolio of dot-com stocks.
Sometimes, the part of your portfolio that you are unhappy with is simply the lowest gainer in a year in which everything does well. 2009 was one of these years. Coming off of the “Great Recession” market crash, the laggard was large US growth stocks. Despite a robust return of 26.46% for the S&P 500, it lagged all other major equity asset classes which had returns of between 27.17% for US small cap, measured by the Russell 2000 to an astounding 78.51% for the MSCI Emerging Markets Index.
Other times, the sore thumb of your portfolio is the biggest loser in a losing year. In 2008, all major equity asset classes were negative. But it was the Emerging Markets that took the biggest lumps with a loss of 53.33%. Other major equity asset classes had losses between 45.94% for International Small Value (EAFE Small Value Index) to 28.92% for US Small Value stocks (Russell 2000 Value).
The most difficult years from a perception standpoint are the years in which some of the asset classes are positive while others are negative. Although investors understand that investing involves risk, it’s never fun to lose money. When everything is down, we tend to accept that these losses are simply a down part of the process. But when some asset classes are up and others are down, it becomes much more difficult to accept. Investors begin to question, “why do we own those losers?”
1999 was one such year. The S&P 500 gained 21.04%, while the NASDAQ soared considerably higher. Value stocks, on the other hand were lagging. In fact, US Small Value stocks, as measured by the Russell 2000 Value, were negative 1.49%. In fact, the other laggard was the bond market. The Barclays US Aggregate Bond index lost 0.83%. Losses of 1.49% and 0.83% may not seem like much, but at a time when it seemed like there was so much money to be made in the stock market, many investors ditched their bonds and their value stocks at exactly the wrong time. Of course, ditching bonds and value stocks in favor of large growth stocks at that time was all too common, and sadly, a disastrous move.
2014 was another such year. US stocks were all positive, led by large cap growth with the S&P 500 closing with a gain of 13.69%. Small cap stocks were less impressive with the Russell 2000 delivering returns of 4.89%. However, in US Dollar terms, International stocks were down. The EAFE index of large non-US companies lost 4.90%. International small cap and small value stocks lost slightly more, -4.95% and -5.27% respectively. Emerging Markets nearly finished the year in plus territory, but after a poor December, the MSCI Emerging Markets index lost 2.19% for the year.
The question is this: should you ditch the international stocks in your portfolio, just as investors ditched bonds and value stocks in 1999?
There’s more to the story behind the 2014 investment returns. Namely, the strength of the US dollar. If you have travelled overseas in the past year, certainly you have noticed that everything is cheaper now than it was a few years ago. This is true pretty much regardless of where you went, but certainly true in the major developed regions of Western Europe, Japan and Australia. In 2014, the US Dollar gained nearly 12% on the Euro, 11.5% on the Japanese Yen, and 8.3% on the Australian Dollar.
Why does this matter? Equity market returns are expressed in US dollar terms. In other words, if your foreign stocks make 5%, but they’re in a currency that lost 10% to the dollar, your net return will be a loss of 5%.
That’s basically what happened with most International investments this year. Out of 22 major developed markets, all but three had positive returns when measured in their local currency. However, measured in dollar terms, 15 of the 22 countries had losses.
What this tells us is that foreign markets, themselves, are not faring as poorly as the numbers appear. In fact, most major foreign markets were positive year to date in their local currency. History has shown repeatedly that attempting to predict the future direction of currencies is a loser’s game. What’s more, you don’t need to. Currencies, when operating in an open market, tend to work as a self-correcting mechanism. Goods and commodities of the countries of de-valued currencies are cheaper relative to the highly valued ones. Consumers, businesses, governments and traders buy the cheaper goods, driving the currency back up.
Will this happen in 2015? The good news is that we don’t need to predict the movement of currencies. By remaining globally diversified, your portfolio will participate in both sides of the currency fluctuations. This means that our focus is on the continued growth of the global economy, wherever that growth occurs.