2015: What You Know… and Don’t Know

By David B. Armstrong, CFA | Jan 05, 2015 | Weekly Market Commentary

Let’s get all of the boring stuff out of the way.  For 2014, the S&P 500 finished up +12.68% and of the twelve calendar months, only three were negative. The Utilities sector came in at the number one spot of all ten S&P 500 sectors; it was  up +28%.  Biggest loser?  Drum roll please… Energy was down -9.2%.  Of course I’ll have to look into Russian Equities.  Believe it or not, you’ll only get that joke if you’ve read my blog from back in December.  Oh, and for those of you who like to keep track, I’ve got the data on how much the S&P 500 is up since the bull market began on March 9^th of 2009.  It’s all inside this blog, but be sure to read through my quick thought on RISK at the bottom.  It’s important.

209%.  Yes, it’s hard to believe. Especially if you are one of those people glued to CNBC and fretting every little market hiccup we have seen since then.  I’m not sunshine pumping the market, I’m just saying that for those of you who had a long-term financial plan and only sold when you needed liquidity instead of when you got scared, you have done okay.

I’ve been reading that a lot of people think the current bull market is getting “long in the tooth.”  It may be.  But just because something goes longer than you think, it is not necessarily a reason to think it’s about to go down.  In fact, while this current bull market is the 4^th longest on record in terms of both percentage gain (+209%) AND number of calendar days (2,121), the longest bull market on record in terms of percentage gain and number of days is higher.

How much higher?

Try about double.  For both.  The longest bull market on record was the market from December of 1987 to March of 2000 at 4,494 days and +582%.

Above is how the S&P 500 did throughout 2014 (Bespoke).

So, what’s my opinion?  Here’s a simple wrap up.  We are still in the middle of an economic expansion and while it has been slow relative to other expansions, it is still picking up pace.  Just take a look at GDP growth over the past five quarters. Four of those five quarters have been above average.  Add to that the fifty straight months of job creation, which is the longest period on record without interruption.  Add to THAT the drop in oil prices at the end of the year, the continued low interest rates, and wage growth picking up pace, and 2014 does not go down as a horrible year.

Of course that does not mean everything will be smooth sailing in 2015, since things can quickly turn in the market.  The Fed can still end up pouring a bucket of ice water all over the party.  That will mean volatility and here’s the problem with that: investors have become used to low volatility and forget about what the market may have been like at times in the past.  People who think that earning extra return is as simple as just increasing the risk exposure in their portfolios are probably going to feel a lot like our friend above sitting on that fire and drinking a cold one.

RISK – READ THIS

As I put the finishing touches on this week’s missive, I’m watching CNBC in the background announce that it is the S&P 500’s worse day in three months and stocks have dropped to the lowest level in two weeks. Oil tumbles 5% and energy stocks are selling off, which you can read more about in the first paragraph of one of our recent blogs.

The holidays are a great time to catch up with friends and family from OUTSIDE of my industry.  I get asked questions like, “how risky do you think the market is right now?”  It’s a natural question for someone to ask, but what they are really asking is “will I lose money if I invest in the market right now?”

In their mind, taking risk results in a binary outcome: I take risk and I either make money or lose money.  If I take more risk, I either make more money or on the flipside, I could also lose more money.  That’s linear thinking.

And it’s DANGEROUS.

I plan to write more about this over the next week in a separate blog, but risk reward is NOT A LINEAR FUNCTION.  It’s not some 45 degree angle of risk verses reward drawn by some finance professor on a chalk board.  I read a memo written by Howard Marks of Oaktree Capital over my vacation and in it he states:

“Risk means uncertainty about which outcome will occur and about the possibility of loss when the unfavorable [outcomes] occur.”

Here’s the way I put it to a neighbor last week:

“I used to have a job in the Marines that required me to parachute.  Military parachuting is actually pretty safe and the probability of the parachute not opening is miniscule.  [I was pretty certain of the outcome that would occur.]  But when it does not open, the possibility of a serious injury or even dying got very high.” [The possibility of loss was pretty high, given the unfavorable outcome.]

Think about that and ask yourself if you truly understand that there is a big difference between possibility (probability) and outcomes.

Understanding risk has a lot to do with understanding the combination of the two. Things that aren’t supposed to happen sometimes do and when they do, there can be the possibility of loss.

It’s not likely that you will break an ankle playing quarterback in the NFL… unless you are playing against Ndamukong Suh of the Detroit Lions.  And if you break your ankle as the starting quarterback, the possibility of sustaining a loss is high.

 

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