Q3 2014 Stock Market Commentary: Cautious Optimism

cautious optimismThe optimist proclaims that we live in the best of all possible worlds; and the pessimist fears this is true. – from The Silver Stallion, 1926 by James Branch Cabell (1879 – 1958)


Although 2014 isn’t quite over yet, it’s looking like the optimists are going to have an “IAsset Class Returns told you so,” especially when it comes to the U.S. stock market and real estate market. As shown in the graph on the right, real estate, as measured by U.S. REITs, has earned 14% in the first nine months of 2014, and U.S. stocks, as measured by the S&P500, have earned 8%. By contrast, foreign securities, gold, and commodities have struggled, due in large part to the strengthening U.S. dollar, which has appreciated 7.5%. All returns are measured in $U.S. In the following, I review what has been working, and not working, in both U.S. and foreign markets, with a look forward to the homestretch in the remaining three months of 2014.

An Important Notice: New Benchmark Released for Target Date Fund FiduciariesNew Investable TDF Index

But before I dive into performance results, I’d like to tell you about an important new development in the hottest investment in pension land – target date funds (see our InfoGraphic for TDF details). We’ve just released a new index for evaluating target date funds. As described in this chapter on TDF Benchmarks, fiduciaries can choose a benchmark that is based on procedural prudence (follow the herd) or substantive prudence (doing what’s right). The SMART Fund® Target Date Index embodies the primary benefits of TDFs, namely diversification and risk control at a reasonable price, and it follows my patented Safe Landing Glide Path®. Importantly, this benchmark is investable, unlike the other TDF benchmarks. You can actually own this index.

Now on to the markets review.

U.S. StocksStyle Returns

This is one of those time periods where the stuff in the middle has surprised by not performing in between the stuff on the ends. Large cap core stocks outperformed both large cap value and large cap growth, earning 11%. Core is defined as the stuff in between value and growth. Small companies have suffered losses of 2%. I use Surz Style Pure® classifications throughout this commentary.

Sector ReturnsOn the sector front, there has been a wide range of performance, with healthcare stocks earning 15% while consumer discretionary companies have lagged with a slight loss. Consumer discretionary and healthcare stocks both led last year’s rally with 45% returns. There have been both reversals and momentum in economic sector performance, which leads us to heat maps and clues to the homestretch of 2014.

The interesting details lie in the cross-sections of styles with sectors, as shown in the following heat map. A heat map shows shades of green for “good,” which in this case is good performance relative to the total market. By contrast, shades of red are bad, indicating under-performance. Yellow is neutral. In the table below, we see that the best performing stock market segment in the first 9 months of 2014 was comprised of mid-cap core companies in the materials sector, earning 23.9%. We also see that, with the exception of smaller companies, healthcare has done well across the style board. By contrast, the worst performing segment was small- cap core in the utilities sector, losing 18%.

Many quantitative managers employ momentum in their models, buying the “green” and selling the “red.” Non-quants, also known as fundamental managers, use heat maps as clues to segments of the market that are worth exploring, for both momentum and reversal potential.

Heat Chart

Foreign StocksForeign stocks

Looking outside the US, foreign markets earned 5%, lagging the U.S. stock market’s 6.4% return but outperforming EAFE’s 1.4% loss. For those with a broad foreign mandate, EAFE has been easy to beat because the better performing regions are not included, namely Emerging Markets, Canada and Latin America. Emerging Markets have led in the year to date with a 17% return. By contrast, the UK has lost 2%.

On the style front, value has led with an 8% return, while growth stocks earned less than half that amount.

Like the U.S., further insights into market behavior are provided by heat maps, as shown in the following tables. As you can see, healthcare stocks in emerging markets have performed best, with a 36.6% return, while Utilities in the UK have performed worst, with a 20.8% loss.

Heat Chart2

Q3 returns


As mentioned in the Introduction, the strengthening U.S. dollar penalized investment performance in foreign countries, especially in the third quarter, as shown in the graph on the right.


How to Use This Information

It just keeps getting better, until it doesn’t. U.S. stocks and real estate are up this year, while metals and commodities are down. Will these continue? Which asset classes will continue to deliver strong returns (momentum) and which will not (reversals, also known as regressions to the mean). We all have outlooks on the economy and the stock market, and adjust our thinking as results roll in. I personally remain surprised and grateful that stocks have performed so well in the past 5 years, following the 2008-2009 meltdown; it’s been a long-term reversal. You can use the information above to test your personal outlooks, to see which are unfolding as you think they should and which are not, with the intention to clear the haze from those crystal balls.

To learn more about Ron Surz, visit him at www.TargetDateSolutions.com.

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