Stock Market: Lessons Learned in 2014 by Seth J. Masters, AllianceBernstein
In 2014, US stocks forged ahead, international developed and emerging-market stocks lagged, bonds did better than expected, and the IRS took a bigger bite. Here are some lessons for US investors to carry forward into 2015.
Lesson 1: The US Market Keeps on Ticking
Geopolitical crises were in the headlines throughout 2014: the threat from ISIS in Syria and Iraq, tensions between Russia and Ukraine, fighting in Gaza, the Ebola epidemic in West Africa, slower growth in China, and economic stagnation in both the Eurozone and Japan. Yet the US equity market still motored ahead.
We are living in a global economy. If the rest of the world is struggling, can US companies continue to prosper?
In the medium term, the answer could be yes. The US is still in the early stages of a cyclical expansion, and we think the overall growth rate will be supported by key trends among consumers, governments, and companies. US consumers paid down debt after the financial crisis and are now beginning to spend again—cautiously. Similarly, US federal and local governments pared back during the immediate post-crisis years, and they are now able to increase their budgets. Finally, US companies are gaining market share globally, and US manufacturing is now undergoing something of a renaissance. We think that these trends could continue for a while and that they are positive for US stockholders.
It would be a serious mistake to think that the US market is invulnerable, but it would be just as erroneous to underestimate its resiliency.
Lesson 2: Diversification Means Owning Laggards
After leading globally in 2013, in 2014 through November the US stock market beat developed international developed stock markets by 15.5 percentage points in US dollar terms; it beat emerging markets by 11.5 percentage points, as shown in the first Display, below. This outperformance by US stocks has some investors ready to throw in the towel on global investing.
We think selling an asset after a stretch of lagging performance is a bad decision. Often, the lagging asset may be more attractive looking ahead. And that’s what we’re seeing in developed international stocks markets, where valuations are more attractive than in the US stock market.
Since 1990, non-US stock markets have outperformed the US market more than half the time. Since no one can be certain just when this will occur, we think it’s wise to own stocks in all regions.
A similar argument can be made for diversification by size. Large-cap US stocks trounced small- and mid-caps by 8.4 percentage points so far in 2014, but large-caps trailed smaller stocks by 11.7 percentage points annualized from 2001 through 2003. The key is to hold stocks across the size spectrum.
Diversification remains a fundamental tenet of smart investing—both as a way to manage risk and as a way to maximize return.
Lesson 3: Eat Your Bonds—They’re Good for You!
High-quality intermediate bonds in a portfolio serve, above all, as a counterweight to stocks. When stock values tumble, bond values typically rise and help to offset the declines. As the second Display, below, shows, when the stock market dipped from mid-September to mid-October, a 60% stock/40% bond portfolio gave investors a smoother ride than an all-stock portfolio—smooth enough that some might have stayed in the market rather than fleeing in fear.
Of course, investors also like the income bonds provide. And through November 2014, core bond strategies delivered about 4% in total return—less than bonds have returned over the past 30 years, but a bit above the 3.5% we project for them over the next 30 years.
Don’t neglect bonds. Even with today’s lower yields, they can help you sleep at night. Investors should have enough bonds on their plate to be confident they will be able to withstand the next market downturn—whenever it happens.
Lesson 4: If You’re Afraid to Invest, Dollar-Cost Average
In 2014, too many investors sat on the sidelines in cash, convinced that they’d missed the bull run and afraid that if they invested now, the market would soon tumble and afflict them with buyer’s remorse.
Dollar-cost averaging can reduce the odds of experiencing these painful regrets. Our research shows that investing all at once has historically been the more effective approach, as shown in the third Display, below. But if the market turns volatile, dollar-cost averaging can help to dampen the effects. If stocks fall right after your first purchase, you’ll take a hit, but you’ll also be able to buy your next installment at a lower price. If you average into the market within a limited period of time—say six months or a year—you’ll likely be better off than if you’d stayed on the sidelines.
You can think of dollar-cost averaging as a kind of regret insurance. Beyond this emotional benefit, the key advantage is that it gets you to your strategic asset allocation target, albeit after a delay. Like all insurance, dollar-cost averaging has a price—lower returns, typically, during the period of averaging in. But the longer-term benefits of being fully invested can outweigh this cost.
Lesson 5: Be Tax Savvy
In April 2014, taxpayers in the top bracket saw their final 2013 tax bills at new, higher rates. There may be further unpleasant surprises ahead for the 2014 tax year. The rising stock market has left investors with few or no remaining capital loss carryforwards, so to rebalance or spend from their portfolios, they have to realize capital gains. Smart strategies can help minimize the resulting tax bills that will arrive next year.
There are two ways to reduce taxes: avoidance and deferral. Avoidance permanently eliminates or reduces a tax, while deferral puts off payment into a later tax year. Avoidance is worth more to your bottom line.
By diligently tracking and timing trades, you can ensure that capital gains will be long-term and dividends will be qualified. This permanently reduces the rates at which they are taxed.
Another way to avoid taxes in the current year is through charitable contributions. Cash gifts avoid taxes by creating a tax deduction, but savvy taxpayers can further avoid tax by giving appreciated securities, thereby also eliminating an embedded capital gain. Additional techniques, such as converting a traditional IRA to a Roth IRA and contributing to a 529 plan, can provide tax benefits further into the future.
While not as valuable, tax deferral can also help reduce the current year tax bill. First, to the extent you can defer taking gains until after January 1, you can delay the tax hit. Next, volatility could create an opportunity. If the price of a stock falls below your basis in it, you can harvest the loss to reduce your tax bill in the current year. Some investors seized this opportunity in mid-October, but rising stock markets since then have limited loss harvesting opportunities for the remainder of 2014.
You also can defer taxes by making larger contributions to retirement vehicles such as 401(k), IRA, and Keogh plans. Timing is important: In a rising market, making contributions early next year can help you shelter more growth over the course of 2015.
The views expressed herein do not constitute