On the whole, 2015 proved to be a year of relatively lackluster returns across the capital markets.
While most major U.S. stock indexes ended flat to slightly down, large-capitalization U.S. stocks (as represented by the S&P 500) performed better, in aggregate, than their midsize and small domestic brethren. Furthermore, U.S. stocks generally outperformed international stocks in U.S. dollar terms—particularly emerging market stocks (with the MSCI Emerging Markets index posting a negative return of –15%).
Although returns were comparatively lower and more compressed across various stock categories relative to last year, the hierarchy of returns was actually quite similar—particularly with the S&P 500 continuing to outperform many major stock indexes. Given that the S&P 500 is ingrained as a popular benchmark, its performance has made the task more challenging for those of us who advocate the benefits of broad diversification.
Regardless, we remain resolute in our conviction that broad diversification beyond the S&P 500 is always prudent. After all, in the United States alone, there are nearly 4,000 publicly listed companies, not just 500 (let alone 30, the number of stocks in the Dow Jones Industrial Average). And outside of the United States, there are approximately 40,000 listed stocks.
Given that our central objective is to give you the best chance of financial success, we believe it is wise to structure your portfolios expansively, with targeted, cost- and tax-efficient exposure to various segments of the global markets, not only to control risk but also to maximize your investment opportunities. Suffice it to say that diversification is not just a cornerstone of any sound investment strategy, it is also predicated on our humility: We have no shame in acknowledging that neither we nor other mere mortals can consistently predict which equity sectors are going to outperform—and which will underperform—next. Maintaining a portfolio with balance and a blend of a variety of equity sectors is the antidote to this uncertainty; it has proven, over time, to be one of the key controllable factors and reliable means of helping investors meet their financial goals.
Our humility extends to the bond markets as well. While the Federal Reserve (finally) boosted short-term interest rates for the first time in nearly a decade, the direction of rates has for years defied the predictions of financial pundits. And, those who acted on these faulty or premature predictions may have incurred minimally an opportunity cost, and possibly worse. Just as we have always advised against timing the stock market(s), we have likewise counseled against timing with respect to interest rates, and we have structured our clients’ fixed-income holdings accordingly—again, with balance, and ultimately by aligning bond/CD maturities and bond fund durations with individual cash needs.
Despite the recent, long-anticipated hike, it’s important to bear in mind that there is still no telling what the timing and magnitude of subsequent rate increases will be. The Fed’s policy will, of course, continue to adjust depending on how the economy evolves (although clearly, the Fed believes the U.S. economy has improved sufficiently to withstand the initial monetary tightening).
Also worth noting is that the Fed normally sets short-term rates—specifically the so-called “federal funds rate,” the target for overnight bank lending rates. A rise in the fed funds rate may influence, but does not necessarily guarantee, an accompanying rise in long-term rates. Rather, longer-term rates are driven by supply and demand in the market. Indeed, despite the recent rise in the fed funds rate, long-term interest rates have remained relatively stable (for instance, as of December 31st, the yield on the benchmark 10-year U.S. Treasury note was 2.27%, still within close range of its 2.12% yield at the start of 2015). Among other factors, this reflects continued uneven economic growth, expectations that the government’s need to raise funds will be modest next year, and solid demand for long-term debt—driven in part by even lower rates in some foreign fixed income markets, particularly in Western Europe.
Finally, there’s been much consternation and media coverage about what may happen to bond prices in a rising rate environment. While ultimately affected by a variety of factors, bond prices do have a seesaw relationship with interest rates, with rising rates placing downward pressure on prices. Still, some perspective remains in order. As shown in this piece from Vanguard, bonds and stocks categorically have different risk/reward characteristics. As such, they have historically performed as one would expect, given that stock owners assume higher risk (with a commensurate higher expected return) than fixed-income lenders. Furthermore, in spite of low yields, bonds—particularly those of high credit quality, which we prefer—continue to serve an important role in portfolios, providing diversification and valuable downside protection.
As we ring in the new year, here is our customary list of general financial planning items to keep in mind for 2016:
- The maximum federal tax rate on qualified dividends and long-term capital gains remains 20%, but only for taxpayers who are in the 39.6% marginal income tax bracket. Investors below those thresholds will continue to pay a maximum 15% rate on qualified dividends and long-term capital gains. However, these figures do not include the 3.8% Medicare tax on so-called unearned income for singles earning more than $200,000 and couples earning in excess of $250,000, as mandated under the Affordable Care Act.
- Maximum IRA contributions remain $5,500 for those younger than 50 and $6,500 for those aged 50 and up.
- Eligibility income ceilings for Roth IRA contributions increase, with contributions phasing out at adjusted gross income thresholds of $184,000 to $194,000 for couples and $117,000 to $132,000 for singles.
- The annual contribution limit for 401(k), 403(b), and 457 plans remains unchanged at $18,000 for those younger than 50 and $24,000 for those aged 50 and up.
- The limit on defined-contribution plans (Keogh profit sharing and SEP-IRA) remains unchanged at $53,000.
- The federal estate, lifetime gift, and generation-skipping tax exclusions, which remain uniform and indexed annually to inflation, increase from $5.43 million to $5.45 million per person. The top tax rate remains 40%.
- The annual gift tax exclusion amount remains $14,000 per recipient.
On a closing note, 2015 marked the 10th anniversary of ELM Advisors’ founding as an independent advisory firm. Many of you have been with us even longer, beginning when our practice was housed within Smith Barney. We thank you for placing your trust with us since the start. And to all of you—our longstanding and newer clients alike—we look forward to continuing to help you reach your financial goals in the years to come.
Our best wishes to you and your loved ones for a happy and healthy 2016.