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Perverse Markets Might Toe Line in 2005
Defied Expectations Create Need for Diversification
By Russell Investment Group
Global Leaders in Multi-Manager Investing
The following article has been issued by our parent Frank Russell Company in Tacoma, Washington
Investment markets in 2004 were a contrarian's delight, failing to perform as expected.
The perverseness was across the board. Large company growth and value stocks, small company stocks, bonds, real-estate investment trusts and, to a degree, international stocks defied analysts' expectations.
Of course, the markets are always a little perverse by nature. But in 2004 global events — such as elections, the threat of terrorism and oil prices — diverted investors' attention.
"Investors spent much of 2004 on the sidelines of the stock market, playing a waiting game and investing in bonds and real estate — areas they believed would deliver a high yield with a lower risk than stocks," says Ernie Ankrim, Russell's Chief Investment Strategist.
What surprised money managers most was the strength of investors' fears, which were such that they caused almost every asset class to move contrary to the direction suggested by fundamental market measures, such as corporate earnings and interest rates.
"Analysts were really surprised by the action of bonds during the year," says Mike Ruff, a Russell fixed-income portfolio manager. "They had been pretty bearish about where interest rates were going to go and had expected bond prices to tumble, but they did not."
Diversification Did its Job
If you had a well-diversified portfolio divided among domestic and international stocks, bonds, and real estate, you stood a good chance of enjoying returns in line with historical patterns of about 10% a year — if not higher.
Now money managers believe a recent turnaround in US large-cap growth stocks may have marked the start of a return to market movement in line with fundamental standards and that the pattern may continue in 2005 should geopolitical factors have less influence.
"Our managers believe we may have decent economic growth, inflation should be contained and investors are likely to gain confidence," says Russell US equity portfolio manager Dennis Trittin.
Looking Back and Forward
Here is a brief analysis of what individual market segments did in 2004 and what they may do this year — if recent movements continue and turn into a trend.
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- Large company US growth stocks were expected to take off after two years of hibernation. They didn't — until November.
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The US presidential election and the resulting uncertainty, which markets hate, along with high oil prices, led investors to become defensive and seek a safe haven in value stocks and high-yield bonds.
Reflecting this defensiveness, from Jan. 1 to Oct. 29, the Russell 1000® Growth Index, which tracks large company growth stocks, was down 1.1% in US dollar terms.
When the US election was complete and oil prices receded, investors became more confident, believing it was safe to take risks again. From Nov. 1 to Dec. 31, the Russell 1000reg; Growth Index gained 7.5%, bringing its overall gain for the year to 6.3%. Now managers are waiting to see whether the new pattern will persist in 2005.
"We lost 10 months to the election and oil prices," Trittin observes. But managers generally are confident the pendulum is shifting toward growth and lower-yielding stocks, he adds.
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- Small company stocks were expected to fall behind large caps in 2004. Instead, for the sixth consecutive year, the Russell 2000® Index (+18.3%) outperformed the Russell 1000® Index (+11.4%).
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Historical trends indicate that small stocks perform well as an economy emerges from recession and then taper off as economic growth takes hold (which happened in 2004).
Nonetheless, small caps led all year and much of the large cap advance didn't come until after Nov. 1.
Now managers are anticipating the long-predicted dip in small company stocks will occur in 2005.
"The longer the small-cap out-performance continues, traditionally the stronger the eventual swing back," says Erik Ogard, a Russell small cap portfolio manager.
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- Rising interest rates were supposed to dampen real estate investment trusts and bonds. Instead, both scored well for the year.
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After falling strongly in the first half of 2004, both REITs and bonds recovered well. Real-estate securities were ahead 31.5% — as measured by the Morgan Stanley REIT Index. The Lehman Brothers U.S. Aggregate Bond Index gained 4.1% during 2004. Both advanced even though the Federal Reserve Board raised rates 1.25% in 2004. The Bank of Canada also raised its rates throughout the year, and finished 2004 at 2.50%.
Interestingly, some market rates failed to follow the lead of the Federal Reserve. The 10-year Treasury Note dipped from 4.26% to 4.22% at year-end.
"Our managers believe bonds may not do as well in 2005 as they did in 2004," Ruff indicated. "They are not willing to take a lot of risk going into 2005."
Diversifying Against Conventional Wisdom
Will 2005 follow the pattern set by 2004 and once again defy conventional wisdom and reward contrarians? Of course, no one knows.
What we do know is that if historical precedents hold, investors may be best served if they diversify their investments among large as well as small stocks, bonds, real estate and international equities, says Ankrim.
"That way they will not score huge gains if one or two sectors take off, but they are unlikely to suffer catastrophic losses if one or two sectors collapse," he adds.
Nothing contained in this material is intended to constitute legal, tax, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. The general information contained in this publication should not be acted upon without obtaining specific legal, tax, and investment advice from a licensed professional.
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