Rather than simply rehashing the events of last year’s stock market, I thought it might be instructive to republish what I said I thought might happen in my A Look Forward at TSP Investing in 2015 post and discuss what I got right and what I got wrong. So without further ado, last year’s post is in the italics below and my commentary is in regular text:
The growth of the US economy largely continues to strengthen and I believe the stock market will in all likelihood end the year higher than where it started. I think small cap stocks will slightly outperform large cap stocks, and US markets will outperform most established and emerging international markets. These beliefs are based on the performances of the US and foreign economies over the past quarter.
The economy did continue to strengthen, reaching full employment and even starting to see wage growth at the end of the year, but there were enough bumps in the road to push us to a flat year in the market (because after all the drama and volatility, that’s what we had). But overall, it was a flat year for just about everyone in the market – it really didn’t matter what your strategy was, nobody (from hedge funds to investment banks to commodities traders to bond traders to little retail investors like us) was able to break out from the pack clustered right around that 0% return for the year.
The Impact of Low Oil Prices
Low oil prices are not good for everyone, but they are more good than bad for investors who hold general, diversified funds such as the TSP S and C Funds. In general, low oil prices will be good for the US economy, freeing consumers to spend their gas savings on other things which will lead to growth in other sectors. It will also be good for Europe and Japan, although to a lesser extent because the weakening of the Euro and Yen means gas in those places is still nearly as expensive for them now as it was six months ago before the oil crash.
Oil prices wound up lower, and lower for longer, than I expected they would. Low oil prices are generally good, but oil prices which are too low for too long can cause volatility in the stock market. That happens for a few reasons, but primarily because a major dislocation in any part of the financial markets has ripple effects which impact the stock market. In this case, the disruptions in the commodities market (oil) and the junk bond market (oil companies disproportionately fund operations through bond issues) caused bleed over panic in the stock market at various points during the year. There are some genuine financial reasons for the contagion, but for the most part it is just traders who fear any uncertainty pulling their money out of everything until things settle down. Because those traders do that every time, others do the same and the effect is amplified. Those effects aren’t permanent, but they were a cause of a fair bit of volatility last year and the panic in the junk bond market in December caused a market drop which we didn’t have time to recover from before the end of the year. Without that December swoon we would have been positive for the year, which would have been nice psychologically, but realistically any result within about three points in either direction of zero is the definition of a flat year.
Stock Market Volatility
I don’t really see a basis for the opinions of the financial media pundits who say the market will be more volatile in 2015 than normal, but there will certainly be volatility along the way as the price of oil and other external factors cause short term swings. I don’t see ISIS or Russia or any of the other current “crises” having more than a temporary impact at any point in the next 12 months. As at the beginning of every year, I will confidently predict we will see four or five 5% corrections, and probably a 10% correction at some point (because that happens pretty much every year). With history as a guide, I am convinced the timing of those corrections isn’t predictable, and that the market will recover and move higher in each case within a matter of weeks.
We had been spoiled after a few years without a 10% correction, so when it happened this summer it caused a bit of panic. We had a textbook recovery from that and people who bought after the drop made a lot of money initially. Unfortunately, the drag caused by the junk bond panic at the end of the year ruined what would have been a very nice chart showing a classic correction and quick recovery. At any rate, I totally nailed this one (although only because these corrections are so predictable.)
The China Risk
The wild card out there, and the greatest threat I see to global stock markets including our own, is China. At some point in the next few years, China is likely going to undergo a financial crisis which will make the 2008/2009 US meltdown look like a relative blip. China’s development has been funded by very low interest, cheap loans. These loans were never repaid though; instead they were simply rolled over into new loans again and again. The money doesn’t exist to pay these loans off, and with interest rates rising and tighter lending requirements in place it will become increasingly difficult to roll them over.
As a result, the Chinese financial system is in a precarious position. The Chinese certainly realize the predicament they are in and they are trying to create a way for these loans to transition to a sustainable model, but I don’t believe it will be possible without a severe restructuring of their financial system with companies bankrupted, banks failing, and a collapse of the Chinese real estate market. When this takes place, it will send shock waves through markets throughout the world, and it will likely be much more damaging to the Thrift Savings Plan stock funds than the European debt crisis in 2011. When and if this occurs, I will certainly be scrambling for the safety of either the TSP G or F Fund.
That popping sound you heard back in June was China’s stock market bubble starting to collapse. An aggressive response by Chinese regulators spread out the effects into July and August (when we finally had our big drop). After a reasonable recovery (the Chinese market was actually up overall for 2015), some poor economic news sent it into a tailspin again the past few days. The Chinese market is susceptible to panics for a few reasons, primarily because (1) unlike the US market where the vast majority of stocks are owned by institutions, in China over 80% of the market is owned by individuals – most of whom have absolutely no idea what they are doing; and (2) the Chinese government has only a few years of experience trying to regulate a stock market, and has never had to deal with panics like the ones we are seeing now. That has made it messy.
The stock market bubble bursting isn’t the massive financial crisis risk I was talking about in last year’s post, but major dislocations in the Chinese stock market could certainly play a role in tipping China into a broader crisis if distressed companies are not able to roll over their loans and can’t fund loan payments with the sale of new shares of stock.
We aren’t there yet, but we might not be that far off either. I’m not worried about the Chinese stock market dropping 20% – although we will feel that in our TSP balances to be sure. I’m worried about things getting so out of whack (that’s a technical term) that the Chinese financial system locks up and we see massive defaults, bankruptcies, cost slashing leading to massive unemployment, currency devaluation, etc. I will talk more about that in my upcoming Look Forward at TSP Investing in 2016 post.
Thrift Savings Plan Fund Allocation
At this point, I expect I will remain 100% invested in the TSP S Fund for at least the first quarter of the year. At some point in 2015 I believe it is likely I will move to a split with the TSP C fund as we move further into the grey area between business cycle phases. That may come sooner than later as the dollar continues to strengthen against virtually every other currency, which historically has favored large caps over small caps.
Hindsight being 20/20, I certainly wish I had started that move to the TSP C Fund before Christmas (and before Christmas of 2014, for that matter), but there was never a time during that period when I didn’t feel that I was in the right fund based on the fundamental indicators. It is definitely not an exact science and as I look back there were a number of factors which probably cumulatively resulted in the C Fund outperforming the S Fund for both 2014 and 2015. The strong dollar which I mentioned in last year’s Look Forward certainly played a role, but I also think (1) the Fed’s role in holding interest rates artificially low through both their lending and Quantitative Easing programs may have caused a disruption in the normal stock market activity associated with naturally occurring interest rate indicators, and (2) the very slow, drawn out nature of this recovery probably led to the stock market getting ahead of where we really were in the business cycle.
2015 is also a year in which the TSP I Fund may see a relatively small allocation from me at some point (probably 15-20% at the most) depending on how things play out in Europe and Japan. The European Central Bank (ECB) will begin its form of Quantitative Easing shortly in an effort to prevent deflation in the Eurozone by buying over a trillion Euros worth of bonds over the next few years. The form this QE is taking will drive the value of the Euro down, which will make it easier for Europe to export goods. I don’t believe the European economy will really make a full recovery until Germany gives up its austerity demands and debts are restructured for the basket cases like Greece, but even just tipping growth back in the right direction could result in a strong move in the European markets. They aren’t moving in the right direction yet; it was announced just today that Germany tipped into deflation.
Japan has an easier time of managing its solo economy in contrast to the Europe with its 19 separate and very different economies. But Japan’s recovery has stalled over the last year and it remains to be seen whether Abe can restart it.
I moved 15% of my balance and allocation to the TSP I Fund in late July. The I Fund promptly fell off the cliff along with every other stock fund in late August, but it bounced back. It didn’t bounce back as robustly as the US markets did, likely due to the substantially larger dependency of the European and Japanese economies on exports to China relative to the US. All things being equal, I would have been slightly better off sticking with the 100% S Fund allocation rather than adding in that little bit of I Fund, but not to any meaningful degree (a 0.195% difference overall if my math is correct).
It was a flat year. That happens. If someone had told me at the beginning of the year that oil would continue to fall and stay low, that China would have a pretty major hiccup, and that we would see a 10% correction at some point during the year, I still would have invested exactly as I did. Losing 2% occasionally is the price of admission for the majority of the years when we see much higher returns in the stock funds, so I won’t lose any sleep over it.
Big picture, I will be more aggressive about starting to make the switch between the S Fund and the C Fund when we hit that grey area at the end of the recovery phase of the business cycle next time. But as I mentioned pretty routinely in the monthly updates, I was already building up C Fund equivalents (S&P 500 funds) in my non-TSP portfolio for the past two years, so I was already well into that transition overall before I finally made the change in my Thrift Savings Plan.
In my next post I will take a Look Forward at TSP Investing in 2016. Hopefully I will get that written over the weekend.
In the meantime, if you find this website useful or interesting, you can help me out by linking to this site from your own webpage or blog; liking it on Facebook (updates will show up in your news feed if you do); sharing on Twitter and in other investing forums; or actively participating on our Message Board. Please do me the favor of sharing it with your friends and colleagues using the email and social sharing buttons below right now. Thanks, and good luck!