3rd Quarter 2020 Key Takeaways
Despite some choppiness in September, the S&P 500 Index rose 8.9% in the quarter and has recovered all its losses for the year. Without the FANMAG stocks (Facebook, Amazon, Netflix, Microsoft, Apple, and Google/Alphabet), the S&P 500 would still be losing 3.6% for the year. The FANMAG stocks were up 42.5% by themselves and brought the total average for the S&P 500 index to +4.1%
These few mega-large-cap growth names dominate the market. Most every growth mutual fund will own them, or risk being left behind. You already own these popular names through our recommended funds. The widely accepted strategy of diversification means you also own some value-based mutual funds, and these funds may have disappointing returns in comparison. That is the price of using a risk reduction technique called diversification.
The U.S. mega-cap growth effect has driven the relative returns of U.S. versus foreign stocks this year. Developed international stocks gained 6.0% this quarter which is almost three percentage points behind U.S. stocks, though emerging-market stocks outperformed U.S. stocks with a return of 10.2% for the quarter. Both groups still trail U.S. stocks year-to-date.
Bond markets were calm throughout the summer, thanks in large part to the Federal Reserve’s extremely accommodative monetary policy. With Treasury yields unchanged, core investment-grade bonds gained 0.6% in price during the third quarter. Bonds are typically utilized to lower portfolio risk, but the super safe U.S. Treasury Bonds currently have a meager rate of 7/10 of 1% for ten years.
Going into the final quarter of 2020, multiple crosscurrents and uncertainties are presenting both investment opportunities and risks.
There are reasons to be cautiously optimistic: An economic recovery is underway. A vaccine is likely in 2021. Monetary policy is extremely supportive. And U.S. stocks are cheap relative to bonds.
There are also reasons for caution: Election uncertainty could cause financial market volatility. A disputed result or ballot-counting delays could mean greater volatility than usual. The pandemic remains a significant societal, economic, and financial market risk. U.S. stocks are expensive relative to history. And there is always the potential for a geopolitical or other unknown shock.
Since it’s playoff time for baseball, let me explain our investment philosophy in baseball terms. We do not swing for the fences by taking a bet on either side. If we did, this would likely create some exciting home runs but also a disproportionate number of strikeouts. Our portfolio construction and positioning are to remain balanced and resilient. We would rather play small ball and hit lots of singles and doubles to score runs in a safer manner.
Investing in a way that accounts for the wide range of plausible outcomes requires discipline, patience, and a willingness to stand away from the herd at times. It can feel uncomfortable to stay the course, or add to equities when markets are plunging, or care about valuations and not chase markets higher when they are soaring. But in the end, this is the best approach we have found for helping you achieve your long-term investment goals.
3rd Quarter 2020 Investment Letter
Market Recap
Despite some choppiness in September, equity investors were treated to solid gains during the third quarter. The S&P 500 Index rose 8.9% in the quarter and has recovered all its losses for the year. Underneath the surface, mega-cap growth names continue to lead the U.S. market. Without the astonishing 42.5% year-to-date price return of the six so-called FANMAG stocks (Facebook, Amazon, Netflix, Microsoft, Apple, and Google/Alphabet), the S&P 500 would still be down for the year.
The outperformance of these top names means they now dominate the index. Market concentration is not unusual, but with the top 10 stocks in the S&P 500 making up 28% of the index, it is extreme today. The important investment takeaway is to not be lured into chasing the returns of what has worked well in the recent past. These companies outsized past returns have come from their ascension to the top, not from owning them once they were already there. Owning the largest stocks has badly lagged owning the diversified index over time.
Nevertheless, this U.S. mega-cap growth effect is driving the outperformance of U.S. stocks versus foreign stocks this year. Developed international stocks gained 6.0% this quarter, almost three percentage points behind U.S. stocks, though emerging-market stocks outperformed U.S. stocks with a return of 10.2%. Both groups still trail U.S. stocks year to date.
Some of this relative performance is deserved. Unlike in the dot-com era of the 1990s, today’s large U.S. growth firms have created real economic value. This has come at a time when growth has been scarce and interest rates low, so investors have been willing to pay up for their growth. That said, a durable economic recovery taking hold could be the catalyst for investors to turn away from these highflyers and favor undervalued stocks in out-of-favor industries and overseas markets. We anticipate a market rotation from growth stocks to value stocks at some point.
Bond markets were calm throughout the summer, thanks in large part to the Federal Reserve’s extremely accommodative monetary policy. Treasury yields were unchanged, and core investment-grade bonds gained 0.6% in the third quarter. Fed officials say they are now targeting “average inflation” of 2% and have signaled that they do not expect to raise rates at least through the end of 2023. Since inflation has not topped the Fed’s target in a decade, many market participants expect low rates and supportive policy to continue for a long time.
Going into the final quarter of 2020, multiple crosscurrents and uncertainties are presenting both investment opportunities and risks, over the near term and medium to longer term. A unique U.S. election approaches in November. The market does not like uncertainty, so the weeks leading up to the election and afterward may be volatile. But history shows any election year declines are usually short-lived, and the political party in power is not a significant driver of investment returns. Political views have no place in our investment process, and we do not attempt to predict the short-term market reaction to elections (or any short-term event). There are simply too many other factors that impact markets over time. Instead, we stick to our longer-term analytical framework in which we consider and weigh multiple macro scenarios and assess the potential risks and returns for numerous asset classes and investments in each scenario. The fundamentals are what really drive long-term market performance.
Looking past the election, there are reasons to be cautiously optimistic about the investment prospects for global equities and corporate bonds. And there are reasons for caution.
Reasons for Optimism
An economic recovery is underway. Economic data and forecasts are improving. (See the growth projections from the Organization for Economic Co-operation and Development, or OECD, in the chart above.) All else equal, rebounding economic growth here and abroad should support equity and corporate bond markets.
On the virus front, the speed of progress in vaccine development is promising. An effective and widely distributed vaccine would allow economic activity to return to its full pre-pandemic potential.
And this year’s extraordinarily supportive monetary policy (asset purchases and lower interest rates) and huge fiscal stimulus, both here and abroad, were key drivers of the speedy recovery in markets and the global economy. Central bank actions and government spending do not guarantee the absence of volatility, another bear market, or recession. But there are programs now in place, especially in the United States, that could step in to help the functioning of markets and the economy in case volatility returns or setbacks occur.
Reasons for Caution
It remains to be seen how strong the actual economic recovery is and how much of it is already factored into current prices. There is an equal balance between the recovery being disappointing as there is in it being encouraging.
While vaccine development steams ahead, the potential remains for a resurgence of COVID-19 in the fall and winter months. We are seeing this already in Europe, and the infection rate has popped up recently here in the United States. This raises the risk of renewed shutdowns and another economic downturn.
Monetary policy is supportive, but more fiscal support from Congress is likely needed to further protect citizens, help businesses survive, and shore up the financial condition of several states. If it does not happen, it will be a hit to 4th quarter economic growth, which could in turn impact markets.
Finally, there is always the potential for a negative geopolitical shock. The U.S.-China conflict and Brexit come to mind, but a new development could emerge that no one is considering (like the pandemic did earlier this year).
Portfolio Positioning
We are very comfortable with how our portfolios are constructed. The watchwords of our current positioning remain balance and resilience. Our portfolios are balanced across multiple dimensions: domestic versus international stock exposure, growth versus value strategies, interest rate risk versus credit risk, traditional versus alternative investments. And we have designed our portfolios with the goal of generating solid returns, while also having one eye on being resilient in challenging scenarios.
Each of our portfolios are built with a targeted risk level ranging from conservative to aggressive. If you are uncertain about whether you have the right level of risk, please give us a call to review your individual level of risk and how it relates to your financial future.
Closing Thoughts
History shows that markets are consistently unpredictable. Adding to the uncertainty are the unprecedented circumstances, challenges, and structural changes the global economy is currently facing.
As nervous as this sounds, investors are paid well for taking on this uncertainty. (If certainty is the goal, then returns will be less than 1% – and most investors’ financial plans will fail with this outcome.) Assuming some degree of uncertainty can be the difference between a successful financial plan and one that fails. Our job is to help you understand how much risk you have taken on, and how to harness risk as a tool to achieve your goals.
We utilize lessons from the history of investing to both withstand this uncertainty and reap the results. Solid financial plans, limiting taxes, investing with discipline and patience, spending within your budgetary restraints, and listening to experienced advisors are some of the tools we recommend to slant the odds in your favor.
Ron Dickinson, CPA, CFP®, MPA-Tax
P.S. Once again, we appreciate the large number of referrals we have been receiving from our clients. We are honored that you consider us worthy of being introduced to your family, friends, and neighbors.
[Financial Planning and Investment Management Services offered through Dickinson Investment Advisors, Registered Investment Advisor. Statistics and market information provided by Litman Gregory Advisor Intelligence.]
