The number one question we have received recently is whether we are selling stocks and holding cash as the presidential election looms over the country. We all have our personal political views, but as investors we have to remain neutral. In summary, markets prefer certainty and dislike uncertainty. A Clinton victory should bring the most stability to the markets in the short term, and it appears she has the edge at this point. Mr. Trump is a wild card, but represents a dissatisfied portion of our society desiring structural change. There could be an October surprise, but it’s hard to believe that anything more surprising could possibly be revealed about the two candidates. Voters have a difficult decision and will mostly likely fall back to their traditional party following. We will be happy to have the phone stop ringing with the nightly survey and get back to reading the funny papers.
Despite numerous uncertainties, including a U.S. presidential campaign that continues to unfold as the most unconventional in recent memory, the S&P 500 Index rose nicely in the third quarter. Stock market volatility remained at extremely low levels through July and August. September seemed to usher in a change in tone. During the month, stock investors registered high anxiety, with markets rising and falling sharply in response to any oil-related headlines and any suggestion of interest rate hikes by central banks.
European stocks outperformed the S&P 500 after the Brexit low and over the course of the third quarter. They still trail U.S. stocks for the year. We continue to believe European stocks provide a good value relative to U.S. stocks, based on normalized earnings power.
Emerging-market stock returns have been particularly striking, building upon their sharp rebound and outperformance versus other markets that began in late January. Emerging-market stocks are now up 17% for the year.
Real Estate investments continue to be a strong defensive diversification technique in our portfolios along with enhanced returns.
Yields on U.S. 10-year Treasury bonds rose as high as 1.75% during the quarter on worries over central bank policies, but the Federal Reserve’s decision not to raise interest rates in September soothed markets. (Here’s a reminder: as yields rise, bond prices fall.) Yields ended the quarter at 1.56%, still up from 1.44% on July 1. A December rate hike is potentially still on the table, and financial markets remain keenly attuned to this possibility. The core bond index produced a small gain for the quarter.
In this quarter’s investment commentary, we briefly review portfolio performance and recap our current views, before discussing the importance of actual versus perceived diversification and why we choose not to run with the herd, especially during times of elevated market risk. In our view, making investment decisions based on short-term market forecasts (guesses) is a losing game. We have no confidence that this approach can be executed successfully over time.
Third Quarter 2016 Investment Commentary
U.S. Stocks: Domestic stocks gained nicely during the quarter all within a context of a market that saw sharp drops and reversals. Volatility increased in September and is anticipated to keep everyone nervous until the unknowns of the elections, interest rate increases, corporate profits, etc. become more clear. Negative headlines surrounding Deutsche Bank and Wells Fargo have not helped. We continue to view future increases in U.S. stocks as a struggle as they appear overvalued relative to historical averages. Based on these uncertainties maturing in the 4th quarter, you can anticipate some buying and selling in your portfolios around year-end to reduce our exposure.
In summary, U.S. stocks are experiencing fading or disappointing earnings and are priced high. This is not a prospect that lends itself to further outsized gains, other than the fact that there is a lack of profitable alternatives to turn to.
International Stocks: European stocks outperformed their U.S. counterparts during the third quarter, yet they still trail U.S. stocks for the year. We continue to believe European stocks provide a good value relative to U.S. stocks, based on normalized earnings power.
There are any number of known and unknown catalysts that could begin an earnings recovery. One may be the European Central Bank’s continued efforts to keep borrowing costs down to stimulate lending and investment spending. The ECB recently started buying investment-grade corporate bonds as part of its quantitative easing program. That may spur investment and lead to better economic growth. Or, it may spur financial engineering, with companies using the proceeds from issuing debt to buy back stock and boost earnings per share. Either outcome would bode well for future profits and stock prices.
Brexit, along with the rise of many right-wing political parties, may serve as a wake-up call that authorities need to generate better growth in the economic bloc soon. As a result, they may become more open to loosening the fiscal purse strings to assist the ECB’s reflation efforts.
The exact timing is highly uncertain. It’s possible nothing much happens with fiscal stimulus until major elections are completed over the next year, meaning the ECB continues to do what it can and Europe muddles along.
Emerging-Market Stocks: Returns have been particularly striking, building upon their sharp rebound and outperformance that began in late January. Returns have been driven primarily by investors’ willingness to pay more for each $1 of earnings, rather than an actual upturn in earnings.
Emerging markets can be volatile, unpredictable and downright scary at times, causing many investors to shy away. The political and economic risk, including the very rapid growth of debt in China in particular, are well known and hopefully factored into security pricing. Having said all this, emerging markets can provide more growth and more investor returns over the next several years versus U.S. equities, thus we have to include them as a meaningful portion of our portfolios.
Bonds and Fixed Income: We have been nervous about bonds for years as rates are low and the risk that rates may rise is high. Nevertheless, bonds contributed nicely in the mid-single digits as rates remained stable this year. We still are like a “cat on a hot tin roof” with our exposure to bonds. They serve a role of giving investors liquid assets to use for distributions as well as reduced overall portfolio volatility. We are starting to wonder if low rates are here to stay, notwithstanding modest increases from the Federal Reserve. If this becomes the norm, bonds will continue to provide value in being a portion of a well-diversified portfolio.
Real Estate: We have used real estate as a tool to reduce our bond exposure, and it has performed very well in this capacity, all with less risk – in our opinion. We will continue to explore options to add real estate to our portfolios while being as selective as possible. For investors that are accredited (i.e. over $1 million of net worth, according to the SEC), we have been able to purchase private real estate locally to provide enhanced returns and stable value. Regulations prevent us from providing some of these opportunities to investors that are not accredited. (Somehow investors get smarter as their net worth increases, so goes an assumption that we challenge). We will continue to seek out opportunities for all of our investors.
Perception Versus Reality: Managing Risk
While we spend time analyzing each of our individual positions and holdings, in portfolio management, the whole is much more than simply the sum of its parts. By definition, a well-diversified portfolio (i.e. one with investments that do not all move together in the same direction) will contain some laggards during any given measurement period, particularly over shorter-term periods. But it is at least as important to focus on the overall portfolio, how the pieces fit together and perform relative to each other, and whether that performance is consistent with the original rationale for owning them. We occasionally receive calls from clients wanting us to sell that portion of the portfolio that has performed poorly over the past six months to a year, and to invest in that portion that has done well. Most often this is a mistake. If we had a crystal ball, we should have done this ahead of time – but we don’t have this insight.
Successfully managing portfolios also requires the discipline to resist trading based on emotion, rather than on long-term return drivers such as valuations, yield, and earnings growth. Even in an advanced economy such as the United States, the stock market has fallen by at least 10% every 16 months on average since 1950. Bear markets (20% or greater declines) in the United States have happened about every seven years on average. In most cases you can’t predict what the exact cause of the volatility will be or exactly when it will hit. Even if you could successfully call it, you’d need to also successfully time your re-entry so as not to miss out on the subsequent gains—and do so consistently and repeatedly over an investment lifetime. That is not realistic, which is why our investment approach is based on a range of potential outcomes and a longer-term time frame.
To take just one example of why making investment decisions based on short-term market forecasts (guesses) is a losing game, we turn to the U.S. presidential election. We are being asked about the election even more than usual this year. While the specific circumstances of any given election are always unique, our approach remains the same. To the extent a particular result is widely expected, current asset prices will reflect the market consensus. There is too much uncertainty and too many variables that impact investment outcomes for us to see any value in positioning our portfolios for a particular result. Instead, we stick to our longer-term analytical framework.
Along with the U.S. presidential election, central banks’ policies, particularly the Fed’s, remain a key near-term wildcard for financial markets. At its September 21 meeting, the Fed remained on hold but signaled it is on course to raise rates later this year, likely in December. It also lowered its longer-term forecast of rate hikes yet again. It now forecasts just two in 2017, down from the three forecasted at the June meeting and the four forecasted at the March meeting. Financial markets responded positively.
Investors are effectively being forced out of low-risk, extremely low-yielding, core bonds into riskier assets that offer higher current yields (still quite low compared to historical levels). Many investors appear to be “reaching for yield” as well as perceived safety in traditionally “defensive” yield-oriented sectors of the stock market, such as utilities, telecoms, consumer staples, and traded REITs. Valuations have soared. But these trades can unwind quickly and momentum can work in reverse. It certainly seems “defensive” plays are vulnerable to any hint of interest rate increases and are potentially higher-risk right now than the broad stock market, not to mention bonds.
To the extent that the “buy ‘bond-like’ and dividend-yield stocks” theme remains in play, it will likely be a headwind for our U.S. stock funds overall.
While ultra-low interest rates are supportive of financial asset prices, we continue to view them as unsustainable and inconsistent with longer-term economic growth. Trying to anticipate the markets’ reaction to each Fed governor utterance or Fed policy statement is a short-term guessing game that we simply won’t play with our investment portfolios.
Putting It All Together
Our decision-making is anchored in our long-term fundamental and valuation-driven approach. We and our clients need to be psychologically and financially prepared for periods of market stress, and be able to ride them out on the path to achieving long-term investment and financial goals. Investors who can’t stomach a given level of volatility or downside risk should reallocate into a portfolio with a lower targeted risk level. The time to do so is before a period of volatility, not during or right after it when they would be selling their riskier assets at lower prices and buying more defensive assets at higher prices.
We structure our balanced portfolios across a well-diversified mix of investments, each with a distinct role. We expect them to be resilient and to perform at least reasonably well across a wide range of outcomes, balancing our objective of long-term capital appreciation with shorter-term downside risk management appropriate for each client’s risk tolerance.
Volatility has picked up in September. We’re prepared for more of it heading into (and potentially coming out of) the November election, as well as on increased likelihood of a Fed rate hike in December.
Ron Dickinson, CPA, CFP®, MPA-Tax
[Financial Planning and Investment Management Services offered through Dickinson Investment Advisors, Registered Investment Advisor. Statistics and market information provided by Litman Gregory Advisor Intelligence.]