Third Quarter 2018 Key Takeaways
Larger-cap US stocks hit new highs in late September and gained 7.7% for the quarter and over 10% for the year. S&P 500 operating earnings per share grew 27% year over year in the quarter – compared to their 6% long-term annualized growth rate. A record high 80% of S&P 500 companies reported earnings that beat the consensus expectations. Corporate profits have been extremely strong.
It has taken a lot of earnings growth to justify the already historically high stock valuations. We are predicting less US stock valuation growth moving forward, but it’s a tough call to bet against America at this point in history, especially with weakness in all other areas of the world.
Developed international stocks are down around 3% for the year, while emerging market stocks (EM) have fallen 8%. Foreign stock markets were impacted by poor sentiment, tariffs, and a rising US dollar.
In fixed income markets, the 10-year Treasury yield rose to over 3% at the end of September, flirting with a seven-year high. Consequently, the core investment-grade bond index has had a negative return for the year.
If US stocks are doing so well, why is my investment portfolio basically flat for the year?
A quick glance at 2017 indicated the following returns:
US large-cap (blue chip) stocks +22%; US small-cap stocks +15%; international developed economies +26.%; international emerging economies +32%; and bonds +4%.
2017 was a perfect market. Diversification rarely works this way; typically the process of lowering risk results in both positive and negative returns in different asset classes. Your individual portfolio returns in 2017 were thus dependent on your risk preference and thus how many fixed income/bonds were in the portfolio versus high performing stocks. The more stocks you owned, the better your performance.
Now let’s review the year-to-date performance in 2018:
US large-cap (blue chip) stocks +10 %; US small-cap stocks +7 %; international developed economies -3%; international emerging economies -8%; bonds -2%. The only broad asset class with positive returns was US equities.
2018 portfolio returns are once again dependent on each investor’s mix of stocks and bonds. In addition, not all stocks are performing well. International stocks are negative, thus pulling down overall returns. It’s natural to review your portfolio and compare it to what you hear in the daily news. As investors we tend to over focus on the large US markets and extrapolate that our portfolios should be in line with them.
Every investor needs to make a return versus risk decision. It’s true that we could easily duplicate the large US markets exactly by purchasing only one style of investments. In fact this would make our jobs easier. However, that’s not an approach that would help to accomplish reducing risk during your retirement. A diversified portfolio includes portions of all asset classes, and in our mind that also includes private real estate. A diversified portfolio can often lead to comparably disappointing results when US stocks are outshining all other asset classes.
Third Quarter 2018 Investment Commentary
Market trends in the third quarter were largely an extension of what we’ve seen so far this year, with a stark divergence in return between US stocks and EM stocks. The US market was propelled by continued strong profit growth (thanks in large part to the corporate tax cuts), beating emerging markets by roughly 20 percentage points year to date through the end of September.
This level of divergence in relative performance is not unusual. It is common for US stocks or EM stocks to outperform the other over 12-month periods as shown in the chart to the right. Just last year, EM stocks gained 32% and outperformed the S&P 500 by roughly 10 percentage points. That has sharply reversed this year.
Reiterating our Outlook for EM and US Stocks
While there are always multiple factors behind short-term market moves, there were two dominant headwinds facing EM stocks in the third quarter: the intensifying trade conflict between the US and China, and the strength of the US dollar. While neither of these factors presents new or material threats to our analysis of EM stocks, they have impacted our portfolios’ short-term returns given the magnitude by which EM stocks have lagged US stocks so far this year. (The hockey legend Wayne Gretzky described that his strategy was to skate to where the puck is going rather than where it has been.)
There are several points worth highlighting that give us confidence in our assessment that EM stock valuations are cheap and that their attractive long-term return potential remains intact:
- A core belief we have is that a full-fledged trade war is unlikely as it is in neither country’s best interest, despite the fact that we may see an overhang of trade tensions for awhile. It’s also not clear whether US stocks would be less impacted than EM stocks given the global presence of US companies.
- US dollar strength has hurt dollar-based foreign stock returns, but longer term there are reasons to think this will reverse. We believe the fiscal stimulus of tax cuts at a time when the US economy is strong will cause fiscal deficits and debt levels to rise – both potential headwinds for the US dollar.
- Economic crises in Argentina and Turkey have made headlines, but these countries’ economies and financial markets are small. We see little risk of contagion to other emerging markets. In contrast to previous EM crises, the fundamentals of most other EM countries are much healthier in terms of debt levels, trade balances, dependence on foreign capital, foreign exchange reserves, etc.
As for US stocks, no one knows exactly when this record-longest US bull market will end. Despite their unattractive fundamentals, it’s certainly possible US stocks will continue to be favored by investors over the short term. However, S&P earnings growth expectations are now exceedingly high, and the US economy is operating at or near full capacity and full employment. These are unsustainable conditions, and the direction in which they will move next is less attractive for US stocks.
No matter how we slice it, our analysis suggests that the US market is the most expensive major stock market in the world. As a result, it presents one of the biggest risks to our portfolios. This is why we have diversified our portfolios’ stock exposure by investing a significant amount in foreign markets that, in contrast, look significantly cheaper and offer a much stronger medium- to longer-term growth outlook. But these positions come with additional shorter-term risk, as we’ve seen so far this year.
Outside of traditional markets, we have added lower-risk alternative investments to our portfolios for their risk management and portfolio diversification benefits. As we have mentioned multiple times in the past, we believe in private real estate funds as a tool that is less volatile than stocks and that pay higher income than bonds.
How Our Portfolios Are Constructed:
Typical retirees have historically allocated 60% of their nest egg to various classes of stock and 40% to fixed income/bonds. Our Medium Risk models closely match this approach.
Several years ago we highlighted a concern about rising interest rates. We adjusted the fixed income component of our portfolios down (from 40%) to 20% and replaced these investments with a 20% allocation to private real estate. The goal was to capture higher income and to dramatically lower the risk that bonds bring during an environment of rising interest rates. However, risk reduction can be a nebulous concept and not easy for investors to fully appreciate. The main focus for many folks when reading reports tends to be on total return.
Rising rates have been slow to develop, but in recent months we believe we are starting to see a healthy increase in rates (as evidenced by the 10-year Treasury rate exceeding 3%). We are aggressively seeking answers to the remaining fixed income portion of our recommended portfolios. We will be reducing our bond allocation further and increasing credit income funds that provide income with less volatility. We are still in the evaluation phase but plan to implement some changes prior to year end.
In closing, why are trades occuring in your accounts? We are rebalancing.
Most everyone knows that long-term success comes from buying low and selling high. This is an objective that is easy to verbalize but often difficult to execute. There is a natural (although misguided) inclination to instead buy the areas that have been doing well and to sell areas that have been weak. We believe in a process of rebalancing which will sell off a portion of asset classes that have outperformed and are now overweight (e.g. US stocks) , and then buy into asset classes that have underperformed and are now underweight (e.g. international stocks). This may seem silly in the short term, but it is critical to long-term risk reduction and success in your retirement.
Thank you for your continued confidence and trust.
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.]