Quick Look
- The current bull market is now entering its ninth year. Investor confidence and fund flows are rising, and complacency (as measured by the VIX) is in the bottom decile of its historic levels.
- Economic surveys on consumer confidence, small business optimism and manufacturing have all turned noticeably higher, and suggest a strengthening economy of which we should begin to see some hard evidence in the coming months.
- As of quarter-end, U.S. stocks are up 11% since the presidential election and nearly 30% from the 2016 market bottom. In terms of drawdown risk, a 20% bear market correction would only “chute” us back to where we were just 13 months ago.
- Over the past ten years, while U.S. stocks have doubled, developed international stocks have barely broken even.
- The wide discrepancy of returns has created a valuation gap between U.S. and international stocks. Historically, a period of mean reversion often closes this gap and can lead to meaningful outperformance by international stocks.
- Bonds offer low returns and little help against inflation, but they can provide a level of capital preservation during equity market drawdowns.
- Portfolio changes this quarter included our decision to increase our international equity allocation at the expense of U.S. stocks. Additionally, continued strong returns triggered a rebalance out of U.S. stocks in many of our portfolios, as the upper band in the asset class was breached.
Review of First Quarter 2017
As many of our clients know, our firm has a number of employees with young children. Of last count, out of our 17 employees, there are a combined 18 kids under the age of ten. Two more babies arrived during the past quarter alone, while one more was added to our pipeline. Office happy hours have transformed from “6 pm to whenever, frequently” to “5 pm to 5:10 pm, intermittently”. Dinner reservations on the weekends have been replaced with kids’ birthday parties. Office chatter centers around the coffee machine with opposing theories on the upcoming Frozen sequel.
A recurring commonality among many of us is revisiting long-forgotten childhood activities. As parents, the enjoyment that comes from playing Candy Land or reading Alice in Wonderland or watching Sesame Street or building Legos is an opportunity to spend time and build bonds with our children as they learn valuable life lessons through fun activities. Occasionally, these adolescent lessons can strike a chord with your seemingly complex adulthood responsibilities.
Take, for example, the game of Chutes and Ladders (or its originator Snakes and Ladders, for our more worldly, refined readers) and its parallels to long-term investing. As a quick refresher, each player starts at square one and works her way up the board, navigating random squares fastened with either a chute or a ladder. The game neatly represents an analogy of investing through the working years life-cycle, with square one being a proxy for your first dollar invested in your IRA or 401(k). Eventually, you will make it to the top (i.e. retirement) through a combination of time, persistence and long-term earnings growth. Neither are zero-sum games; some may not reach square 100, but all participants can finish with positive values. As opposed to taking from another participant, the game (and investing) is more about the number of turns it takes to cross the finish line.
Holding aside the crucial tenets of long-term investing (discipline, diversification, increased savings, reduced spending, etc.), there is still an element of luck to the number of years you will need to flick the spinner. As an example, if you started saving annually for retirement in 1980, you have needed far fewer years to accumulate the same inflation-adjusted retirement savings as your parents did when they started their stock market investing in 1950. This same dynamic may play out between college graduates of 2008 (provided they were even able to land a job) and the graduates of today. We will just have to wait and see.
Recently, it seems the spins have been coming up all ladders. The current bull market is now entering its ninth year. Investor confidence and fund flows are rising, and complacency (as measured by the VIX) is in the bottom decile of its historic levels. A recent down day in late March ended what was a 109-day streak in which the S&P 500 traded without a decline greater than 1%. As of quarter-end, U.S. stocks are up 11% since the presidential election and nearly 30% from the 2016 market bottom. In terms of drawdown risk, a 20% bear market correction would only “chute” us back to where we were just 13 months ago.
U.S. Stocks
From the dot-com bubble in 2000 until 2013, the S&P 500 Index reached all-time highs only nine times, all of which were clustered in 2007, the year before The Great Recession. Comparatively, since 2013, the S&P 500 has set all-time highs 137 times. This statistic isn’t necessarily a red alert signal, but it does speak to increasing complacency, as all-time highs are no longer considered worthy of a top of the fold headline. Over your investing life-cycle, you will get to experience the euphoric feeling of viewing your portfolio’s market balance at all-time highs about a quarter of the time. The other 75% of the time will be spent in some phase of drawdown, lamenting why you didn’t sell months ago. Market highs make you feel rich. Drawdowns leave you wondering if you are destined to die poor.
With the purpose of not having any of our clients die poor, we have been hard at work on portfolios over the past quarter. First, our investment committee increased our international equity allocation at the expense of U.S. stocks. Second, the continued strength in U.S. stocks triggered a rebalance in many of our portfolios, as the upper band in the domestic large cap equity asset class was breached. Let’s unpack both of these portfolio moves separately, starting with our international equity decision.
We acknowledge that over the past ten years, international stocks have been a drag on portfolios. Their primary diversification contribution over this time has been to diversify away portfolio returns. How bad has it been? As you can see in the table, over the past ten years, while U.S. stocks have doubled, developed international stocks have barely broken even. During this time, our portfolios have benefitted on a relative basis, as our international equity weighting has been lower than our peers or comparable target-date funds.
There are certainly valid reasons for this decade-long malaise – geopolitical risks, debt concerns, delayed monetary response to The Great Recession, anemic economic growth, U.S. dollar strength, etc. In comparison to other developed nations, the U.S. is often described as the best of a bad lot, a fairly apt depiction. These reasons, coupled with the wide discrepancy of returns, have created a valuation gap between U.S. and international stocks.
Historically, a period of mean reversion often closes this gap and can lead to meaningful outperformance by international stocks. Some clients may remember the lengthy outperformance international stocks provided during the 2000s, in which U.S. stocks mostly spun their wheels. Lengthy outperformance of internationals occurred in the late-1970s and late-1980s as well. Though highly correlated, the combination of both U.S. and international stocks should improve risk-adjusted returns. Currently, U.S. stocks comprise 53% of the world’s stock market. Because of currency effects, we fundamentally believe in maintaining a U.S. bias, and acknowledge that clients obtain indirect international exposure through a number of U.S. global conglomerates. Therefore, we would contend that weighting your international equity based on world market cap would be unnecessarily high. We think the sweet spot lies around one-quarter of your total equity exposure, which allows you to capture nearly all of the diversification benefit between the two asset classes.
Both international stocks and emerging markets outperformed U.S. stocks during the first quarter, but whether or not this represents an actual leadership turn will take some time. This should not be misconstrued as a short-term tactical call. If your investment time horizon was only for 2017, the answer would be easy. You would choose neither, knowing that stocks are long-term investments. But provided you are a long-term investor, the valuation gap in the chart below offers a pretty compelling argument for increasing international equities, as U.S. stocks are more expensive on every valuation metric.
This leads us to a nice segue into our other move, which was a rebalance of stocks back into bonds. As a reminder, our investment process includes bracketing each asset class with a range that triggers a buy or sell if the weighting falls below or exceeds a threshold. We believe this discipline better equips us to catch market valleys or peaks for our clients. This past quarter, the more conservative your portfolio asset allocation, the more likely your large cap stocks breached their upper band threshold. Unlike the domestic to international adjustment, which is an allocation shift between risky assets, the rebalance is simply a formulaic discipline to harvest profits.
Again, this is not a tactical call, as there are a number of positives for U.S. stocks. Earnings are once again growing and forecast to jump 9% in the upcoming quarter, the largest projected increase in five years. Economic surveys on consumer confidence, small business optimism and manufacturing have all turned noticeably higher, and suggest a strengthening economy of which we should begin to see some hard evidence in the coming months. In light of the decision to raise interest rates in March, Fed Chair Janet Yellen stated, “the simple message is that the economy is doing quite well.” Corporate tax reform is widely expected and has the potential to lead to a surge in share buybacks and dividend increases, presuming negotiations go smoother than the stumbles we saw in regards to the National Health Care Act.
Despite these positives, we are still cognizant that valuations are above historical levels on an absolute basis. The Shiller CAPE ratio (which values markets based on the prior ten years of earnings) is above 25x, a far cry from the obscene levels of 1999, but above the 20x average of the past 50 years. Admittedly, CAPE has a couple of flaws and a lousy track record of predicting one-year returns. It has, however, a much better track record of forecasting future 10-year returns, and the data suggests pretty good odds that the next 10 years provide lower returns than the 9.5% U.S. stocks have delivered on an annualized basis historically.
Paradoxically, the one valuation metric in which U.S. stocks look cheap is when compared to bonds. This is conveyed via the equity risk premium (ERP), or the excess return an investor demands for taking equity risk. Rather than rehashing a somewhat mundane topic, we will summarize by saying that stocks still look attractively priced versus bonds, but not as much as they did nine months ago. At quarter-end, bonds are priced to provide investors an annualized return of 2.4% over the next ten years. In terms of excitement, high quality bonds are the microwave TV dinner of asset classes. So why rebalance into such an unappetizing asset class? Bonds offer low returns and little help against inflation, but they can provide a level of capital preservation during equity market drawdowns. As we mentioned last quarter, a bad quarter in bonds can be matched by one bad day in stocks.
In closing, we come back to our Chutes and Ladders analogy. At some point, we will inevitably land on a chute square. Our moves over the quarter will not prevent a drawdown, but it should mitigate some of the slide. As always, please feel free to contact us should you want to discuss these matters in greater detail. Until then, enjoy the spring season!
Article by Opus Capital Management
