Ariel Investments commentary for the month ended September 30, 2015.
Given the current commotion, we think it makes sense for investors and market pundits to pause and put the recent equity returns in perspective. That is, unless you have been actively avoiding newspapers and television, you already know that stocks’ performance in the recent quarter was rough, with almost nowhere to run to and nowhere to hide. As investors who have adopted a tortoise as our corporate logo, we certainly have not been looking to run and have no interest in hiding; instead, we march slowly on with our long-term goal in mind. Given that, here is what we think of the markets at this point.
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This past quarter has been a difficult market for performance. As The Wall Street Journal proclaimed on the front page of the October 1st edition, it was “A Painful Quarter for Markets; Stocks had their worst quarter since 2011 amid growth worries.” Indeed, in the third quarter of 2015, the U.S. large-cap S&P 500 Index fell -6.44%, the U.S. small-cap Russell 2000 Index dropped -11.92%, and the international, developed large-cap MSCI EAFE Index slid -10.23%. On the other hand, we have not seen or heard much attention paid toward how different these returns are from the last time stocks were down hard. During the third quarter of 2011, the S&P 500 dove -13.87%, the Russell 2000 skidded -21.87%, and the MSCI EAFE tumbled -19.01%. By comparison, then, the recent drop was mild; it was hardly a devastating quarter within the long history of equity downturns.
Ariel Investments – Keeping an eye on indexes in or near a correction
At this point the three broad indexes we watch most closely are in or near a correction (as we noted in last month’s commentary) but not in a bear market using most standards. That is, two of the three indexes are down more than -10% from their year-to-date highs: through September 30, the EAFE is down -14.91% since its mid-May high; the Russell 2000 has fallen -14.70% since the end of June. The S&P 500 did not quite dip -10%; it is off -9.00% since the end of May. None of these three key benchmarks meets the other common standards for a bear market: being down more than -20% or being down -15% using month-to-month returns. We also think the year-to-date pattern of returns matters in assessing the 2015 market. While it is clearly a down year so far, the MSCI EAFE, Russell 2000 and S&P 500 have each had four positive months and five negative months. And among these indexes, only the Russell 2000 has managed to have three straight down months. So by the end of the year, 2015 could look like an up-and-down campaign more than anything else.
Just as the monthly return patterns have been similar among these headline indexes, so too have the top sector results. (Admittedly, sector gains have been rare: the S&P 500 and MSCI EAFE both have just two sectors with gains, while the Russell 2000 has none.) The top-performing areas in large-caps at home and abroad are consumer discretionary, consumer staples and health care. For the U.S. large-cap index, consumer discretionary and consumer staples stocks have small gains; health care stocks have the most minor negative returns. Abroad, consumer staples and health care stocks are up a small amount, while consumer discretionary stocks are off nearly -4%. (Note: despite the recent biotechnology rout, health care stocks have the least negative returns in the Russell 2000 Index.) We think these results mirror economic reality. That is, in developed markets, consumers are relatively healthy-unemployment is stabilizing, household balance sheets are much improved, home values are back up, and consumer confidence surveys are solid. Healthcare has shown other strengths: there has been significant consolidation to boost share prices, earnings have come through well, and the U.S. Affordable Care Act has been a boon to many large companies at home and abroad.
Ariel Investments – The worst-performing sectors
On the other side of the coin, the worst-performing sectors have been the same across U.S. large-caps, U.S. small-caps and international large-caps. The commodity collapse has driven energy stocks to the worst returns and materials stocks (sometimes grouped with processing companies) to the second-worst performance for all three indexes. In the large-cap indexes, these are the only two areas with double-digit losses, and in the Russell 2000 just one other sector, producer durables, joins that unfortunate group. As we have noted elsewhere, commodities are notoriously volatile and largely unpredictable. They are extremely sensitive to small movements in supply and demand. Moreover, many market participants use commodity futures and other derivatives to make leveraged bets on their movements, driving up volatility. As a backdrop to this market structure, the fracking boom and controversy in the United States, the concentration of natural resources in politically unstable areas, and the slowdown in China are big yet erratic forces in the aforementioned supply/demand balance. As a firm, we strive to avoid predicting the short-term movements of commodity prices for these reasons.
So what is a patient investor to do at this point? Our counsel is roughly the same as it is at most points through most market cycles. Investing in the stock market is a long-term, rational exercise. Thus the market is very efficient, meaning it is relatively rare for it to become wildly expensive or dirt cheap. We think it had been a tad expensive earlier this year and, as a result of the recent correction, is now closer to fair value. So we believe the prudent course of action is to have and follow a reasonable asset allocation plan. Among the least sensible things to do, in our view, is to attempt to time the market or to panic and dump stocks because of rather modest, short-term losses.