The 1st Quarter 2018 Market Review is out! Times like these with sudden yet short-term declines will tempt you to make knee-jerk reactions, even after a year like 2017 where the global stock markets rose by more than +20%. Our goal is to makes sure our clients are investors with the resolve to stay the course so they may capitalize on market-based returns over the long-term. This report features world capital market performance and a timeline of events for the last quarter. It begins with a global overview, then features the returns of stock and bond asset classes in the US and international markets. Also included are the returns of select countries as well as the performance of globally diversified portfolios. Click the link to read the full version.
Embarking on a financial plan is like sailing around the world. The voyage won’t always go to plan, and there’ll be rough seas. But the odds of reaching your destination increase greatly if you are prepared, flexible, patient, and well-advised.
A mistake many inexperienced sailors make is not having a plan at all. They embark without a clear sense of their destination. And once they do decide, they often find themselves lost at sea in the wrong boat with inadequate provisions.
Likewise, in planning an investment journey, you need to decide on your goal. A first step might be to consider whether the goal is realistic and achievable. For instance, while you may long to retire in the south of France, you may not be prepared to sacrifice your needs today to satisfy that distant desire.
Once you are set on a realistic destination, you need to ensure you have the right portfolio to get you there. Have you planned for multiple contingencies? What degree of “bad weather” can your plan withstand along the way?
Key to a successful voyage is a good navigator. A trusted advisor is like that, regularly taking coordinates and making adjustments, if necessary. If your circumstances change, the advisor may suggest you re-plot your course.
As with the weather at sea, markets can be unpredictable. A sudden squall can whip up waves of volatility, tides can shift, and strong currents can threaten to blow you off course. Like a seasoned sailor, an experienced advisor will work with the conditions.
Once the storm passes, you can pick up speed again. Just as a sturdy vessel will help you withstand most conditions at sea, a well-diversified portfolio can act as a bulwark against the sometimes tempestuous conditions in markets.
Circumnavigating the globe is not exciting every day. Patience is required with local customs and paperwork as you pull into different ports. Likewise, a lack of attention to costs and taxes is the enemy of many a long-term financial plan.
Distractions can also send investors, like sailors, off course. In the face of “hot” investment trends, it takes discipline not to veer from your chosen plan. Like the sirens of Greek mythology, media pundits can also be diverting, tempting you to change tack and act on news that is already priced in to markets.
A lack of flexibility is another impediment to a successful investment journey. If it doesn’t look as though you’ll make your destination in time, you may have to extend your voyage, take a different route to get there, or even moderate your goal.
The important point is that you become comfortable with the idea that uncertainty is inherent to the investment journey, just as it is with any sea voyage. That is why preparation and planning are so critical. While you can’t control every outcome, you can be prepared for the range of possibilities and understand that you have clear choices if things don’t go according to plan.
If you can’t live with the volatility, you can change your plan. If the goal looks unachievable, you can lower your sights. If it doesn’t look as if you’ll arrive on time, you can extend your journey.
Of course, not everyone’s journey is the same. Neither is everyone’s destination. We take different routes to different places, and we meet a range of challenges and opportunities along the way.
But for all of us, it’s critical that we are prepared for our journeys in the right vessel, keep our destinations in mind, stick with the plans, and have a trusted navigator to chart our courses and keep us on target.
At the beginning of 2017, a common view among money managers and analysts was that the financial markets would not repeat their strong returns from 2016. Many cited the uncertain global economy, political turmoil in the US, implementation of Brexit, conflicts in the Middle East, North Korea’s weapons buildup, and other factors. The global equity markets defied their predictions, with major equity indices in the US, developed ex-US, and emerging markets posting strong returns for the year.
The broad global advance underscores the importance of following an investment approach based on diversification and discipline rather than prediction and timing. Attempting to predict markets requires investors to not only accurately forecast future events, but also predict how markets will react to those events. The 2017 markets were a good reminder that there is little evidence suggesting either of these objectives can be accomplished on a consistent basis.
Instead of attempting to make predictions about future events, investors should appreciate that today’s price reflects the expectations of market participants and information about future expected returns. The following quote by the late Merton Miller, Nobel Laureate, describes this view:
“Everybody has some information. The function of the markets is to aggregate that information, evaluate it, and get it incorporated into prices.” —Merton Miller
The chart above highlights some of the year’s prominent headlines in the context of global stock market performance as measured by the MSCI All Country World Index-Investable Market Index (MSCI ACWI IMI). These headlines are not offered to explain market returns. Instead, they serve as a reminder that investors should view daily events from a long-term perspective and avoid making investment decisions based solely on the news.
In 2017, the global economy showed signs of stronger growth, with 45 countries tracked by the Organization for Economic Cooperation and Development (OECD) all on pace to expand. Economic outlook and the expected impact on future cash flows are among the many variables markets consider when setting prices. Therefore, investors should remember that growth in the economy is not always linked to stock market performance.
Equity Market Highlights
Global equity markets posted another positive year of returns in 2017. The S&P 500 Index recorded a 21.83% total return and small cap stocks, as measured by the Russell 2000 Index, returned 14.65%, both above their long-term average return of 11.96% and 11.73%, respectively, since 1979.
Returns among non-US equity markets were even higher. The MSCI World ex USA Index, which reflects non-US developed markets, logged a 24.21% return and the MSCI Emerging Markets Index a 37.28% return2, making this the fifth highest return in the index history.
As the S&P 500 and other indices reached all-time highs during the year, a common media question was whether markets were poised for a downturn. History tells us that a market index being at an all-time high generally does not provide actionable information for investors.
For evidence, we can look at the S&P 500 Index for the better part of the last century. From 1926 through 2017, the frequency of positive 12-month returns following a new index high was similar to what is observed following months of any level. In fact, over this time period, almost a third of the monthly observations were new closing highs for the index. The data shows that new index highs have historically not been useful predictors of future returns.
Global Diversification Impact
Developed ex US markets and emerging markets generally outperformed US equities. As a result, a market cap-weighted global equity portfolio would have outperformed a US equity portfolio.
The S&P 500 Index’s 21.83% return marked its best calendar year since 2013 and placed 2017 in the top third of best performing calendar years in the index’s history. Despite these returns, the US ranked in the bottom half of countries for the year, placing 35th out of the 47 countries in the MSCI All Country World Index (IMI).
Delving into individual countries, country level returns were mostly positive. Using the MSCI All Country World Index (IMI) as a proxy, 45 out of the 47 countries posted positive returns. Country level returns were dispersed even among those with positive returns. In developed markets, returns ranged from +10.36% in Israel to +51.39% in Austria. In emerging markets, returns ranged from –24.75% in Pakistan to +53.56% in Poland—a spread of almost 80%. Without a reliable way to predict which country will deliver the highest returns, this large dispersion in returns between the best and worst performing countries again emphasizes the importance of maintaining a diversified approach when investing globally.
China provides an example highlighting the noise in year-to-year single country returns. After a flat-to-negative return (USD) in 2016, Chinese equities returned more than 50% (USD) in 2017, making China one of the best performing countries for the year.
Most major currencies including the euro, the Australian dollar, and the British pound appreciated against the US dollar. The strengthening of non-US currencies had a positive impact on returns for US investors with holdings in unhedged non-US assets. This may surprise some investors given that the US dollar has strengthened against many currencies over the past five- and 10-year periods. However, just as with individual country returns, there is no reliable way to predict currency movements. Investors should be cautious about trying to time currencies based on the recent good or bad performance of the US dollar or any other currency.
In 2017, the small cap premium4 was generally positive in developed ex US markets and negative across US and emerging markets. The profitability premium5 was positive across US, developed ex US, and emerging markets, while the value premium6 was negative across those markets.
In the US, small cap stocks underperformed large cap stocks and value stocks underperformed growth stocks. On a positive note, high profitability stocks outperformed low profitability stocks as measured marketwide.
Although US small cap stocks, as described by the Russell 2000 Index, provided a healthy 14.65% return in 2017, the US small cap premium (as measured by the Russell 2000 Index minus the Russell 1000 Index) was negative, ranking in the lowest third of annual return differences since 1979. However, over the 10-year period ending December 31, the small cap premium was positive.
US value stocks returned 13.19% in 2017, as measured by the Russell 3000 Value Index. While double-digit returns from value are appealing, US growth stocks performed even better, with a 29.59% return as represented by Russell 3000 Growth Index. The difference between value and growth returns, as measured by the Russell 3000 Value Index minus Russell 3000 Growth Index, made 2017 the fourth lowest year for value since 1979 and pulled the five-year rolling premium return into negative territory.
Even over extended periods, underperformance of the value premium or any other premium is within expectation and not unusual. Over a 10-year period ending in March 2000, value stocks underperformed growth stocks by 5.61% per year, as measured by the Russell 1000 Value and Russell 1000 Growth indices.
This underperformance quickly reversed course and by the end of February 2001, value stocks had outperformed growth stocks over the previous one-, three-, five-, 10-, and 20-year periods. Premiums can be difficult if not impossible to predict and relative performance can change quickly, reinforcing the need for discipline in pursuing these sources of higher expected returns.
The profitability premium was positive in 2017, with US high profitability stocks outperforming low profitability stocks. Viewing profitability through the lens of the other premiums, high profitability stocks outperformed low among value stocks while underperforming among growth stocks.
The complementary behavior of premiums in 2017 is a good example of the benefits of integrating multiple premiums in an investment strategy, which can increase the reliability of outperformance and mitigate the impact of an individual premium underperforming, as was the case with value among US stocks in 2017.
Developed ex US Markets
In developed ex US markets, small cap stocks outperformed large cap stocks while value stocks underperformed growth stocks. High profitability stocks outperformed low profitability stocks.
Over both five- and 10-year rolling periods, the small cap premium, measured as the MSCI World ex USA Small Cap Index minus the MSCI World ex USA Index, continued to be positive.
Similar to the US equity market, value stocks posted a healthy 21.04% return for 2017 as measured using MSCI World ex USA Value Index. However, growth stocks performed even better with a 27.61% return, as measured by the MSCI World ex USA Growth Index.
The profitability premium was positive in developed ex US markets viewed marketwide. Looking within size and style segments of the market, high profitability outperformed low profitability in all but the large growth segment.
In emerging markets, small cap stocks underperformed large cap stocks and value stocks underperformed growth stocks. Similar to the US equity market, high profitability stocks outperformed those with low profitability.
Value stocks returned 28.07% as measured by the MSCI Emerging Markets Value Index, but growth stocks fared better returning 46.80% using the MSCI Emerging Markets Growth Index. The value premium, measured as MSCI Emerging Markets Value Index minus MSCI Emerging Markets Growth Index, was the lowest since 1999.
Though 2017 generally marked a positive year for absolute equity returns, it marked a change in premium performance from 2016 when the size and value premiums were generally positive across global markets. Taking a longer-term perspective, these premiums remain persistent over decades and around the globe despite recent years’ headwinds. It is well documented that stocks with higher expected return potential, such as small cap and value stocks, do not realize these returns every year. Maintaining discipline to these parts of the market is the key to effectively pursuing the long-term returns associated with the size, value, and profitability premiums.
Both US and non-US fixed income markets posted positive returns in 2017. The Bloomberg Barclays US Aggregate Bond Index gained 3.54%. The Bloomberg Barclays Global Aggregate Bond Index (hedged to USD) gained 3.04%.
Yield curves were upwardly sloped in many developed markets for the year, indicating positive expected term premiums. Realized term premiums were indeed positive both globally and in the US as long-term maturities outperformed their shorter-term counterparts.
Credit spreads, which are the difference between yields on lower quality and higher quality fixed income securities, were relatively narrow during the year, indicating smaller expected credit premiums. Realized credit premiums were positive both globally and in the US, as lower-quality investment-grade corporates outperformed their higher-quality investment-grade counterparts. Corporate bonds were the best performing sector, returning 6.42% in the US and 5.70% globally, as reflected in the Bloomberg Barclays Global Aggregate Bond Index (hedged to USD).
In the US, the yield curve flattened as interest rates increased on the short end and decreased on the long end of the curve. The yield on the 3-month US Treasury bill increased 0.88% to end the year at 1.39%. The yield on the 2-year US Treasury note increased 0.69% to 1.89%. The yield on the 10-year US Treasury note decreased 0.05% for the year to end at 2.40%. The yield on the 30-year US Treasury bond decreased 0.32% to end the year at 2.74%.
In other major markets, interest rates increased in Germany while they were relatively unchanged in the United Kingdom and Japan. Yields on Japanese and German government bonds with maturities as long as eight years finished the year in negative territory.
The year of 2017 included numerous examples of the difficulty of predicting the performance of markets, the importance of diversification, and the need to maintain discipline if investors want to effectively pursue the long-term returns the capital markets offer. The following quote by David Booth provides useful perspective as investors head into 2018:
“The key is to have the correct view of markets and how they work. Once you accept this view of markets, the benefits go way beyond just investing money.” —David Booth
Click the link to read the full version
The 4th Quarter 2017 Market Review is out! This report features world capital market performance and a timeline of events for the last quarter. It begins with a global overview, then features the returns of stock and bond asset classes in the US and international markets. Also included are the returns of select countries as well as the performance of globally diversified portfolios. Click the link to read the full version.
The 3rd Quarter 2017 Market Review is out! This report features world capital market performance and a timeline of events for the last quarter. It begins with a global overview, then features the returns of stock and bond asset classes in the US and international markets. Also included are the returns of select countries as well as the performance of globally diversified portfolios. Click the link to read the full version.
It will soon be the 10-year anniversary of when, in early October 2007, the S&P 500 Index hit what was its highest point before losing more than half its value over the next year and a half during the global financial crisis. Over the coming weeks and months, as other anniversaries of major crisis-related events pass (for example, 10 years since the bank run on Northern Rock or 10 years since the collapse of Lehman Brothers), there will likely be a steady stream of retrospectives on what happened as well as opinions on how the environment today may be similar or different from the period leading up to the crisis. It is difficult to draw useful conclusions based on such observations; financial markets have a habit of behaving unpredictably in the short run. There are, however, important lessons that investors might be well-served to remember: Capital markets have rewarded investors over the long term, and having an investment approach you can stick with—especially during tough times—may better prepare you for the next crisis and its aftermath.
BENEFITS OF HINDSIGHT
In 2008, the stock market dropped in value by almost half. Being a decade removed from the crisis may make it easier to take the past in stride. The eventual rebound and subsequent years of double-digit gains have also likely helped in this regard. While the events of the crisis were unfolding, however, a future of this sort looked anything but certain. Headlines such as “Worst Crisis Since ’30s, With No End Yet in Sight,”1 “Markets in Disarray as Lending Locks Up,”2 and “For Stocks, Worst Single-Day Drop in Two Decades”3 were common front page news. Reading the news, opening up quarterly statements, or going online to check an account balance were, for many, stomach-churning experiences.
While being an investor today (or during any period, for that matter), is by no means a worry-free experience, the feelings of panic and dread felt by many during the financial crisis were distinctly acute. Many investors reacted emotionally to these developments. In the heat of the moment, some decided it was more than they could stomach, so they sold out of stocks. On the other hand, many who were able to stay the course and stick to their approach recovered from the crisis and benefited from the subsequent rebound in markets.
It is important to remember that this crisis and the subsequent recovery in financial markets was not the first time in history that periods of substantial volatility have occurred. Exhibit 1 helps illustrate this point. The exhibit shows the performance of a balanced investment strategy following several crises, including the bankruptcy of Lehman Brothers in September of 2008, which took place in the middle of the financial crisis. Each event is labeled with the month and year that it occurred or peaked.
Although a globally diversified balanced investment strategy invested at the time of each event would have suffered losses immediately following most of these events, financial markets did recover, as can be seen by the three- and five-year cumulative returns shown in the exhibit. In advance of such periods of discomfort, having a long-term perspective, appropriate diversification, and an asset allocation that aligns with their risk tolerance and goals can help investors remain disciplined enough to ride out the storm. A financial advisor can play a critical role in helping to work through these issues and in counseling investors when things look their darkest.
In the mind of some investors, there is always a “crisis of the day” or potential major event looming that could mean the beginning of the next drop in markets. As we know, predicting future events correctly, or how the market will react to future events, is a difficult exercise. It is important to understand, however, that market volatility is a part of investing. To enjoy the benefit of higher potential returns, investors must be willing to accept increased uncertainty. A key part of a good long-term investment experience is being able to stay with your investment philosophy, even during tough times. A well-thought-out, transparent investment approach can help people be better prepared to face uncertainty and may improve their ability to stick with their plan and ultimately capture the long-term returns of capital markets.
In the world of investment management there is an oft-discussed idea that blindfolded monkeys throwing darts at pages of stock listings can select portfolios that will do just as well, if not better, than both the market and the average portfolio constructed by professional money managers. If this is true, why might it be the case?
THE DART BOARD
Exhibit 1 shows the components of the Russell 3000 Index (regarded as a good proxy for the US stock market) as of December 31, 2016. Each stock in the index is represented by a box, and the size of each box represents the stock’s market capitalization (share price multiplied by shares outstanding) or “market cap” in the index. For example, Apple (AAPL) is the largest box since it has the largest market cap in the index. The boxes get smaller as you move from the top to the bottom of the exhibit, from larger stocks to smaller stocks. The boxes are also color coded based on their market cap and whether they are value or growth stocks. Value stocks have lower relative prices (as measured by, for instance the price-to-book ratio) and growth stocks tend to have higher relative prices. In the exhibit, blue represents large cap value stocks (LV), green is large cap growth stocks (LG), gray is small cap value stocks (SV), and yellow is small cap growth stocks (SG).
For the purposes of this analogy you can think of Exhibit 1 as a proxy for the overall stock market and therefore similar to a portfolio that, in aggregate, professional money managers hold in their competition with their simian challengers. Because for every investor holding an overweight to a stock (relative to its market cap weighting) there must also be an investor underweight that same stock, this means that, in aggregate, the average dollar invested holds a portfolio that looks like the overall market.
Exhibit 2, on the other hand, represents the dart board the monkeys are using to play their game. Here, the boxes represent the same stocks shown in Exhibit 1, but instead of weighting each company by market cap, the companies are weighted equally. For example, in this case, Apple’s box is the same size as every other company in the index regardless of its market cap. If one were to pin up pages of newspaper stock listings to throw darts at, Exhibit 2 would be much more representative of what the target would look like.
When looking at Exhibits 1 and 2, the significant differences between the two are clear. In Exhibit 1, the surface area is dominated by large value and large growth (blue and green) stocks. In Exhibit 2, however, small cap value stocks dominate (gray). Why does this matter? Research has shown that, historically over time, small company stocks have had excess returns relative to large company stocks. Research has also shown that, historically over time, value (or low relative price) stocks have had excess returns relative to growth (or high relative price) stocks. Because Exhibit 2 has a greater proportion of its surface area dedicated to small cap value stocks, it is more likely that a portfolio of stocks selected at random by throwing darts would end up being tilted towards stocks which research has shown to have had higher returns when compared to the market.
This does not mean, however, that haphazardly selecting stocks by the toss of a dart is an efficient or reliable way to invest. For one thing, it ignores the complexities that arise in competitive markets.
Consider as an example something seemingly as straightforward as a strategy that holds every stock in the Russell 3000 Index at an equal weight (the equivalent of buying the whole dart board in Exhibit 2). In order to maintain an equal weight in all 3,000 securities, an investor would have to rebalance frequently, buying shares of companies that have gone down in price and selling shares that have gone up. This is because as prices change, so will each individual holding’s respective weight in the portfolio. By not considering whether or not these frequent trades add value over and above the costs they generate, investors are opening themselves up to a potentially less than desirable outcome.
Instead, if there are well-known relationships that explain differences in expected returns across stocks, using a systematic and purposeful approach that takes into consideration real-world constraints is more likely to increase your chances for investment success. Considerations for such an approach include things like: understanding the drivers of returns and how to best design a portfolio to capture them, what a sufficient level of diversification is, how to appropriately rebalance, and last but not least, how to manage the costs associated with pursuing such a strategy.
THE LONG GAME
Finally, the importance of having an asset allocation well-suited for your objectives and risk tolerance, as well as being able to remain focused on the long term, cannot be overemphasized. Even well-constructed portfolios pursuing higher expected returns will have periods of disappointing results. A financial advisor can help an investor decide on an appropriate asset allocation, stay the course during periods of disappointing results, and carefully weigh the considerations mentioned above to help investors decide if a given investment strategy is the right one for them.
So what insights can investors glean from this analysis? First, by tilting a portfolio towards sources of higher expected returns, investors can potentially outperform the market without needing to outguess market prices. Second, implementation and patience are paramount. If one is going to pursue higher expected returns, it is important to do so in a cost-effective manner and to stay focused on the long term.
The 2nd Quarter 2017 Market Review is out! This report features world capital market performance and a timeline of events for the last quarter. It begins with a global overview, then features the returns of stock and bond asset classes in the US and international markets. Also included are the returns of select countries as well as the performance of globally diversified portfolios. Click the link to read the full version.