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.
Should stock investors worry about changes in interest rates? Research shows that, like stock prices, changes in interest rates and bond prices are largely unpredictable. It follows that an investment strategy based upon attempting to exploit these sorts of changes isn’t likely to be a fruitful endeavor. Despite the unpredictable nature of interest rate changes, investors may still be curious about what might happen to stocks if interest rates go up.
Unlike bond prices, which tend to go down when yields go up, stock prices might rise or fall with changes in interest rates. For stocks, it can go either way because a stock’s price depends on both future cash flows to investors and the discount rate they apply to those expected cash flows. When interest rates rise, the discount rate may increase, which in turn could cause the price of the stock to fall. However, it is also possible that when interest rates change, expectations about future cash flows expected from holding a stock also change. So, if theory doesn’t tell us what the overall effect should be, the next question is what does the data say?
Recent research performed by Dimensional Fund Advisors helps provide insight into this question. The research examines the correlation between monthly US stock returns and changes in interest rates. Exhibit 1 shows that while there is a lot of noise in stock returns and no clear pattern, not much of that variation appears to be related to changes in the effective federal funds rate.
For example, in months when the federal funds rate rose, stock returns were as low as −15.56% and as high as 14.27%. In months when rates fell, returns ranged from −22.41% to 16.52%. Given that there are many other interest rates besides just the federal funds rate, Dai also examined longer-term interest rates and found similar results.
So, to address our initial question: when rates go up, do stock prices go down? The answer is yes, but only about 40% of the time. In the remaining 60% of months, stock returns were positive. This split between positive and negative returns was about the same when examining all months, not just those in which rates went up. In other words, there is not a clear link between stock returns and interest rate changes.
There’s no evidence that investors can reliably predict changes in interest rates. Even with perfect knowledge of what will happen with future interest rate changes, this information provides little guidance about subsequent stock returns. Instead, staying invested and avoiding the temptation to make changes based on short-term predictions may increase the likelihood of consistently capturing what the stock market has to offer.
Doubt is not a pleasant condition, but certainty is an absurd one. — Voltaire
“The market hates uncertainty” has been a common enough saying in recent years, but how logical is it? There are many different aspects to uncertainty, some that can be measured and some that cannot. Uncertainty is an unchangeable condition of existence. As individuals, we can feel more or less uncertain, but that is a distinctly human phenomenon. Rather than ebbing and flowing with investor sentiment, uncertainty is an inherent and ever-present part of investing in markets. Any investment that has an expected return above the prevailing “risk-free rate” (think T-Bills for US investors) involves trading off certainty for a potentially increased return.
Consider this concept through the lens of stock vs. bond investments. Stocks have higher expected returns than bonds largely because there is more uncertainty about the future state of the world for equity investors than bond investors. Bonds, for the most part, have fixed coupon payments and a maturity date at which principal is expected to be repaid. Stocks have neither. Bonds also sit higher in a company’s capital structure. In the event a firm goes bust, bondholders get paid before stockholders. So, do investors avoid stocks in favor of bonds as a result of this increased uncertainty? Quite the contrary, many investors end up allocating capital to stocks due to their higher expected return. In the end, many investors are often willing to make the tradeoff of bearing some increased uncertainty for potentially higher returns.
While the statement “the market hates uncertainty” may not be totally logical, it doesn’t mean it lacks educational value. Thinking about what the statement is expressing allows us to gain insight into the mindset of individuals. The statement attempts to personify the market by ascribing the very real nervousness and fear felt by some investors when volatility increases. It is recognition of the fact that when markets go up and down, many investors struggle to separate their emotions from their investments. It ultimately tells us that for many an investor, regardless of whether markets are reaching new highs or declining, changes in market prices can be a source of anxiety. During these periods, it may not feel like a good time to invest. Only with the benefit of hindsight do we feel as if we know whether any time period was a good one to be invested. Unfortunately, while the past may be prologue, the future will forever remain uncertain.
STAYING IN YOUR SEAT
In a recent interview, David Booth was asked about what it means to be a long-term investor:
“People often ask the question, ‘How long do I have to wait for an investment strategy to pay off? How long do I have to wait so I’m confident that stocks will have a higher return than money market funds, or have a positive return?’ And my answer is it’s at least one year longer than you’re willing to give. There is no magic number. Risk is always there.”
Part of being able to stay unemotional during periods when it feels like uncertainty has increased is having an appropriate asset allocation that is in line with an investor’s willingness and ability to bear risk. It also helps to remember that, during what feels like good times and bad, one wouldn’t expect to earn a higher return without taking on some form of risk. While a decline in markets may not feel good, having a portfolio you are comfortable with, understanding that uncertainty is part of investing, and sticking to a plan that is agreed upon in advance and reviewed on a regular basis can help keep investors from reacting emotionally. This may ultimately lead to a better investment experience.
The 1st 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.
There has been much discussion in the news recently about new nominal highs in stock indices like the Dow Jones Industrial Average and the S&P 500.
When markets hit new highs, is that an indication that it’s time for investors to cash out? 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. Exhibit 1 shows that from 1926 through the end of 2016, the proportion of annual returns that have been positive after a new monthly high is similar to the proportion of annual returns that have been positive after any index level. In fact, over this time period almost a third of the monthly observations were new closing highs for the index. Looking at this data, it is clear that new index highs have historically not been useful predictors of future returns.
Given that the level of an index by itself does not seemingly have a bearing on future returns, you may ask yourself a more fundamental question: What drives expected returns for stocks?
POSITIVE EXPECTED RETURNS
One way to compute the current value of an investment is to estimate the future cash flows the investment is expected to deliver and discount them back into today’s dollars. For an investment in a firm’s stock, this type of valuation method allows expectations about a firm’s future profits to be linked to its current stock price through a discount rate. The discount rate equals an investor’s expected return. A simple, but important, insight we glean from this is that the expected return from holding a stock is driven by the price paid for it and what its investors expect to receive.
Stock prices are the result of the interaction of many willing buyers and sellers. It is extremely unlikely that in aggregate, those willing buyers apply negative discount rates to the expected profits of the firms they are purchasing. Why? Because there is always a risk that expected profits will not materialize or that the price might decline because of unanticipated future events. If investors apply positive discount rates to the cash flows they expect to receive from owning a stock, we should expect the price of that stock to represent a level such that its expected return is always positive. Unless the expected cash flows are persistently biased downward or upward, we can expect this to be the case.
There is little evidence, though, that the aggregate expectations of investors that set market prices have been persistently biased downward or upward. Many studies document that professional money managers have been unable to deliver consistent outperformance by outguessing market prices. In the end, prices set by market forces are difficult to outguess. The market does a good job setting prices, and we can assume that the expected return investors have applied when setting prices are not biased.
Therefore, it is reasonable to assume that the price of a stock, or the price of a basket of stocks like the S&P 500 Index, should be set to a level such that its expected return is positive, regardless of whether or not that price level is at a new high. This helps explain why new index highs have not, on average, been followed by negative returns. At a new high, a new low, or something in between, expected returns are positive.
EXPECTED RETURNS, REALIZED RETURNS, AND HOLDING HORIZONS
Today’s prices depend on expected returns and expectations about future profits. If either expected returns or expectations about future profits change, prices will also change to reflect this new information. Changes in risk aversion, tastes and preferences, expectations about future profits, or the quantity of risk can all drive changes in expected returns. All else equal, an increase in expected returns is reflected through a drop in prices. A decrease in expected returns is reflected through a rise in prices. Thus, realized returns can differ from expected returns.
This means there is a probability that the realized return on any stock, an index like the S&P 500, or the market as a whole can be negative even when expected returns are positive. But what can we say about the relation between the probability of a negative realized return and an investor’s holding horizon?
Exhibit 2 shows rolling 10-year performance of the equity market premium (equity returns minus the return of one-month US Treasury bills, considered to be short-term, risk-free investments). In most periods it was positive, but in several periods it underperformed.
There is uncertainty around how long periods of underperformance like this may last. Historically, however, the probability of equity returns being positive increases over longer time periods compared to shorter periods. Exhibit 3 shows the percentage of time that the equity market premium was positive over different time periods going back to 1928. When the length of the time period measured increases, so does the chance of the equity market premium being positive. So to answer our question from before: as an investor’s holding period increases, the probability of a negative realized return decreases. This is why it is important to choose a level of equity exposure that you can stay invested in over the long term.
By themselves, new all-time highs in equity markets have historically not been useful predictors of future returns. While positive realized returns are never guaranteed, equity investments have positive expected returns regardless of index levels or prior short-term market returns. The collective wisdom of market participants and their competitive assessment of expected returns and risks allow investors to rely on the information contained in prices to inform their investment decisions and assume positive expected returns from stocks. Historically speaking, over longer time horizons, the odds of realized stock returns being positive have increased. This is one reason why investors should consider investing a long-term commitment: Staying invested and not making changes based on short-term predictions increases your likelihood of success.
In 2016, the US market reached new highs and stocks in a majority of developed and emerging market countries delivered positive returns. The year began with anxiety over China’s stock market and economy, falling oil prices, a potential US recession, and negative interest rates in Japan. US equity markets were in steep decline and had the worst start of any year on record. The markets began improving in mid-February through midyear. Investors also faced uncertainty from the Brexit vote in June and the US election in November.
Many investors may not have expected global stocks and bonds to deliver positive returns in such a tumultuous year. This turnaround story highlights the importance of diversifying across asset groups and regional markets, as well as staying disciplined despite uncertainty. Although not all asset classes had positive returns, a globally diversified, cap-weighted portfolio logged attractive returns in 2016.
Consider that global markets are incredible information-processing machines that incorporate news and expectations into prices. Investors are well served by staying the course with an asset allocation that reflects their needs, risk preferences, and objectives. This can help investors weather uncertainty in all of its forms. The following quote by Eugene Fama describes this view.
“If three or five years of returns are going to change your mind [on an investment], you shouldn’t have been there to begin with.” ―Eugene Fama
The chart above highlights some of the year’s prominent headlines in context of broad US market performance, measured by the Russell 3000 Index. 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.
The chart below offers a snapshot of non-US stock market performance (developed and emerging markets), measured by the MSCI All Country World ex USA Index (in USD, net dividends). The headlines should not be viewed as determinants of the market’s direction but as examples of events that may have tested investor discipline during the year.
Equity Market Highlights
After a rocky start, the US stock market had a strong year. The S&P 500 Index logged an 11.96% total return and small cap stocks, as measured by the Russell 2000 Index, returned 21.31%.
Overall, performance among non-US markets was also positive: The MSCI World ex USA Index, which reflects non-US developed markets, logged a 2.75% return and the MSCI Emerging Markets Index an 11.19% return.
Global Diversification Impact
Overall, US equities outperformed equities in the developed ex US markets and emerging markets. As a result, a market cap-weighted global equity portfolio would have underperformed a US equity portfolio. Investors generally benefited from emphasizing value stocks around the world, as well as US small cap stocks.
Returns at the country level were dispersed. In developed markets, returns ranged from –24.87% in Israel to +24.56% in Canada. In emerging markets, returns ranged from –12.13% in Greece to +66.24% in Brazil.
Strong performance in the US placed it as the 17th best performing country out of the 46 countries in the MSCI All Country World Index (ACWI), which represents both developed and emerging markets. Although the S&P 500 Index had a positive return in 2016, the year was not in the top half of the index’s historical annual returns.
Brazil offers a noteworthy example of market prices at work and the difficulty of trying to forecast and time markets. Despite a severe recession, Brazil was the top performing emerging market country in 2016. Brazil’s GDP was projected to shrink 3.4% in 2016, according to the OECD in November, yet its equity market logged strong performance. The lesson is that prices incorporate a rich set of information, including expectations about the future. One must beat the aggregate wisdom of market participants in order to identify mispricing. The evidence suggests that this is a very difficult task to do consistently.
In 2016, equity market volatility, as measured by the CBOE Volatility Index (VIX), was below average. There were, however, several spikes—as you might expect—as new information was incorporated into prices. The high was reached in early February, and spikes occurred following the Brexit vote in June and again in November preceding the US election.
In 2016, the small cap and value premiums were mostly positive across US, developed ex US, and emerging markets, while the profitability premium varied by market segment. Though 2016 marked a generally positive year, investors may still be wary following several years of underperformance for value and small cap stocks. Taking a longer-term perspective, the premiums remain persistent over decades and around the globe despite recent years’ headwinds. The small cap and value premiums are well-grounded in financial economics and verified using market data spanning decades, but pursuing those premiums requires a consistent, long-term approach.
In the US market, small cap stocks outperformed large cap stocks and value stocks outperformed growth stocks. High profitability stocks outperformed low profitability stocks in most market segments. Over 2016, the US small cap premium marked the seventh highest annual return difference since 1979 when measured by the Russell 2000 Index minus Russell 1000 Index. Most of the performance for small caps came in the last two months of the year, after the US election on November 8. This illustrates the difficulty of trying to time premiums and the benefit of maintaining consistent exposure. Through October, US small cap stocks had outpaced large company stocks for the year by only 0.35%. By year-end, the small cap premium had increased to 9.25%, as shown below.
US value stocks outperformed growth stocks by 11.01% following an extended period of underperformance. Over the five-year rolling period, the value premium, as measured by the Russell 3000 Value Index minus Russell 3000 Growth Index, moved from negative in 2015 to positive in 2016.
Developed ex US Markets
In developed ex US markets, small cap stocks outperformed large cap stocks and value stocks outperformed growth stocks. Over both the 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. The five- and 10-year rolling periods for the small cap premium have been positive for the better part of the past decade.
Value stocks outperformed growth stocks by 9.26%, as measured by the MSCI World ex USA Value Index minus the MSCI World ex USA Growth Index. Similarly to US small caps, most of the outperformance occurred in the fourth quarter, reinforcing the importance of consistency in pursuing premiums. Despite a positive year, the value premium remains negative over the five- and 10-year rolling periods.
In emerging markets, small cap stocks underperformed large cap stocks and value stocks outperformed growth stocks. Despite the underperformance of small cap stocks, small cap value stocks fared better than small cap growth stocks and performed similarly to large cap value stocks. Investors who emphasized small cap value stocks over small cap growth stocks benefited.
Both US and non-US fixed income markets posted positive returns. The Bloomberg Barclays US Aggregate Bond Index gained 2.65%. The Bloomberg Barclays Global Aggregate Bond Index (hedged to USD) gained 3.95%.
Yield curves were generally upwardly sloped in many developed markets, indicating positive expected term premiums. Indeed, realized term premiums were positive in the US and globally as longer-term maturities outperformed their shorter-term counterparts.
Corporate bonds were the best performing sector, returning 6.11% in the US and 6.22% globally, as reflected in the Bloomberg Barclays Global Aggregate Bond Index (hedged to USD). Credit premiums were also positive in the US and globally as lower quality investment grade corporates outperformed their higher quality investment grade counterparts.
While interest rates increased in the US, they generally decreased globally. Major markets such as Japan, Germany, and the United Kingdom all experienced decreases in interest rates. In fact, yields on Japanese and German government bonds with maturities as long as eight years finished the year in negative territory.
In the US, interest rates increased the most on the short end of the yield curve and were relatively unchanged on the long end. The yield on the 3-month US Treasury bill increased 0.35% to end the year at 0.51%. The yield on the 2-year US Treasury note increased 0.14% to 1.20%. The yield on the 10-year US Treasury note closed at a record low of 1.37% in July yet increased 0.18% for the year to end at 2.45%. The yield on the 30-year US Treasury bond increased 0.05% to end the year at 3.06%.
The British pound, euro, and Australian dollar declined relative to the US dollar, while the Canadian dollar and Japanese yen appreciated relative to the US dollar. The impact of regional currency differences on returns in the developed equity markets was minor in most cases. US investors in both developed and emerging markets generally benefited from exposure to certain currencies.
“There’s no information in past returns of three to five years. That’s just noise. It really takes very long periods of time, and it takes a lot of stick-to-it-iveness. You have to really decide what your strategy is based on—long periods of returns—and then stick to it.”