Pendleton Street Advisors


insight & investment commentary


Investment Commentaries: Third Quarter 2018

Index Returns 3rd Quarter Year to Date Trailing 12 Months
S&P 500 US Large Cap Index 7.7% 10.6% 17.9%
MSCI All Country World Stock Index 0.7% -3.1% 1.8%
Barclays Capital Aggregate Bond Index 0.0% -1.6% -1.2%
US Core Consumer Price Index - (Inflation) 0.5% 1.7% 2.2%

*All figures as of 9/30/2018 unless otherwise noted.

Executive Summary:

  • US Stocks are leading the pack this year: the S&P 500 has returned over 10% compared to negative returns for most other major asset classes.

  • Compared to the returns of US stocks, our portfolios are under-performing. In this commentary, we discuss why portfolios are under-performing the market, and what it means for our clients’ long-term objectives.

  • Diversification has exerted a significant drag on performance of balanced portfolios, prompting us to ask: Is diversification worth it?

  • During the current bull market (March, 2009 – Current), US stocks have delivered the highest levels of return at the lowest levels of volatility in the post-WW II era. Is it worth owning anything other than US stocks?

  • This year-to-date represents the only nine-month period in over 23 years of data that returns on US stocks are positive, while returns on all other major asset classes are negative.

  • All-things-considered bonds still deliver a needed level of stability and income-based return for long-term oriented investors, and international stocks present the most opportunity going forward due to more attractive valuations, as markets have likely overstated political and economic risks in other economies.

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Entering the fourth quarter of 2018, most asset classes except for domestic stocks have delivered poor performance. We can identify several underlying causes for this divergence in performance between US equities and everything-else, but none of those reasons makes it any easier to stomach the negative impact those asset classes have had on performance in diversified portfolios so far this year. In other words: we can explain the lackluster returns, but we cannot explain them away.

At this point in the year our portfolio performance has not correlated with growth in US stocks. We believe performance has been negatively impacted by two factors:

  1. What has under-performed*:

  • We increased exposure to precious metals (gold, silver, platinum, and palladium) early in the year as an inflation hedge (portfolio holding GLTR is down -9.7% year-to-date). While inflation has picked up, the sharp increase in the value of the dollar has driven the price of gold down.

  • We have maintained exposure to Emerging Markets stocks, which are discussed further below (Emerging Markets holdings SCHE and ODMAX are down -7.98% and -4.66% year-to-date, respectively).

That said, we believe other activity attributable to our investment decisions within fully diversified portfolios has helped to offset those negative impacts. For example,

  • In July, portfolio holding CA Technologies announced it was being acquired by Broadcom at a 20%+ premium to its pre-acquisition price. We exited the position shortly after the announcement at an approximately 30% gain for the year.

  • Also, we have maintained exposure to commodities as an alternative investment, which has helped portfolios as commodities prices have continued to climb (portfolio holding GSCAX returned 10.68% through September 30th).

2. Global Diversification:

By far, the largest impact on performance has been that portfolios contain anything other than US stocks. Global diversification is a fundamental principal of our approach to portfolio management, but this year has been quite a test of that principal. The unusual behavior of markets has prompted us to re-evaluate our approach, to consider whether our underlying assumptions are still valid. Is portfolio diversification a good thing? Are US stocks the only investment worth holding over the long-term?

Is portfolio diversification a good thing?

Despite how being diversified has played out so far this year, we believe the answer is: yes, it is. We often remind our clients that “your portfolio is not the market.” Stock market movement should not have a 1-for-1 impact on portfolios, because portfolios are diversified across several asset classes in large part to prevent any holdings from having an out sized impact on the entire portfolio. But, in years like this one when the performance of one asset class far exceeds all others, the idea that “your portfolio is not the market” can feel like a bad thing.

But, we remain diversified because while asset-class returns are predictably cyclical, the dynamics of those cycles (i.e. When? How much? And How Long?) are less predictable over shorter time periods. The table below shows benchmark returns of major asset classes and market segments annually since 2007. One thing made clear by this table is that it is unlikely for any asset class, including US stocks, to remain in the same position relative to others from year-to-year.

It is normal for returns amongst and between various asset classes to differ. Capturing the differences in direction (up vs. down) and magnitude (up-more/down-more) is a major benefit of portfolio diversification over time. What is different about this year is the difference in direction of US stocks and almost everything-else.

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Are US stocks the only investment worth holding over the long-term?

It has been difficult over the last few years to view diversification as a good thing: like taking antibiotics after you already feel better. Each day, we along with everyone else are fed the idea that market-behavior can be summed-up by the movement in one or two indexes. The “market” for most people means either the Dow Jones Industrial Average or the S&P 500 index. Many investors assume that those indexes are a proxy for portfolio performance because they are the benchmarks that media outlets traditionally reference when discussing financial markets on a daily basis.

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The problem is that those indexes only include the largest companies within one country (the US), which in the case of the S&P 500 companies:

  • Represent over 77% of total US stocks’ market capitalization, but

  • Represent less than 36% of the total market value of stocks listed on global exchanges, and

  • Only 8% of the global market value of stocks and bonds.

We can lose sight of the fact that the global markets are much more than a handful of stocks in our home country. Additionally, the fact that these companies are from our home can make us more comfortable with them, regardless of whether they are good investments or not (a.k.a. Home-Country Bias). This is why the average investor has historically allocated over 80% of the equity portion of their portfolios to large cap US stocks. But, the usefulness of non-US stocks as a diversifier should be judged by more than the most recent year or even few years. In his Wall Street Journal column “The Intelligent Investor” Jason Zweig recently noted:

“The U.S. was among the worst-performing stock markets worldwide in the 1970s and the 2000s; it also earned lower returns than the average international market in the 1980s… even over the decade through December 2007, U.S. stocks lagged the rest of the world by an annualized average of 3.1 percentage points. No one can say when that might happen again. Chances are it will. Markets tend to lose their dominance right around the time they seem most irresistible.”

Excluding the rest of the world would have worked great in a year like this one, but is less-than-helpful in a year like 2017 when Emerging Markets and Developed Markets stocks in aggregate returned over two times more than US stocks. Again, what grabs our attention is the uniformity and direction of the difference between US stocks and everything else. We analyzed data since 1995 for major asset classes to determine how many other times U.S. Stock returns have been positive while returns of everything-else have been negative over 9-month periods. The answer: NONE. In fact, there has only been one other 9-month period when returns for all classes including US stocks were negative: April through December of 2015.

Can we expect this dominance to continue, enough to shun all other categories? Are all other asset classes that unattractive, and is the case for US stocks so compelling, that one will continue to shine while the others decline?

There are some convincing arguments for that position:

  • Interest rates are on an upward trajectory, which should cause bond prices to continue to decline over time.

  • The economy is still running hot on all cylinders, nearly 10 years into the post-2008 recovery and expansion.

  • 2017 tax reform should make companies more profitable, all else the same, and provisions regarding repatriation of overseas profits along with reinvestment of earnings should result in an increase in productivity and capacity.

  • The US is initiating trade-reform across the globe in an attempt to level the playing field for US companies and strengthen our competitive position within the global economy.

  • By many measures, US stocks in aggregate are not over-valued. So, there is still “room to run.”

While all of those points make sense, there are usually two sides to each argument:

  • As yields increase, bonds become a more attractive investment relative to stocks. Stocks’ increase over the past few years is due to historically-low interest rates, driving savers to take more risk than they prefer in order to achieve a reasonable return. As bond yields rise, investors will flock to the relatively higher predictability and stability of bonds.

  • The longest economic expansion on record was the 120 months between March, 1991 and March, 2001. The next-longest was 106 months from 1961-1969. The current expansion has lasted 111 months so far. How much longer will it last?

  • The current administration’s approach to trade reform, could result in retaliatory measures, putting US companies at a disadvantage with major trade partners.

    • On the other hand, successful trade reform could drive the value of the dollar higher to a point where, ironically, imported goods become even cheaper.

  • By many measures, US stocks are fully to slightly over-valued, suggesting that investors should expect returns at the lower-end of historical ranges over the next 5-10 years.

We see the merits of both sides of the issue. There is no clear-cut answer, but we can look to the past for clues about how this story will progress…

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On a historical, risk-adjusted basis, US stocks have never looked better, but both risk and return tend to revert to their means over time. From 1950–2006, stocks returned 8.1% annually, compared to 14.5% annually over the trailing seven years. Note that neither of those time periods includes the -38% decline during 2008. Annual volatility in returns, has been about 30% below its long-term levels since 2011.

The last seven years have lulled many investors into the belief that US stocks are superior to all others, and that we should always expect high returns and low volatility. A longer-term perspective on US stock market behavior indicates that the reverse is true: Volatility has historically been higher than returns over longer time horizons.

By contrast, international stocks have performed poorly relative to US stocks so far this year; far below their historical averages. Yet, they exhibit valuations on the cheaper end of their historical ranges along with continuing growth in revenues and earnings. Expected growth in profits for developed and emerging market stocks are both within a few percentage points of what is expected for the S&P 500. Comparable growth in Non-US earnings becomes even more significant when we consider that they will have neither the benefit of sweepingly positive tax reform, nor the hoped-for benefits of aggressive US trade policies.

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Bottom-line: international stocks are on sale, and US stocks are not. It can be difficult to follow facts rather than feelings given the recent behavior of international stocks but, as investor Mark Yusko put it:

“Investing is the only business I know, that when things go on sale, people run out of the store.”

As this quote suggests, investor behavior has an undeniable impact on market behavior. Our process relies heavily upon objective analysis of factual financial data – we favor facts over feelings. At times, our performance will differ from the market because markets tend to abandon facts for feelings when feelings are dominated by the fear of missing out. We are not able to predict when prices will realign with fundamentals, but we have conviction that they will do so and that the discomfort of missing some of the short-term gains in US stocks will be outweighed by the long-term benefits of diversification.

Conditions can change quickly, and we strive as a team to be ready and able to make changes as quickly as necessary. We adhere to our investment process that relies on proper diversification amongst asset classes; systematic rebalancing of portfolios to keep allocations in-line; diligent research and analysis to evaluate and adjust positions when necessary; and frequent communication with you, our clients, to make sure we understand and stay updated on your objectives. We do not take lightly your patience or the trust you place in us as advisors, and we look forward to speaking with you soon.

Matt A. Morley, CVA, CEPA
Chief Investment Officer

CommentariesMatt Morley