There is an old saying that goes “if you don’t like the weather in New England, just wait a few minutes”. This can be true of the capital markets as well, with this year being a prime example. As you might recall from previous quarter market reviews (Q1, Q2), this past year has had numerous bouts of volatility, allowing all of the expected doomsayers to have their day in the spotlight on CNBC and other TV channels. These bears were out in January and then their close friends, the “Sell in May” crowd, were out in full force this summer with extra uncertainty from Britain’s Brexit vote, which provided yet another excuse to allow erratic behavior for many market participants. A few interesting circumstances have developed along the way over this past year: the U.S. dollar has stabilized (from its rapid ascent), oil has found a trading range that is more sustainable for Energy companies to stay afloat, the Fed has provided dovish language about rate increases, macro-economic data has appeared to remain fairly positive both in the U.S. and across many other markets around the globe and prices of most stocks and bonds have risen.
One of the key challenges for all investors, including advisors here at Bridgeworth, is being able to sort through the noise and all the data that is readily available today in order to focus on the key drivers of not only risk and return, but also economic changes and policies. One constant we feel seems to remain true during these challenging times … watching TV headlines or listening to mainstream media reports, designed to fuel emotions, can lead investors to make bad investment decisions.
Looking forward, our view is fairly similar to what it has been over the past year. That is, many asset classes, whether they be different classifications of stocks or bonds, are pretty expensive on a historical basis. This issue has primarily occurred due to unprecedented low interest rates, not just in the U.S., but around the globe. While some analysts may use words like “bubble”, this is not a term we feel is appropriate in the traditional sense of how it has been used in the past. We feel an asset bubble is typically caused by unknowing investors piling into an asset, with hopes that another investor will buy that asset for more money in the future, with no real concern for risk or no belief that fundamentals would ever allow that to actually happen. We have seen bubbles in tech stocks in the late ‘90s and in the housing market about a decade ago. Today, we see no signs of unfettered optimism driving asset classes, and see understandable reasons for the current valuations. Our current view is that the developed economies will continue to improve and that the Federal Reserve will remain dovish (keeping interest rates low). Somewhat higher valuations on most asset classes means that, going forward, returns may be more modest than in past years, when valuations were lower.
You may find it interesting that we haven’t yet mentioned Presidential politics; here is why. First, the party of the President alone is less important than the balance of power between Congress and the White House. If Hillary wins, we feel it is unlikely that the House would also be retaken by the Democrats (though they may take the Senate). This would likely lead to more of the same, gridlock. If Trump were to win, the Republicans might still lose the Senate, in which case gridlock may be again on the table. Only if a clean sweep were to occur, in which one party wins both the presidency and control of both houses of Congress, could there be a path to substantial change (tax, regulation, immigration, healthcare reform, etc.). This is not to say that any one of these outcomes will not have an impact, it’s just that the possibilities are so numerous and incalculable that markets do not tend to really trade on one particular outcome. However, markets don’t like uncertainty and there is currently plenty of it. As the uncertainty begins to fade, markets generally respond in a positive manner. Since Trump is a “change” candidate, his Presidency represents a bit more uncertainty for markets. In the short-run, it would not be surprising if markets were to remain volatile; however, as mentioned earlier, these headlining-grabbing events are typically not worth trying to speculate about. Instead, issues like the path of interest rates may be far more meaningful to markets in the short-run than which candidate attains the Oval Office.
We had a small glimpse of how the markets might respond to rate increases when the Fed raised rates in December of 2015 … the U.S. dollar strengthened, commodity prices sank, and Emerging Markets sold off. We feel the Fed recognizes that it must move at a glacial pace in order to not upset the global rate environment and to prevent the U.S. dollar from strengthening substantially, potentially having negative effects on markets around the world. With stock and bond valuations very high, prices are very sensitive to any rate increases that aren’t viewed by investors as fully justified. For those afraid that rates will increase and cause havoc, there are a few items to consider. First, we believe that the Federal Reserve is fully aware of their predicament. Secondly, interest rates around the globe are near or below zero, causing demand for U.S. bonds to be tremendous. These foreign buyers of U.S. bonds will put a cap on how much domestic rates can increase, even if the Fed were to start trying to push them up. Lastly, while the U.S. economic picture is not dire, conditions are not so robust in either the growth or inflation department that any substantial moves appear imminent. With our “base case” view being that global economies stay in a low/slow growth mode, with no recessions imminent (we don’t see any of the excesses that normally lead to recessions like over-spending, over-borrowing, etc.), our portfolio positioning remains pretty much unchanged for now.
Looking more closely at U.S. stocks, comparing this year to last, is also an interesting exercise. Many of the sectors of the market that performed poorly last year (utilities, basic materials, industrials, telecom), have led the indexes this year. There are reasons we feel for this beyond actual company performance. Many times the performance difference stem from two simple ideas: First, when something becomes cheaper it often becomes more attractive from a valuation standpoint (so bad performance can often precede good performance). Secondly, performance can be impacted by the perceived safety of certain types of stocks. In times of volatility, investors often prefer stocks that have “stable” revenues. So, if you think the market may be volatile or heading south, some investors choose to buy “safer” stocks. This continues until these “safety” stocks get expensive, at which time investors often sell them in favor of another stock or sector that is now more attractively priced. As you can guess, trying to play this game back and forth can result in something similar to switching lanes of traffic, you often move at the wrong time and pay a penalty for this flip-flopping mentality. We balance our portfolios with stocks of different types, with only modest overweights and underweights to sectors that we view as having enough valuation discrepancy (or some other catalyst) to cause performance to be impacted over a long time-frame. The S&P 500 was up 7.85% through September 30th. The Russell 2000 was up 11.46% during the same time period.
International and Emerging Market Stocks
It has been several years since Developed International or Emerging Market stocks have had “good” performance relative to U.S. stocks. Developed International stocks have been plagued by a European double-dip recession (after 2008-2009), while we feel political/government debt issues have kept banks and investors wary and economic activity low. Just as important but often overlooked in our opinion, U.S. investors’ returns have also been hurt by the U.S. dollar strengthening against other currencies. As we have stated for a few years now, the picture does seem to be brightening but remains muted by continued uncertainties related to events like Brexit (Britain leaving the European Union). For investors who look at fundamentals and not headlines, we believe there are reasons to be optimistic about specific businesses in these markets. Emerging markets likewise have had an air of fear, keeping a lid on market growth, much of which has to do with U.S. interest rate policy. These fears have become somewhat tempered and economic signs are modestly positive, which has fueled recent market rises driven by investors looking for cheap stocks. The MSCI EAFE index was up 1.73% and the MSCI Emerging Market index was up 16.02% through September 30th.
As we’ve mentioned before, the fear of another “bubble” is heard regarding current bond prices. With interest rates at historically unprecedented lows, it is hard to argue that bond prices aren’t high. As longer-term rates have moved down over the past year it is less probable that investors will see a repeat of the bond returns we are currently experiencing. However, the notion of a “bubble” insinuates that it might “pop”. I suggest that this bubble popping might be more likened to a slow leak, as worldwide demand for yield may continue to provide buyers for bonds. An extreme example: let’s say that country “X” issued a 10-year bond today at 5% (this is high in today’s rate environment). Assuming that everyone had reasonable comfort that country “X” could pay the money back, investors would buy that bond and drive the price so high on the bond that its yield would no longer be 5%, but much lower and very close to other 10-year bonds with similar credit risk. We are all in this together and rates are unlikely to go anywhere fast. The Barclay’s Aggregate Bond index was up 5.8% and the Markit iBoxx US High Yield Index was up 13.76% through September 30th.
Focus on What We Can Control
As professional investors, our job is to position portfolios so that clients get compensated in return for the risks they are taking. We attempt to weight portfolios in such a way that they have a targeted amount of risk (to meet a client’s preference and objectives) while aiming for the highest expected return. We make these decisions thoughtfully, test and measure our selections continually, and stand ready to change our positioning if any facts change. Importantly, we must recognize that this approach is not the same exercise that those on TV or other investors may be engaged in. There are investors who try to be right “in time” and not really focused on “over time”. Our goal is to assist our clients in working towards their goals, as opposed to trying to guess what is going to happen in the markets over the short run. Thankfully, investing is also not the only value-added service we offer; we also have planning strategies and disciplines that can complement our investing efforts. Ultimately, your success should not be driven, nor should it be judged, by an investment benchmark like the S&P 500, whose risk profile changes constantly. Instead, your success is reflected by your progress towards your own individual goals. We thank you for your trust in us as we take seriously our role as stewards of your capital.
This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of Oct. 17, 2016, and may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and nonproprietary sources deemed by Bridgeworth, LLC to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. Past performance is no guarantee of future results. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader. Investment involves risks.
International investing involves additional risks, including risks related to foreign currency, limited liquidity, less government regulation and the possibility of substantial volatility due to adverse political, economic or other developments.
The two main risks related to fixed income investing are interest rate risk and credit risk. Typically, when interest rates rise, there is a corresponding decline in the market value of bonds. Credit risk refers to the possibility that the issuer of the bond will not be able to make principal and interest payments.
Any securities, indices, and other financial benchmarks shown are provided for illustrative purposes only, and reflect reinvestment of income, dividends, and other earnings. They do not reflect the deduction of advisory fees. Investment products are subject to investment risk, including possible loss of the principle amount invested. You cannot invest directly in an index.
Neither Bridgeworth nor its content providers are responsible for any damages or losses arising from any use of this information. To determine which investments may be appropriate for you, consult your financial advisor prior to investing.
Investment advice offered through Bridgeworth, LLC, SEC Registered Investment Advisor.