Oct 10, 2018 3rd Quarter 2018 Commentary – The Death of Diversification?

Market Summary

The third quarter of 2018 was the best quarter for U.S. stocks (as measured by the S&P 500 Index) in nearly five years. Tax cuts continued to push U.S. corporate profits higher with corporate America on track for another quarter of 20% growth in the third quarter[1]. The S&P 500 Index reached an all-time high during the quarter despite disappointing returns from other major asset classes. Continued trade tensions with China and a stronger U.S. dollar, hurt returns in developed international and emerging markets assets. The quarter marked the longest bull market on record (113 months and counting) in the United States, surpassing the 1990-2000 bull market. The current bull market began on March 9, 2009. Nearly nine and-a-half years later, the S&P 500 has rallied 323%[2].

Investors continued to prefer technology and faster-growing companies, as the S&P 500 Growth Index returned 9.3% in the quarter versus 5.9% posted by the S&P 500 Value Index. This brought the year-to-date difference between the two indexes to 13.7%[3].  All sectors within the S&P 500 Index were positive with health care leading the way. Two tech companies, Apple and Amazon, made history during the quarter as they became the first companies with trillion-dollar market capitalizations.

The U.S. economy remained strong during the quarter, driven by robust manufacturing activity and continued job growth. Both business and consumer sentiment surveys were near record highs and inflation was moderate. Although most U.S. economic data reflected a solid backdrop, the housing and auto markets cooled, tariffs started to curb some business investment, and growth in Europe slowed. While the trade disputes focus mainly on the U.S. and China it seems the European Union has the most to lose. Trade accounts for 86% of Gross Domestic Product in the European Union, compared to just 27% in the United States and 38% China[4].

Given the overall positive economic backdrop, it was not surprising to see the Federal Reserve raise rates to 2.25%. Long-term rates have moved up slowly compared to shorter-term rates and the result is an increasingly flat yield curve. Most types of bonds posted flat returns in the quarter and were down year to date. Below are returns for the major asset classes[5].

 

The Death of Diversification

Does it make sense to invest anywhere but in U.S. equities? After all, U.S. economic data has been meaningfully stronger than many foreign countries. For example, the unemployment rate in the U.S. was at its lowest level in nearly 50 years[7], U.S. manufacturing and services data were at their highest levels in nearly 15 years[8] and U.S. corporate profits were at their all-time highs[9].

This strong economic and fundamental data has carried over to strong U.S. stock performance in recent years and has made any attempt at investing outside the U.S. look foolish. Examine the table above and you’ll see that U.S. stocks (both large and small) have outperformed the other listed asset classes in every listed time period. This year has been more of the same. Take the MSCI World Index for example[10]. 62% of the index is comprised of U.S. stocks yet the U.S. accounts for 120% of the return in 2018 (see chart below)[11] In a nutshell, diversification away from U.S. stocks has not worked in recent years.

To make diversification sound even less attractive, the S&P 500 has outperformed international stocks, as measured by the MSCI World ex USA Index, over the past one, three, five, 10, 15, 20, 25, 30, 35, 40 and 45 years[12]. The graph below shows performance of US stocks (blue line), emerging market stocks (red line), foreign developed stocks (green line) and US bonds (yellow line) from 2009 through the end of the quarter[13]. U.S. stocks really began their dominant performance around 2013 and have not looked back. According to the Financial times, “the relative performance of the S&P 500 versus the rest of the world is now at its most extreme level since 1970.”[14]

 

While the diversification benefits of embracing a global investment opportunity set are well documented, these numbers seem to indicate we’d be crazy to diversify into anything but U.S. equities. Of course, it’s easy to say we should only hold U.S. equities with the benefit of hindsight. It’s a much more difficult task to do so before the outperformance of U.S. equities. So, what does the next five years have in store? We accept that we do not know the answer, which is largely the point of diversification. Diversification can reduce the impact of any one region or market segment and better positions portfolios to capture returns wherever those returns occur. We continue to think diversification makes sense, arguably more so now than ever.

 

Reason 1: Timing Matters

Looking back in time from today, U.S. stocks seem to have dominated over the long run only because they have done so extraordinarily well in recent years. Lofted by a combination of quantitative easing, record corporate profits and a strong U.S. dollar, U.S. stocks have risen much more than the rest of the world over the last 10 years. This has obscured their historical record. The table below compares U.S. stocks to foreign developed stocks[15]. Foreign stocks had a higher annualized return from 1971 through 2007. It is only because of last 10 years that U.S. stocks have a higher annualized return.

In addition, emerging markets equities have outperformed U.S. equities over the long run. From 1988 (the earliest data we have for emerging markets) through 2017, the S&P 500 earned average annual returns of 12.2% per year, while the MSCI Emerging Markets Index averaged 16.3% per year[16]. Over the last 10 years, U.S. stocks have outperformed emerging markets by nearly 7% per year.

Taking a long-term view and understanding that extended periods of lagging results have tended to be followed by extended periods of higher relative returns shines perspective on relative returns. The chart below shows the relative 3-year rolling returns between the MSCI EAFE vs the S&P 500 Index through from 1973 through 2017. You can see that this is the longest cycle of U.S. outperformance since 1973. Including 2018 returns, the U.S. outperformance has lasted 101 months and counting. Selling international stocks and buying U.S. stocks at this point in the cycle is a bet that the record long U.S. outperformance will continue rather than revert to the mean.

 

Reason 2: Valuations

As U.S. equity outperformance has widened, a significant valuation gap has emerged between U.S. stocks and non-U.S. stocks. We reviewed four different valuation indicators in four different regions of the world in the table below.[17]

The lower the ratio, the lower the region is priced relative to earnings (E), cashflow (C), book value (B), or sales (S). The U.S. has the highest valuations in all four indicators. Valuations matter because they have a strong correlation to future long-term returns even though they do not tell us anything about returns in the shorter term. Generally, the lower the valuation ratio, the better the future long-term returns[18]. Based on valuations, we expect better future long-term returns from non-U.S. stocks than U.S. stocks.

 

Reason 3: Global Market Cap

International stocks represent a sizable fraction of the world’s equity market wealth. The cartogram below illustrates the balance of equity investment opportunities around the world as of December 31, 2017[19]. The size of each country has been adjusted to reflect its total relative market capitalization[20]. Many investors tend to use U.S. equities as a performance benchmark even though the global market cap for stocks is roughly 52% U.S. stocks, 35% foreign developed stocks and 13% emerging market stocks.

Furthermore, the table below shows there are nearly four times as many stocks in non-U.S. markets (combining Developed Markets ex US and Emerging Markets) as there are in the U.S.[21] Also, most emerging markets, compared with developed markets, have a stronger tailwind from more attractive demographics and a rising middle class.

 

 

Summary

It’s important to understand why diversification still makes sense, especially when times have been as good as they have in U.S. equities. A globally diversified strategy will always perform somewhere in the middle of its component asset classes. Thus, diversifying globally can enhance the stability of returns and the reliability of outcomes. Focusing only on recent performance of a top performing asset class can drive us to harmful decisions. This is when disciplined investing becomes even more important. Diversifying an investment portfolio around the globe is part of disciplined investing. To quote Wayne Gretzky, “Skate to where the puck is going, not where it has been.”

Next quarter we will revisit the case for owning bonds and alternatives as part of a diversified portfolio.

As always, please call if you have any questions or would like to discuss your account in more detail.

 


[1] Based on Thomson Reuters’ estimates
[2]LPL Research, 8/21/2018
[3] YTD S&P 500 Growth Index 17.24% vs YTD S&P 500 Value Index 3.5%. Data per Morningstar
[4] Capital Group
[5] Data from Morningstar
[6] The Alternatives benchmark includes 50% SG Trend Index, 25% Swiss Re Global Cat Bond TR Index and 25% CBOE Eurekahedge Short Volatility Hedge Fund Index
[7] JPMorgan, Guide to the Markets, as of 9/3-/18
[8] As measured by the ISM Manufacturing Report and ISM Non-Manufacturing Report
[9] https://tradingeconomics.com/united-states/corporate-profits
[10] MSCI.com, as of 9/30/2018
[11] Baird Wealth Management
[12] AJO, monthly market performance. http://www.ajopartners.com/wp-content/uploads/2018/09/18_09.pdf
[13] US Stocks represented by SPDR S&P 500 ETF, emerging market stocks represented by iShares MSCI Emerging Markets ETF, foreign developed stocks represented by iShares MSCI EAFE ETF and US bonds represented by iShares Core US Agg Bond ETF
[14] “Runaway US stock market prompts investors to look overseas” 9/25/2018
[15] Data from Morningstar
[16] ETF.com, “Why Emerging Markets Matter”, October 8, 2018
[17] Source: StarCapital, Thomson Reuters Datastream, as of 8/31/2018. The present valuation ratios are market capitalization weighted. PE (Price to Earnings Ratio), PC (Price to Cashflow Ratio) and PS (Price to Sales Ratio) are based on trailing 12-month values. PB (Price to Book Ratio) is based on the most recent company financial statements.
[18] Based on studies by Ned Davis Research, Robert Shiller, Research Affiliates and others
[19 Cartogram from Dimensional Fund Advisors
[20] A country’s equity market capitalization, or market cap, reflects the total value of shares issued by all publicly traded companies and is calculated as share price times the number of shares outstanding.
[21] Data from Dimensional Fund Advisors

IMPORTANT DISCLOSURES

Leonard Rickey Investment Advisors, PLLC (“LRIA”), is an SEC registered investment adviser located in the State of Washington. Registration does not imply a certain level of skill or training. For information pertaining to the registration status of LRIA, please contact LRIA or refer to the Investment Adviser Public Disclosure website (www.adviserinfo.sec.gov).

This newsletter is provided for general information only and contains information that is not suitable for everyone. As such, nothing herein should be construed as the provision of specific investment advice or recommendations for any individual.  To determine which investments may be appropriate for you, consult your financial advisor prior to investing. All performance referenced herein is historical in nature and is not an indication of or a guarantee of future results. All indices are unmanaged and cannot be invested into directly. Unmanaged index returns do not reflect fees, expenses, or sales charges. Index performance is not indicative of the performance of any investment.

Your experience may vary according to your individual circumstances and there can be no assurance that LRIA will be able to achieve similar results for all clients in comparable situations or that any particular strategy or investment will prove profitable.   As investment returns, inflation, taxes and other economic conditions vary, your actual results may vary significantly. The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful. There is no guarantee that the views and opinions expressed herein will come to pass. This newsletter contains information derived from third party sources. Although we believe these third party sources to be reliable, we make no representations as to the accuracy or completeness of any information prepared by any unaffiliated third party incorporated herein, and take no responsibility therefore.

Stock investing includes numerous specific risks including the fluctuations of dividend, loss of principal, and potential illiquidity of the investment in a falling market. International and emerging markets investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors. Small cap stocks may be subject to a higher degree of risk than more established companies’ securities. The illiquidity of the small cap market may adversely affect the value of these investments. Information presented herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security. This newsletter should not be regarded as a complete analysis of the subjects discussed. Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values and yields will decline as interest rates rise and bonds are subject to availability and change in price. The risks associated with investment-grade corporate bonds are considered significantly higher than those associated with first-class government bonds. The difference between rates for first-class government bonds and investment-grade bonds is called investment-grade spread. The range of this spread is an indicator of the market’s belief in the stability of the economy. The fast price swings in commodities and currencies can result in significant volatility in an investor’s holdings. There is no assurance that the techniques and strategies discussed are suitable for all investors or will yield positive outcomes. The Value investments can perform differently from the market as a whole. They can remain undervalued by the market for long periods of time.

Any projections, forecasts and estimates, including without limitation any statement using “expect” or “believe” or any variation of either term or a similar term, contained here are forward-looking statements and are based upon certain current assumptions, beliefs and expectations that LRIA considers reasonable or that the applicable third parties have identified as such. Forward-looking statements are necessarily speculative in nature, and it can be expected that some or all of the assumptions or beliefs underlying the forward-looking statements will not materialize or will vary significantly from actual results or outcomes. Some important factors that could cause actual results or outcomes to differ materially from those in any forward-looking statements include, among others, changes in interest rates and general economic conditions in the U.S. and globally, changes in the liquidity available in the market, change and volatility in the value of the U.S. dollar, market volatility and distressed credit markets, and other market, financial or legal uncertainties. Consequently, the inclusion of forward-looking statements herein should not be regarded as a representation by LRIA or any other person or entity of the outcomes or results that will be achieved by following any recommendations contained herein. While the forward-looking statements here reflect estimates, expectations and beliefs, they are not guarantees of future performance or outcomes. LRIA has no obligation to update or otherwise revise any forward-looking statements, including any revisions to reflect changes in economic conditions or other circumstances arising after the date hereof or to reflect the occurrence of events (whether anticipated or unanticipated), even if the underlying assumptions do not come to fruition. Opinions expressed herein are subject to change without notice and do not necessarily take into account the particular investment objectives, financial situations, or particular needs of all investors. For additional information about LRIA, including fees and services, please contact us for our Form ADV disclosure brochure using our contact information herein. Please read the disclosure brochure carefully before you invest or send money.

INDEX DEFINITIONS

The Barclays Aggregate Bond Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment-grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities.

The Standard & Poor’s 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. It cannot be invested into directly.

The Russell 2000 Index is an unmanaged index generally representative of the 2,000 smallest companies in the Russell Index, which represents approximately 10% of the total market capitalization of the Russell 3000 Index.

The MSCI Emerging Markets Index is a float-adjusted market capitalization index that consists of indices of approximately 800 stocks and is designed to measure equity market performance in 23 emerging economies: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, , Peru, Philippines, Poland, Qatar, Russia, South Africa, Taiwan, Thailand, Turkey, and the United Arab Emirates.

The MSCI EAFE (Europe, Australasia, Far East) Index is a free float-adjusted market capitalization index of approximately 900 stocks and is designed to measure equity market performance in 21 developed market countries outside of North America.

The Nasdaq Composite Index is the market capitalization-weighted index of over 3,000 domestic and international based common type stocks listed on the Nasdaq stock exchange.

The S&P Growth Index consists of stocks within the S&P 500 Index that exhibit strong growth characteristics as measured by three factors: sales growth, the ratio of earnings change to price, and momentum.

The S&P Value Index consists of stocks within the S&P 500 Index that exhibit strong value characteristics as measured by three factors: the ratios of book value, earnings, and sales to price.

MSCI World Index is a broad global equity index that represents large and mid-cap equity performance across 23 developed markets countries. It covers approximately 85% of the free float-adjusted market capitalization in each country and MSCI World Index does not offer exposure to emerging markets.

The MSCI World ex USA Index captures large and mid cap representation across 22 of 23 Developed Markets (DM) countries*–excluding the United States. With 1,015 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.

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Important Disclosures

Leonard Rickey Investment Advisors, PLLC (“LRIA”), is an SEC registered investment adviser located in the State of Washington. Registration does not imply a certain level of skill or training. For information pertaining to the registration status of LRIA, please contact LRIA or refer to the Investment Adviser Public Disclosure website (www.adviserinfo.sec.gov).

This is provided for general information only and contains information that is not suitable for everyone. As such, nothing herein should be construed as the provision of specific investment advice or recommendations for any individual. To determine which investments may be appropriate for you, consult your financial advisor prior to investing. There is no guarantee that the views and opinions expressed herein will come to pass. This newsletter contains information derived from third party sources. Although we believe these third-party sources to be reliable, we make no representations as to the accuracy or completeness of any information prepared by any unaffiliated third party incorporated herein and take no responsibility therefore.

Any projections, forecasts and estimates, including without limitation any statement using “expect” or “believe” or any variation of either term or a similar term, contained here are forward-looking statements and are based upon certain current assumptions, beliefs and expectations that LRIA considers reasonable or that the applicable third parties have identified as such. Forward-looking statements are necessarily speculative in nature, and it can be expected that some or all of the assumptions or beliefs underlying the forward-looking statements will not materialize or will vary significantly from actual results or outcomes. Some important factors that could cause actual results or outcomes to differ materially from those in any forward-looking statements include, among others, changes in interest rates and general economic conditions in the U.S. and globally, changes in the liquidity available in the market, change and volatility in the value of the U.S. dollar, market volatility and distressed credit markets, and other market, financial or legal uncertainties. Consequently, the inclusion of forward-looking statements herein should not be regarded as a representation by LRIA or any other person or entity of the outcomes or results that will be achieved by following any recommendations contained herein. While the forward-looking statements here reflect estimates, expectations and beliefs, they are not guarantees of future performance or outcomes. LRIA has no obligation to update or otherwise revise any forward-looking statements, including any revisions to reflect changes in economic conditions or other circumstances arising after the date hereof or to reflect the occurrence of events (whether anticipated or unanticipated), even if the underlying assumptions do not come to fruition. Opinions expressed herein are subject to change without notice and do not necessarily take into account the particular investment objectives, financial situations, or particular needs of all investors.

For additional information about LRIA, including fees and services, please contact us for our Form ADV disclosure brochure using our contact information herein. Please read the disclosure brochure carefully before you invest or send money.