The U.S. stock market rallied to new highs last quarter. Investors appeared to be nervous leading up to the election, but whatever concerns they had quickly faded against the promise of lower corporate tax rates and reduced regulation. Investors didn’t buy everything, however. They enthusiastically bought smaller companies and those more sensitive to an economic upturn but they seemingly lost interest in larger, safer companies. The Russell 2000 small cap index rose 8.83% last quarter and many financial services companies gained more than twice that. On the other hand, the NASDAQ 100 Index rose just 0.09%, and dozens of funds in the large cap growth category actually lost money in the 4th quarter. Both Amazon and Facebook dropped more than 10% as technology fell out of favor. So we have to look at the S&P 500’s 3.82% quarterly return as averaging out some spectacular performance and some very dismal returns.[i] See Chart. [ii] Please note that on the chart we display the returns of ETFs that track the underlying indices because those are the returns an investor would experience. Please see the endnote for more information.
Whatever one might say about U.S. stock performance, however, it was quite a bit better than what one received elsewhere. In fact, every single region outside the U.S. experienced a decline last quarter in dollar terms – that includes Europe, Asia (including and excluding Japan), Latin America, and emerging markets as a whole. And mind you, even before the quarter began the U.S. had been soundly trouncing world markets. The ten year annualized return on U.S. stocks is 7.07%, according to Russell,[iii] while the ten year annualized return on stocks outside the U.S. is 0.75% in dollar terms.[iv] That is more than 6.3% every year for ten years! As you can see in Chart 2 the difference in returns is stark.[v] Even if you allow that some of this is due to the effect of a stronger dollar, this has to create, at some point, an incredible opportunity to shift into foreign stocks. U.S. stock out-performance also occurred in the 1990s, leading to a multi-year period of foreign stock strength from 2003 through 2007.
Bonds were also weak last quarter. Interest rates surged on the belief that the Trump Presidency would mean greater economic activity and higher inflation. The Barclay’s Capital Aggregate U.S. Bond index shed -2.98% (the ETF shed -3.12%). Municipal bonds declined even more (the Barclay’s Municipal Index declined -3.62% while the index tracking ETF shed -4.43%) on the idea that a lower tax rate would reduce their attractiveness on an after-tax basis. Foreign also had a rough quarter as the strong dollar hampered securities with foreign currency exposure. High yield corporate bonds managed to eke out a small 0.86% gain. See Chart 3.[vi] After such a poor quarter for bonds, sentiment has understandably become quite poor. This might actually create a bit of a buying opportunity.
It is hard to overstate the change in the market that occurred after the election. Prior to the election the market was defensive, favoring larger companies and defensive industries. After the election, risk was suddenly vigorously embraced. Smaller companies and economically sensitive industries performed much better. A great deal of our activity, therefore, was making sure portfolio were not overly exposed to less volatile, high dividend stocks, which had been so successful in 2015 and early 2016. We bought more small caps and sold some positions that were too defensive to succeed in the new environment, including USMV. We also made several transactions in non-qualified portfolios to reduce realized capital gains or in a few cases to more effectively use a capital loss.
We have been gradually decreasing cash levels in portfolios. All of this has had the impact of making portfolios modestly more aggressive. That said, we are most comfortable owning larger, dividend-paying companies and industries that are a little less economically sensitive because statistically that cuts down on volatility. For that reason, we weren’t predisposed to sell funds that had done very well for years – both in absolute terms and relative to their peers – just because the fad was to bet on a huge recovery.
What surprised us the most when we looked at November’s performance was how different returns were among funds that we didn’t really believe had much of a cyclical or defensive bias. Principal Midcap (PEMGX), for example, is a 5-star Morningstar rated, middle capitalization, fund with a top decile 3, 5, and 10-year ranking in its category. It gained only 0.85% last quarter. T. Rowe Price Capital Appreciation is in the very top 1% in its peer group over the trailing 3, 5, and 10 years and it could only scratch out a meager 0.15%. On the foreign side, MFS International Value is another 5-star, top decline 3, 5, and 10 year fund that had a surprisingly rough (-5.76%) fourth quarter. We did not fully appreciate the extent to which our portfolios expressed a preference for consistent growth over opportunistic growth. We are not going to abandon great funds because they went out of favor for a few months. Everybody underperforms from time to time. We obviously want to know why, and if we know the answer and are satisfied by it, we don’t make a change. If over the next several quarters it becomes apparent that this is truly the dawn of a new economic era then we will make more changes.
I’m going to refrain from making any predictions, because I believe the outlook has never been more uncertain. We have spent the last eight years in a policy regime that emphasized low interest rates as a means of forcing investors to use their cash balances to invest. Investors were generally rewarded, but savers were unquestionably punished. The financial economy (stocks & bonds) did well even as financial services companies themselves were hamstrung by regulation. Main Street (the net worth of the average person) did not do nearly as well, though employment improved dramatically. In any event, the market is predicting that all of this going to change with the new administration and congress. Fiscal policy will replace monetary policy as the main economic lever as Congress in theory now has a President it is willing to work with. Global trading relationships seem certain to change. How this will impact the dollar is uncertain but critical. It is widely expected that corporate tax rates will be slashed. This should improve corporate balance sheets as well as provide more fuel for stock buybacks. Almost certainly, however, the federal budget deficit and debt beyond 2017 will increase.
Until we get more clarity on how all of this will play out, our instinct is to run fairly neutral portfolios, with very little sector exposure and no major interest rate bets. The markets, both stock and bond, have probably overstated the degree to which one individual can change the larger economic forces shaping the globe at this time – the deflationary implications of an aging world population, high and growing government debt burdens, and the increasing use of technology to improve productivity by replacing human workers. Politically, however, one individual can do quite a lot.
The market traded at all-time highs in December. Many clients we spoke with conjured up a mental picture of a rising ocean tide; the idea that all stocks were higher. In reality, you should picture coffee in a mug in a car travelling down a bumpy road. Upon hitting a bump and the level of coffee surged in some areas and plunged in others. Over the five week period between November 4th and December 9th a very large amount of money “sloshed” from bonds and foreign stocks to U.S. stocks. The actual volume of coffee in the mug did not change very much. So if you had a well-diversified globally invested portfolio, then last quarter was entirely unspectacular. Chart 4 highlights the difference in the U.S. stock market (ticker: VTI), the developed economies stock markets (ticker: VEA) and the emerging economies stock markets (ticker: VWO).[vii]
Diversification[viii] is a play on the notion that not everything can have its worst performance simultaneously, because money that comes out of one asset class may go to another. For example, in 2008 almost every asset declined, some quite sharply. However, U.S. Treasury bonds increased 11.34% as investors fled from the risky to the safe.[ix] While diversification is good at helping you avoid the large loss, it will sometimes produce small losses where is might have been possible to avoid them. In a mediocre year like 2015, due to modest weakness in emerging markets and commodities, it actually subtracted from returns.
Diversification is also a hedge on the notion that the asset class we think is going to perform best often doesn’t. In recent years the most popular assets, U.S. stocks and bonds, really have performed well. It is easy at this point to believe that the American economic system is so superior that U.S. securities will always outperform the rest of the world. Experience tells me the outperformance cannot continue in perpetuity. I’ve seen long impressive runs by Japanese stocks (1980’s) and Chinese stocks (2000’s). It seemed at the time that those markets were unstoppable forces. Of course, as we all know those markets because wildly overvalued and eventually re-priced. I often need to remind myself that markets are driven by humans who are subject greed, fear, enthusiasm and despondency. Ultimately all market movements, be they bullish or bearish, are susceptible to those emotions and thus the animal spirit become unsustainable. Keeping some of your eggs in other baskets helps ensure you lose less when the inevitable re-pricing happens. The hardest things to do as a money manager is to remain disciplined and committed to one’s investment strategy, in our case global diversification, after periods of relative underperformance. It is precisely at those times when maximum opportunity is created but it is also the most difficult time to invest.
For our part, we observed the surge in stocks and in the dollar in the days following the election and identified the pockets of greatest strength (small and mid-size stocks, and the industrial, materials, and financial services industries) and greatest weakness (large “blue chip” stocks, and the utility and consumer staples industries). We analyzed our exposure to these asset classes and made changes we felt we were warranted based on relative under or over weights. We believe that markets overreacted in terms of expected 2017 economic growth and that investors will return to less cyclical industries at some point. So far in 2017 bond yields are falling once again and more growth-oriented industries (think info tech and biotech) are performing the best. Regardless, we remain committed to our process of disciplined, globally based investing.
The intent here is to give you an insight into how markets moved over a particular period of time and how diversification plays an important part in our portfolios. Investment decisions always seem easier in retrospect and we are not inclined to chase after sharp market moves. Last quarter the market reacted strongly to the environment it believes will be in place shortly after Inauguration Day, but right now that is all speculation. Those moves might not look good six months from now. You have placed your trust in us to act prudently with your money and we take that trust very seriously. Much like our country’s largest endowments, Trademark pursues a globally diversified portfolio approach because it is the highest standard of practice in the investment management industry.
Please Note – Fee Reduction
We have reduced the fees our clients are charged in several of our asset management programs. The changes are summarized on our Form ADV. Copies of our ADV can be found on our website at www.trademarkfinancial.us/current-disclosures.
Thanks for your continued trust in our management,
Mark Carlton, CFA
[i] Index Return Source: Morningstar Adviser Workstation
[ii] Russell 2000 as measured by iShares Russell 2000 ETF (Ticker: IWM), NASDAQ 100 as measured by PowerShares QQQ ETF (Ticker: QQQ), S&P 500 as measured by iShares Core S&P 500 (Ticker: IVV). Source: YCharts.com. Tracking error, or small differences in the return of the ETF and index, are normal and the result of share creation and redemption, and dividend payments.
[iii] Russell 3000 Index, through 12/31/2016, according to Frank Russell & Associates.
[iv] MSCI EAFE Index, through 12/31/2016, according to Morgan Stanley.
[v] Total returns as measured by iShares Russell 3000 (Ticker: IWV) and iShares MSCI EAFE (Ticker: EFA). Source: YCharts.com
[vi] Total return as measured by iShares Core U.S. Aggregate Bond (Ticker: AGG), SPDR Nuveen Bloomberg Barclay’s Municipal Bond ETF (Ticker: TFI), and iShares iBoxx High Yield Corporate Bond ETF (Ticker: HYG)
[vii] Total return as measured by Vanguard Total Stock Market ETF (ticker: VTI), Vanguard FTSE Developed Markets ETF (VEA) and Vanguard FTSE Emerging Markets ETF (VWO).
[viii] Diversification is a risk management technique that mixes a wide variety of investment within a portfolio. (Hat tip to Investopedia) The idea is that by spreading ones assets among a number of different investments not all will move in the same direction at the same time.
[ix] Total return as measured by Bloomberg Barclay’s Intermediate Term Treasury ETF (ticker: ITE). Source: Morningstar Adviser Workstation
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