Markets abroad led stocks higher in Q2, continuing the trend from Q1 as signs of global economic activity improved further. Developed markets outside the US gained over 6.4% while the S&P 500 chugged along gaining 3.1%. So far for 2017, emerging markets have outpaced everything, gaining over 18%.
The US dollar fell 4.8% in Q2, making it the first major asset to give back its post-election gains. Stocks are up over 15% since the US election, and the 10-Year Treasury yield is 0.49% higher over the same period. The current economic expansion continues despite more twitter wars than tax reform or infrastructure spending in Washington. The Fed has hiked short-term rates three times and earnings growth has broadly exceeded expectations. It’s business as usual outside the beltway.
First it was FANG, then it was FAANG, and now its FAAMG (short for Facebook, Amazon, Apple, Microsoft and Google). These acronyms refer to the group of technology-related stocks that accounted for roughly 13% of the S&P’s gains this year. The usual conclusion is this lack of breadth in the stock market is somehow either unhealthy or an excuse for poor active performance. While this makes for an interesting story, such concentrated performance is not that unusual. The folks at AQR studied this phenomenon and found that there is always a handful of stocks that exert extra influence on the index return. So as for unhealthy, well, it’s actually pretty normal. The fact the constituents have changed (Apple was later added and then Netflix was replaced by Microsoft) should be the tip-off this was mostly a data mining exercise all along.
Too Much of a Good Thing?
Global stocks have outperformed this year, driven by higher economic growth and relief over an easing of political uncertainty in France. The world’s central banks have also noticed, as yields across the globe have risen in response to indications it may be time to ease off the monetary accelerator. Global stocks are off their highs, bucking the typical yields up/stocks up relationship associated with higher growth. Investors are likely recalling the 2013 “taper tantrum,” when 10-year Treasury rates quickly rose after Ben Bernanke indicated the Fed would reduce asset purchases.
The usual fear is central banks tap the brakes too hard, tightening financial conditions, and throwing a wrench into the economy. While this type of cat and mouse game between central banks and financial markets usually creates some volatility, fears of a complete derailment are usually overblown. It is important to remember that while central banks may be shifting away from positions of ultra-loose policy, we are still a way from what many economists would call restrictive monetary policy. While financial markets may protest at the outset of a shift in policy, it takes more to shock the economy.
Investing in an Uncertain World
The world is still, as it has always been, a changing place with no sure bets for the future. We first wrote those words 20 years ago, and they still resonate. The problems we face have changed, but the challenge for investors remains much the same: how to balance risk and return in an uncertain world and build an effective portfolio that achieves personal financial goals and allows one to sleep well. Over the next few months, we will update our series of reports on how to build an effective investment portfolio, or what we call “a portfolio you can live with.”
A core set of beliefs, or investment philosophy, is the first step in establishing a successful process. It lays the foundation for the types of investments to include and how to evaluate different opportunities. Without this grounding, investors are susceptible to the latest costly Wall Street scheme or are driven to make emotional decisions at the most inopportune times.
Our basic philosophy is continually tested and has evolved over time to adjust to long-term structural changes in the markets. We don’t pretend to have all the answers, but we are not convinced there is a better approach offering any reasonable chance of success. The key is finding a philosophy and strategy you can stick with, allowing you to weather the inevitable ups and downs of the markets and maximize the chances of meeting your long-term financial goals.
- Fundamentally, investing is a long-term process. In the short-run, financial markets fluctuate and overreact to current events and crises. History consistently proves that investors are rewarded for sticking with a well-grounded, long-term strategy. Being comfortable with a longer investment horizon often means sitting tight when others are in a panic mode, or giving the capital markets a chance to work for you, rather than trading at the first opportunity to realize gains. The idea that “doing less with your portfolio is better” is often counterintuitive and difficult to accept. Investors sometimes ignore this truth in order to pursue something less important but more exciting. The problem is that excitement can be expensive, while more productive strategies can seem plodding and boring by comparison.
- Return is the reward for taking risk. Certain risk factors are consistently rewarded higher than others over time. In early portfolio theory only one risk mattered – the broad market risk that cannot be diversified away. The extent an asset was leveraged to the market determined its expected return. Now, research has shown that many other risks impact asset returns. Some risks are determined by exposure to macro-economic variables like growth, inflation, and liquidity. Others are driven by collective behavioral mistakes such as over-extrapolating company growth prospects or the tendency for investors to under-react to new information. Effectively pooling risk assets together – the process of diversifying – depends on correctly identifying the primary drivers of risk and return.
- Diversification works. Broad market timing is largely unproductive. The only free lunch in finance is the ability to combine less than perfectly correlated assets, creating portfolios where the returns are maximized for a given level of risk. Bundling assets exposed to various sources of risk reduces the likelihood that the portfolio experiences drawdowns of similar magnitude to any one factor.
- Markets are strongly efficient but not perfectly efficient. They are difficult to outperform. Wall Street is filled with portfolio strategists claiming to have found the magic bullet that always beats the market. There may be opportunities to “beat the market”, but those opportunities are not likely a result of traditional active management. A structured and disciplined approach grounded in evidence-based research offers the best shot at adding return over the broad market. Regardless, investors should carefully allocate assets between low-cost index funds and attempts to outperform the market. For some investors, a 100% indexed portfolio may be the best solution.
- All costs matter. Consideration of all explicit and implicit investment expenses is required to effectively manage costs, maximize returns and avoid the potentially hidden costs of investing. Research has shown that high-cost funds underperform low cost funds.
These beliefs outline our evidence-based approach to investing, an approach that is less dependent on manager intuition and purported ability to forecast the future. When evaluating a new investment opportunity or re-evaluating an old one, we make our decisions based on the data. This does not mean blindly picking recent winners and shunning the losers. We analyze underlying risks and evaluate when certain assets perform well and when they perform poorly, and decide how to best fit them together. We then focus on finding the most cost-effective investment vehicles to capture these risk-based returns.
What It All Means
Politics will continue to create noise. Eventually, what really matters are economic growth, an improving labor market, and steady inflation. Investor psychology ebbs and flows, sometimes leading to overly crowded trades and short-term volatility. Carefully considering which risks are worth taking, and deciding if these fit with your situation and goals are key features of a successful long-term investment strategy.
As always, please contact us with individual questions or concerns.
Contact us at 865-584-1850 or email@example.com
The information provided in this letter is for general informational purposes only and should not be considered an individualized recommendation of any particular security, strategy or investment product, and should not be construed as investment, legal or tax advice. Proffitt & Goodson, Inc. makes no warranties with regard to the information or results obtained by third parties and its use and disclaim any liability arising out of, or reliance on the information. The information is subject to change and, although based on information that Proffitt & Goodson, Inc. considers reliable, it is not guaranteed as to accuracy or completeness. Source information is obtained from independent financial data suppliers (Interactive Data Corporation, Morningstar, etc.). The Market Categories illustrated in this Financial Market Summary are indexes of specific equity, fixed income or other categories. An index is a reflection of the underlying securities in a particular selection of securities picked due to a particular type of investment. These indexes account for the reinvestment of dividends and other income, but do not account for any transaction, custody, tax, or management fees encountered in real life. To that extent, these index numbers are artificial and cannot be duplicated in real life due to the necessity of paying those transaction, custody, tax, and management fees. Industry and specific sector returns (technology, utilities, etc.) do not account for the reinvestment of dividends or other income. Future events will cause these historical rates of return to be different in the future with the potential for loss as well as profit. Specific indexes may change their definition of particular security types included over time. These indexes reflect investments for a limited period of time and do not reflect performance in different economic or market cycles and are not intended to reflect the actual outcomes of any client of Proffitt & Goodson, Inc. Past performance does not guarantee future results.