First Quarter 2018 in Context
The first quarter of 2018 saw the U.S. stock market increase 7.12% within the first month. Then it fell from its highest point by 10.62% to -3.50%. By the end of the quarter, U.S. stocks had stabilized with a cumulative return of -0.64% .
Source: Morningstar, Inc.
In our investment Review of calendar year 2017, we wrote about the remarkably low volatility experienced by investors in the stock market, complemented by a high return over the period. Investors love a high return over a period of time with a low level of volatility experienced. We summarized part of our outlook for 2018 by stating: “We believe—and it’s not going too far out on a limb—that 2018 will bring more asset price volatility than was experienced in 2017.”
Historical context is helpful in evaluating why we made that statement and for the perspective it gives to the recent ups and downs of the U.S. stock market.
Over the past 20 years, normal levels of U.S. stock market volatility ranged from 10.45% to 19.41% . The average one-year realized volatility was 14.93% . The stock market’s average annual return over the 20-year period was 6.74% . That’s 0.45 units of return per unit of “risk”—which is normal. When in 2017 the U.S. stock market returned 21.13% with 5.88% realized volatility, it produced the extraordinary result of 3.60 units of return per unit of risk.
This was an outlier and it came from two components, viz., a return well above average and the lowest 12-month level of volatility experienced in the 20-year period. Believing that that combination would not repeat, and further that the risk measure would be higher was a no brainer.
The volatility upturn from the end of 2017 hasn’t even brought the most recent 12-months’ realized volatility within the middle 50% or normal range. The recent movements in the U.S. stock market were not extreme—they’re merely approaching normal levels.
Returns must also be viewed within the proper context. -0.64% for a quarter is unexciting. 13.81% over a year is exciting. And this is exactly the return over the last 12 months.
Although the first quarter clearly was less stable than the preceding three quarters, it ended with stock prices approximately where they were at the end 2017. In the context illustrated in the chart above, over the past 12 months—including the first quarter of 2018—investors in U.S. stocks returned 13.81%, over two times the 20-year average return of 6.74%. It produced this return with realized volatility of 9.34%, less than two-thirds the 20-year average of 14.93%.
Finally, as we’ve repeated over the years, the U.S. stock market is only a portion—albeit a sizable portion—of the global stock market. At the end of 2017 we claimed that although public companies composing the U.S. stock market appeared relatively expensive compared to their history, “Emerging Markets’ stock hit their low CAPE ratio as recently as February 2016, which showed them at a better bargain than in the depth of the financial crisis in 2009!” Our emerging markets allocation ended the first quarter up 1.96% , which, for perspective, is an annual pace of 8.10%.
Alternative Investments Review
With extremely strong returns from stocks in 2017, it was reasonable to expect our alternatives to lag, which they did. In 2018, as stocks produced negligible returns in our portfolios, the base case was to see alternatives accrue positively to portfolios’ values, leaving investors with a small net gain. Unfortunately, as a whole, they did not.
Two of our three major alternative strategies produced positive returns for the first quarter. Our reinsurance allocation was up 1.60% , a normal accrual during a low-risk period for reinsurance perils. Our absolute return strategy, coming off a 12.10% 2017, continued its positive direction, ending the quarter up 0.77% . Managed futures, however, posted a -5.51% return, dragging the weighted average return of our alternatives allocation down slightly negative. Managed futures has been a difficult strategy for us over the past three-and-a-quarter years.
We have given due consideration to our use of managed futures as a strategy for our clients. Among the questions we’ve discussed are: has anything changed in the nature of the strategy’s ability to produce returns? Have we selected the best managers possible to deliver those returns to our clients? And, is our sizing of the strategy in relation to other assets still appropriate?
All sound long-term strategies have bad patches; losing faith in them during these trying periods is as common a mistake as selling stocks after a deep drawdown, or, on the opposite end, getting too enamored with a strategy after it produces excellent returns.
We believe the underlying elements that result in assets trending are still intact (the nature of the strategy is unimpaired). We believe we’ve allocated thoughtfully to top managers at reasonable prices. The only area in which we believe an adjustment is appropriate at this time is in sizing.
The adjustment in sizing is a function of the relative opportunity set within our alternatives allocation (we believe our overall allocation to stocks and bonds is appropriate). Following the floods, hurricanes, and wildfires of 2018, reinsurance premiums increased. The return expectation of the reinsurance allocation has likewise increased, while the risk has remained effectively the same. Therefore, we believe this part of our alternatives allocation should be supplemented. When we increase our allocation to reinsurance in the late spring, the necessary capital will come from an incremental reduction to the managed futures positions. By doing so, we’ll maintain an appropriate balance within our alternatives allocation with a higher expected return.
Positioning in the Bond Market
Our positioning in the bond market worked to our clients’ advantage in the first quarter of 2018. Overall, the U.S. investment grade bond market’s total return was -1.46% due to long-term rates rising. We structured bond portfolios with low duration (or interest rate risk) and strong ratios of yield compared to duration.
Although nominally positive, our bond allocations significantly outperformed the bond market. Combined with our overweight to emerging markets in stocks, it resulted in each of our investment objectives outperforming both stocks and bonds individually during the first quarter.
It’s easy to become conditioned to recent experiences. Although we knew 2017 was an enjoyable year to invest, we knew that it might condition some investors to low levels of risk and unsustainable levels of return. We tried to recognize the win our clients achieved in 2017 by remaining invested, while tempering expectations for returns and warning about the likelihood of higher asset price volatility in the year ahead.
The first quarter of 2018 woke the investing public up to more normal swings in asset prices and the fact that not every month and every quarter will produce positive returns.
Through this environment, we were able to perform reasonably well. In stocks, our global perspective and overweight to emerging markets added value. Relative to the traditional asset classes used to fund them, alternative investments as a class effectively broke even. Our bond allocation benefited from being short-term and our managers performed admirably in their spaces. Altogether, our investment objectives outperformed both stocks and bonds over the first quarter.
Thank you for your continued trust in our firm and confidence in our investment approach. We look forward to assisting you in reaching your financial goals.