By all accounts, 2017 was an excellent year for investments. The U.S. stock market was up 21.13%i. Developed international stock markets were up 25.03%ii. Emerging markets’ stocks were up 37.28%iii. U.S. high yield bonds returned 17.16%iv. Global bonds—despite a large portion starting the year with non-existent or negative yields—returned 7.39%v. U.S. real estate returned 6.89%vi. The U.S. investment grade bonds market was up 3.54%vii. U.S. agency mortgage-backed securities, REITS, treasuries, municipal bonds, and commodities were all positive for the year. Inflation was a mild 1.8%viii.
Not only were real returns positive and strong across the board, but the path to those returns was remarkably steady. As of December 31, 2017, the U.S. stock market is in its longest stretch in history without a 3% or greater decline from its highest pointix. Global stocks, for the first time ever, were positive every month of the yearx. High nominal returns, low but positive inflation, and steady returns—that’s an investor’s best-case environment.
Global stock market performance since the end of the financial crisis in early 2009 has been good. But 2017 stands out. Look back to 2009, 2010 and 2011 to remember what volatility felt like. In each of those years an investor had to ride out mid-teen to low-twenty percent declines, with the financial crisis fresh in mind. Whereas in 2017 it was a climb straight up, generally at 1% or 2% per month, for twelve straight months. 2017 is certainly the exception, and not the rule.
The Temptation of Market Timing
Everyone knew the U.S. stock market had been on quite a run in late 2016. Certainly by the spring of 2017 the U.S. stock market had gone far enough. If not, then by the end of the summer. For sure it had reached a peak by the end of the fall. How about now at the start of 2018?
It’s true the aggregate performance of stocks has outpaced fundamental improvements in companies’ earnings (the aggregate P/E multiple has increased no matter to which methodology of calculation one subscribes). When re-pricing outpaces fundamental growth, some combination of only two things has happened: expectations for future earnings growth have adjusted upward; investors are willing to accept a lower return for the same expectations going forward.
The thoughtful investor may reasonably conclude that the time to be defensive is when there are rosy growth expectations built into prices and when other market participants aren’t requiring much return for the risk they’re taking. It’s tempting to call the market peak. However, there isn’t a black-and-white transition from inexpensive to expensive. Meanwhile the cost of selling the highest-return asset class works against you. Not only do you have to be right, but the market needs to realize it’s wrong and decline, all the while incoming cash flows to equity owners and revenue growth are being realized.
One service we’ve provided for our clients in 2017 is a steady hand in a jittery world. We let stocks run through October, becoming ever increasing proportions of our clients’ portfolios.
We then rebalanced down to the stock allocation that existed in their portfolios at the beginning of the year.
Rebalancing is much different than market timing, but it accomplishes what market timers often try to do—only in a more disciplined and measured manner. When an asset class performs particularly well compared to other asset classes, rebalancing sells it and buys asset classes that have declined or appreciated by less. This is intelligent risk management.
The Continued Merits of Global Investing
The benefit of investing with a global perspective is a foundational proposition of our investment philosophy. The power of diversification through international stocks is significant.
In investment management, core theoretical work hypothesizes that only “systematic risk” is compensated with expected returns. Intuitively, imagine McDonald’s has a company-specific issue whereby its business declines. Even if they sell fewer hamburgers, some other business will benefit. People might buy Burger King’s hamburgers as a substitute, or salads at Panera Bread because their preferences have changed. Either way, McDonald’s losses are absorbed as gains elsewhere in the system.
By buying the whole system, an investor is left with the one undiversifiable risk: the risk related to the entire market’s activity. Therefore, only to the extent that a share of stock moves with the entire market—maybe 0.5-to-1, 1-to-1, or 2-to-1—is an investor compensated for owning it.
In international markets, there is unique production and consumption solely from local businesses; it’s also a “leak” where losses from certain U.S. businesses may be absorbed by an international company, e.g., Hershey loses business and Nestle gains business. Therefore, U.S.-only risk contains some uncompensated risk from a global perspective and a better risk-reward allocation can be built from owning the global market.
The case above, admittedly, is highly theoretical. Fortunately, practical considerations lead us to the same conclusion. Current stock prices in the U.S. compared to their 10-year average real earnings—the Shiller Cyclically-Adjusted Price-to-Earnings (CAPE) ratio—are more expensive than immediately preceding the financial crisis. This measure shows U.S. stocks are more expensive today than any other time since the collection of data started in the late 1800s, save at the height of the tech bubble.
Meanwhile, developed international stocks are priced below their 20-year average and 40% below the U.S.xi Emerging markets’ stocks 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! Compared to U.S. stocks, emerging markets’ stocks are on sale for less than half-price.
Investing in Alternatives During a Stock Boom
We have been proponents of a large allocation to alternative investments since 2014. Unless you’re using financial leverage, in order to own an alternative investment you must not own some stocks, bonds or a combination thereof (an opportunity cost).
Our alternative strategies significantly outperformed stocks and bonds in 2014 and 2015. In 2016 our alternatives allocation was down 1.68%. In 2017, our alternatives allocation was up 5.05%. Our largest position, AQR Style Premia, returned 12.10% while our reinsurance allocation fell 7.16% due to claims from the hurricanes, floods and fires in the early fall. Managed futures were flat.
A 5.05% absolute return is a fair year. Indeed, our alternatives allocation outperformed bonds—the Bloomberg-Barclays U.S. Aggregate bond Index was up 3.54%. Not owning some bonds to own alternatives was positive for performance in 2017; and we generally fund alternatives with more bonds than stocks. But the impact of not owning some stocks, with the MSCI ACWI up 23.97%, was a headwind.
It is in a year like 2017 when stocks are up over 20% that our alternatives won’t keep up; but we’re willing to trade off some of the upside in those good years for the downside protection of alternative investments. Over time, we expect alternatives to reduce risk and add to return (a tall order). Since 2014 we have realized these goals.
Looking Forward to 2018
An item of significance in 2018 to which to pay attention is the U.S. yield curve. The Federal Reserve has been increasing short-term interest rates as the U.S. economy’s labor market appears at or above full employment.
Curiously, longer-term interest rates have actually declined. One of two things will happen if we continue along this course: the U.S. yield curve will become flat and potentially invert; or long-term bonds will begin to sell off and long-term interest rates will increase. The effect of either of these scenarios on lending and borrowing in the corporate and real estate markets, economic activity, and asset prices, will be significant.
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.
Although the U.S. economy is strong, asset prices are relatively elevated and the Federal Reserve is engaging in contractionary monetary policy—a concerning combination. We believe market timing is not worthwhile, but being price conscious is. International stocks are far less expensive compared to U.S. stocks; holding a global allocation in stocks is as critical for a U.S. investor today as it ever has been. A healthy allocation to well-researched alternative investments is also appropriate in this environment.
Thank you for your continued trust in our firm. We look forward to assisting you in reaching your financial goals in the New Year.
Disclosures and End Note
This newsletter has been prepared solely for informational purposes, and is not an offer to buy or sell, or a solicitation of an offer to buy or sell, any security, product, service or investment. The opinions expressed herein are solely the opinion of Heritage Financial Services and do not constitute investment advice and are subject to change without notice. Heritage customizes client portfolios based on individuals’ financial situations. Various components of this commentary may not be relevant to each client’s personal portfolio due to, without limitation, portfolio legacy securities, portfolio size, accounts with limited investment options, tax considerations, investment accreditation and personal preferences. Past performance may not be indicative of future results.
All data contained herein are believed to be accurate as of the date of publication. Certain third-party sources are relied upon for historical statements and performance information. Heritage is under no obligation to update this document as additional information becomes available over time or if any revisions are made to information herein contained.
- i The U.S. stock market is represented by the Russell 3000 TR Index
- ii Developed international stock markets are represented by the MSCI EAFE TR Index
- iii Emerging markets stocks are represented by the MSCI EM TR Index
- iv High yield bonds are represented by the Credit Suisse High Yield Bond Index
- v Global bonds are represented by the Bloomberg-Barclays Global Aggregate TR Index
- vi U.S. real estate returns is based on the NCREIF Property Index
- vii U.S. investment grade bonds are represented by the Bloomberg-Barclays U.S. Aggregate Bond Index
- viii Bureau of Labor Statistics, CPI-All Urban Consumers
- ix Charles Schwab Schwab Market Perspective: The Big Picture Heading into 2018. Liz Ann Sonders
- x ibid
- xi GMO Quarterly Letter, 3Q 2017. Career Risk and Stalin’s Pension Fund: Investing in a World of Overpriced Assets. Jeremy Grantham
- xii Stocks are represented by the MSCI ACWI TR Index
- xiii Bonds are represented by the Bloomberg-Barclays U.S. Aggregate Bond Index
- xiv Heritage’s alternatives investments are represented by the time-weighted return of a mix of mutual funds internally categorized as such; the weights and funds vary by time period and internal records are kept outlining target weights and fund returns; these returns are corroborated by composite performance across our client base by asset class