Market Outlook Third Quarter 2017
In a Nut Shell:
- Investment returns are driven by valuations. Shifting portfolios toward cheap assets and away from expensive ones “wins” over time.
- Long-term expected returns are likely to be positive, but current valuations suggest they’ll be lower than investors are accustomed to.
- Interest rates may hold the key.
- We’ve identified and increased our allocation to International Developed and Emerging Market country stocks over the last year.
- We emphasize the use of alternatives in our portfolios. They play an important role when traditional bond and stock markets are more expensive.
For an in-depth look at the big picture, read below.
The Big Picture
The big picture for Smith & Howard Wealth Management is always going to be framed by valuations (see our previous article “Why Valuation Matters”). As long-term investors, we recognize that while it is interesting to speculate and debate about near-term events and breaking news, ultimately, investment returns are driven by valuations. Shifting portfolios towards cheap assets and away from expensive ones “wins” over time. It not only generates a higher long-term return, but typically results in smaller drawdowns or losses along the way. Put more simply, it’s the amazingly simple, but difficult to execute philosophy of “buy low, sell high.”
The Market (Still) Isn’t Cheap
Last quarter we introduced the following graphic as part of the discussion on general US market valuations. The chart, while a bit busy, helps not just in understanding current market levels, but also gives some important historical perspective. For a quick recap, what we’re attempting to show is the historical levels of and relationship between real bond yields (BarCap Aggregate Index yield after subtracting out inflation expectations) and normalized equity yields for the S&P 500 (as the graph indicates by yield we mean earnings divided by the index level). The larger black squares and line depict the average for each over the time period while the blue diamonds and line show the current level for each. As an example the average real bond yield has been 2.66%, but today is only 0.71%. The high level summary is that while long term expected returns are still likely to be positive, current valuations suggest they will be lower than investors are accustomed to.
Interest Rates May Hold the Key
While both of those are sobering levels, they are also not new. This dynamic has existed and could continue to exist for quite some time. As noted last quarter, the “slopes” of the blue and black lines are not all that different and should still provide a level of comfort to equity investors. Yes, equities (US large cap in this instance) are expensive compared to where they normally are, but relative to bonds they are still very reasonable. This is why Warren Buffett was recently quoted on CNBC as saying that “valuations make sense with interest rates where they are”. The clear indication in that statement, which we’d agree with, is that if or when rates move meaningfully higher the impact will be felt in both bonds and equities. The Federal Reserve to this point has been successful in raising rates, albeit slightly, without spooking the equity markets. Their clear intention, communication, and deliberate pace, along with global economic momentum continues to give investors comfort that while valuations may be stretched there is no imminent threat of rates skyrocketing.
International and Alternatives Provide Opportunity and Diversification
The previous discussion reflects valuations of U.S. stock and bond markets. Fortunately, both International Developed and Emerging Market country stocks are more attractively valued and priced to return what investors have come to expect from their equities. While markets generally may be on the expensive side, there are always pockets of opportunity and this is one such area we’ve identified and increased our allocation to over the last year.
As most clients know, we have also emphasized the use of alternatives in our portfolios. This is an area we remain committed to, as we believe it plays an important role in managing and diversifying risk in portfolios, particularly when the traditional bond and stock markets are more expensive. These strategies, by design, are not typically correlated with equities, so while unfortunate, it is not a surprise that they wouldn’t be keeping pace with recent equity market performance.
Given that we are now in the heart of football season, perhaps a quick sports analogy will illustrate our thoughts on alternatives. Most every marquee college football team plays a number of easy early season games before heading into a more difficult conference schedule. The outcomes are never really in doubt and they often win these games by 40, 50, or even 60+ points. During such blowouts, a team’s punter rarely leaves the bench and the place kicker is trotted out for inconsequential extra points and kickoffs. Coaches know, however, that those players will undoubtedly play an extremely important role as the games become more difficult. Similarly, when markets are cheap and opportunities abound, investors are in that easy portion of the schedule and often win simply by “showing up” or participating. As a bull market ages and becomes more expensive, investors find the “games” more challenging and can’t win simply with offense (equities) or defense (bonds) alone. Alternatives (the punter or placekicker) play an increasingly important role and quite often end up separating winners and losers.
For more information on our Market Outlook, contact Brad Swinsburg 404-874-6244.
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Unless stated otherwise, any estimates or projections (including performance and risk) given in this presentation are intended to be forward-looking statements. Such estimates are subject to actual known and unknown risks, uncertainties, and other factors that could cause actual results to differ materially from those projected. The securities described within this presentation do not represent all of the securities purchased, sold or recommended for client accounts. The reader should not assume that an investment in such securities was or will be profitable. Past performance does not indicate future results.