Asset Class Summary: Third Quarter 2015
Successful investing requires a long-term holding period for stocks, the conviction to ride through sometimes turbulent waves, and occasionally, the fortitude to buy when others are panicking and selling. We viewed the third quarter as such an opportunity, so we added modestly to U.S. stocks for most investors. As we pointed out in a recent note to clients, since 1928, 67% of years have seen positive returns for U.S. stocks, as measured by the S&P 500 Index, with the average gains far outpacing declines. Focusing on the longer-term (i.e., a few years vs. a few days, weeks or months) has historically been rewarding for investors. Speaking of the long-term, due to two huge drawdowns since the tech bubble, the 15-year trailing return on stocks is now one of the lowest on record. Returns tend to mean-revert, which suggests the next decade or so should see better returns (see chart “Ready for Reversion to the Mean” below). Because of this, and their relatively attractive valuations, we view the intermediate term prospects for U.S. stocks as better than for bonds and cash.
We view European stock valuations as more attractive than those of U.S. stocks, while European corporate earnings are well below normal (unlike in the United States where earnings are well above their long-term trend). So, we see potential for both improved earnings growth as well as some multiple expansion in Europe. Just as the strong U.S. dollar is hurting many of our export based companies, it is greatly helping exporters in Europe.
We did not make any material changes during the quarter in the bond portion of portfolios. We continue to view the expected returns for core bonds as likely to be very low (1%–2%) looking out over the next several years in almost any reasonably likely scenario. This is why our allocation to bonds remains historically low, and our allocation within bonds contains more flexible strategies. Based on our analysis, we believe these types of funds have the potential to generate returns in excess of the core bond index over the next few years, which consists largely of overvalued U.S. Treasuries. Nevertheless, we still maintain some exposure to core bonds because of the risk management role they play—as evidenced by that fact that bonds were one of the only asset classes to experience positive returns in an otherwise dismal quarter for investors.
We invest in Hedged Equities because we believe that over time, this asset class has the potential to return a reasonable amount of the upside of stocks, while protecting during some downturns. The third quarter was a tough one for this asset class, and most of our portfolios saw downside in line with international stocks. Particularly hard hit were the energy-pipeline investments (MLPs), which have become uncharacteristically correlated to oil prices, which remain low. We believe there has been a lot of technical and retail-related panic selling of MLPs, and expect that eventually their prices will reflect their economic reality, which remains positive. Due to their price decline, the Alerian MLP Index had an attractive yield of over 8% as of the quarter end.
We continue to see long-term value — in terms of diversification benefits and expected contribution to overall portfolio risk-adjusted return — from exposure to a highly select group of alternative strategy funds. The alternative strategies we own are intended to generate long-term returns that are better than core bonds, with much lower downside risk and volatility than stocks and relatively low correlation to stock and bond market indexes. We did not make any change during the quarter to our recommended allocation to alternatives.
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All references in this publication referring to our average allocation or “typical portfolios” reflect those of the fully discretionary accounts of clients with moderate risk profiles. Actual client portfolios are tailored to individual client circumstances and asset allocations may vary. Any reference to returns reflect the performance of asset classes, are for illustration purposes only, and do not reflect the returns of any specific investment of Smith & Howard Wealth Management. No representation is made that any investment decisions discussed herein have been profitable in the past or will be in the future. Past performance is no guarantee of future results. A list of all recommended investments is available upon request.