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3rd Quarter 2018 Review: A Very Different Year

This year is so different from last. In 2017, US stocks marched upward each and every month. International stocks delivered even higher returns, making up partially for some years of underperformance. While short-term interest rates were pushed upward by policy makers, longer-term rates were very steady, leading to good bond returns, too. Volatility reached long-term lows. All said, 2017 offered up one of the more benign market environments imaginable. Our typical balanced portfolio was up well into double digits.

This year, not so much. Volatility has returned (to more normal levels, we suggest) to such extent that these third quarter comments, in order to be more timely, also need to take into account the mini (so far) downturn suffered in October, which is undoing some the market’s good third-quarter performance.

Let’s start with the picture as of quarter-end (9/30).

Below is a snapshot a typical 60/40 portfolio allocation, along with trailing returns for the relevant benchmark in each asset class:

US large and small cap stocks each had great quarters, continuing long runs (dating back to the end of the financial crisis) of outperforming nearly every other broad asset class. This is their moment in the sun and they were hot in the quarter.

A broader look at segment returns beyond US stocks, though, shows mostly flat to negative performers. Bonds were flat in the quarter and now down 1.2% over the last 12 months. This is a reminder that bonds can and do suffer negative total returns if rates are rising quickly enough, which they have been. Nonetheless, this shouldn’t diminish much their standing as the best diversifiers; they still play a vital role in preserving capital and their potential for negative correlation may come in handy in a future stock market downturn. We’ve tried to structure the bond portion of client portfolios with lower duration, higher credit quality bonds to limit any downside and so far, that has worked. Stocks outside the US were either barely up (developed markets) or down (emerging markets). We’ll elaborate more on this below.

Now, for October. Since the end of the quarter, stock markets have reversed direction. The S&P 500 is down 6% or so and US small caps are down even more. Stocks outside the US, meanwhile, have dropped further in October and the MSCI Developed Markets index is now down more than 15% from its January 2018 high. Commentators will offer various simple explanations for the downward volatility: higher interest rates, tariff concerns, slowing Chinese (and global) growth, etc. There is of course some truth to all these explanations, but the most important thing to remember is that these types of downturns are common throughout market history and eventually reverse. They shouldn’t shake you off your long-term plan. Keep in mind as you read the headlines that your portfolio is comprised of shares of real businesses and other assets that have an enduring value apart from the tickers crawling by on a screen.

Where Will Future Returns Come From?
There is some good news underneath these recent headlines. We believe, from today’s vantage point, there are reasons to be slightly more optimistic about future returns for significant portions of our diversified portfolios. Please don’t read this the wrong way. Despite the current volatility, US stocks have performed well against a very positive economic backdrop for a long time and as a result still look fully valued. We continue to believe the odds are they will deliver below historical average returns in the intermediate term, not to mention the possibility that we are in the midst of a correction or even sharper downturn.

Rather, when we express guarded optimism, we mean that as we look across our clients’ diversified portfolios, it is clear to us that the majority of the typical balanced portfolio offers better intermediate-term return prospects than a year or two ago. Nearly all our clients’ portfolios include a mix of stocks and bonds, and we have gradually been reducing our exposure to US stocks and increasing our exposure to non-US stocks. We have done this only in small increments over the last few years and, to be sure, US stocks sill form the majority of your stock holdings. Our move to increase international exposure has hurt portfolio performance to date, but we have good reason to believe that could change.

Let’s start with the simpler case of bonds. Rising interest rates can generate modest negative returns while they are occurring, but those higher rates are also the key input into any forward-looking return assumption for the asset class. To be clear, the rise in rates so far has been modest and may have some way to go. The 10-year US Treasury rate bottomed at 1.37% in July 2016 and has now risen to about 3.2%. For context, in the decade leading up to the financial crisis, that 10-year rate averaged about 5%. Whatever the future holds, bond returns will be higher starting from 3 – 4% rates than from 1 -2% rates. Conservative savers should take some solace from this math.

The expected future returns for non-US stocks is not as simple, but let us provide you some background. Stock prices are meant to discount future cash flows, a definition that shouldn’t favor where a company is based. Studies have shown that there isn’t much correlation between GDP growth and stock returns and over long periods, returns of US and non-US stocks haven’t been that different. We’ve always included both in our diversified portfolios because although they tend to produce similar long-term rates of return, those returns aren’t always correlated with one another (one can zig when the other zags).

We are currently in a historically poor performance run for non-US stocks. This year will likely mark seven of the last nine years that the S&P 500 has outperformed the MSCI Developed Markets index. Cumulatively, since the financial crisis, the S&P 500 has returned 15.2% annualized vs. 8.0% for developed markets. That’s measuring from a market low, though, so those returns still seem okay. Adding in the performance since the end of 1999 (essentially the end of the Internet bubble peak), developed market stocks have returned a measly 3.2% annualized over that nearly 19-year period!

As a result, compared both to its own history and to US stocks, non-US developed market stocks look attractively valued. For one data point, take a look at the Research Affiliates CAPE ratio (cyclically adjusted price to earnings ratio, a useful measure of current prices compared to an average of long-term earnings) for each. For non-US developed markets, the ratio is currently 17x, nearer the low end of its long-term range; for US large caps, the ratio is 33, nearly twice as high and above its normal range. Translated roughly into English, this means investors are paying about twice as much for a dollar of earnings by a US company than for one outside the US.

These figures in and of themselves say nothing about future performance. Stock returns are complex and devilishly unpredictable over all but the very long term. This relative valuation insight is no guarantee that future returns for non-US stocks will be higher. We spend a lot of time, though, thinking through what we are getting (value) for what we are paying (price). In this case, we believe the odds are pretty good that non-US stocks will be able to deliver better performance over the next decade than the last two.

As always, please reach out to us with any questions you have about your portfolios or the market generally. We pride ourselves on our equanimity in the face of capricious markets and we are always happy to share some with you if you need it. Think long term.

One of Bristlecone Value Partners’ principles is to communicate frequently, openly and honestly. We believe that our clients benefit from understanding our investment philosophy and process. Our views and opinions regarding investment prospects are "forward looking statements," which may or may not be accurate over the long term. While we believe we have a reasonable basis for our appraisals, and we have confidence in our opinions, actual results may differ materially from those we anticipate. Information provided in this blog should not be considered as a recommendation to purchase or sell any particular security. You can identify forward looking statements by words like "believe," "expect," "anticipate," or similar expressions when discussing particular portfolio holdings. We cannot assure future results and achievements. You should not place undue reliance on forward looking statements, which speak only as of the date of the blog entry. We disclaim any obligation to update or alter any forward-looking statements, whether as a result of new information, future events, or otherwise. Our comments are intended to reflect trading activity in a mature, unrestricted portfolio and might not be representative of actual activity in all portfolios. Portfolio holdings are subject to change without notice. Current and future performance may be lower or higher than the performance quoted in this blog.

References to indexes and benchmarks are hypothetical illustrations of aggregate returns and do not reflect the performance of any actual investment. Investors cannot invest in an index and returns do not reflect the deduction of advisory fees or other trading expenses. There can be no assurance that current investments will be profitable. Actual realized returns will depend on, among other factors, the value of assets and market conditions at the time of disposition, any related transaction costs, and the timing of the purchase.

Economic factors, market conditions, and investment strategies will affect the performance of any portfolio and there can be no assurance that a portfolio will match or outperform any particular index or benchmark. Past Performance is not indicative of future results. All investment strategies have the potential for profit or loss; changes in investment strategies, contributions or withdrawals may materially alter the performance and results of a portfolio. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be suitable or profitable for a client's investment portfolio.