Reading the news headlines in 2017 might have you wondering if the world is coming to an end. We’ve seen daily presidential tweetstorms, endless Russian investigations, terrorist attacks in London, North Korean missile testing and we still don’t have new health care legislation or a tax reform bill. And yet the world economy and global investment markets have continued to shrug off all the bad news to march steadily higher.
After several years in which the performance of international stocks badly trailed US stocks, the second quarter continued the reversal of that trend as international stocks (as measured by the MSCI EAFE index) returned over 6%, while US stocks (as measured by the Russell 3000 Index) returned about 3%. That puts US stocks around 9% for the year compared to 14% for international stocks. On the international side, emerging markets have fared even better than developed markets to the tune of an 18% total return year to date.
While it’s important to be diversified between international and US stocks, it is also important to have diversified exposure within US stocks themselves. You might be familiar with the below chart, called a “style box”, from Morningstar. If you aren’t familiar, this chart breaks down individual US stocks into categories based on certain characteristics. From top to bottom, stocks are classified based on size with the biggest on the top row and the smallest on the bottom row. From left to right stocks are classified based on various valuation metrics that define a stock as either “value” on the left, or “growth” on the right. 2016 and the first half of 2017 have provided a stark example of why it’s important to be well diversified across the style box, as you can see in the opposite distributions between these two charts:
In 2016 small cap stocks in the bottom left quadrant outperformed large cap growth stocks in the upper right quadrant by 26%! Yet so far in 2017 that has reversed and large cap growth is outperforming small cap value by over 16%! What will happen in the coming years is anyone’s guess and this is why we believe diversification across the style box is important. Year to year fluctuations will happen and that can make it very painful in any given year to be over allocated to one segment of the style box. Diversification helps us combat our inherent tendency to want to chase those investments that have performed well recently. Over the long run the return numbers look much more uniform, as can be seen in the below version of the chart looking back over the past 5 years. Keep in mind returns in each of these categories have been much higher over the past 5 years than they have been over the longer-term historically and are certainly higher than we would anticipate going forward.
In the bond markets we saw another rate increase from the Federal Reserve in June. Despite the increase in short-term rates, longer-term bond rates decreased for the quarter. This led to a return of a little under 2% for the US Aggregate Bond Market index. With the difference in rates between short and long-term bonds narrowing, holding longer-term bonds becomes less attractive. We still believe it’s important to own bonds in your portfolio for the significant diversification benefits they provide, especially if we go through an economic downturn.
While it might seem a recession should be inevitable given the extended period of time since the 2008-2009 financial crisis, we don’t believe anyone can accurately predict when the next one will come. The average length of an economic expansion over the past 100+ years is 47 months. We are currently more than double that average at 96 months, but we have also seen expansions lasting longer over time, as shown in the chart below on the left from JP Morgan. In addition to expansions lasting longer, they have also been growing weaker, as seen in the chart below on the right, illustrated by how sharply the line is increasing.
Unfortunately, we don’t know what the future holds so the best we can do is help you maintain a well-diversified portfolio that can withstand any market conditions. It’s also important to keep the right frame of mind and to make sure you are mentally prepared to handle a market downturn. Returns have been strong for such a long time it’s easy to forget what it feels like to see your portfolio lose value. Make sure you remind yourself that market pullbacks are inevitable and if they never happened, you wouldn’t be compensated in the form of the higher returns we have seen in recent years for taking that risk.
The views expressed represent the opinions of L.K. Benson & Company and are subject to change. These views are not intended as a forecast, a guarantee of future results, investment recommendation, or an offer to buy or sell any securities. The information provided is of a general nature and should not be construed as investment advice or to provide any investment, tax, financial or legal advice or service to any person.
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