The second quarter was another strong period for stocks, and surprisingly strong for bonds. Large-cap stocks, as represented by the S&P 500, led the way with a gain of 4.3%. Mid-cap, small-cap, and international stocks all generated respectable returns, but lagged the S&P 500.
Stocks: Ripe for a Change?
This has been a theme for many years now. Similar to the late 1990s, stock market performance has been dominated by the largest stocks, particularly those in the high-growth technology sector.
Just a handful of stocks—Apple, Amazon, Google (parent company Alphabet), Microsoft, and Facebook—have accounted for the lion’s share of the stock market’s current advance. It seems unlikely that will continue. Microsoft’s total market value is over $1 trillion. Apple, Amazon, and Google are all close to $1 trillion, and Facebook is over half a trillion. Additionally, these companies face the prospect of additional government regulation, if not break up, which could slow their growth rates. We read recently that the combined value of these five companies is greater than the GDP of every nation in the world except the U.S., China, and Japan. Even without government speed bumps, strong and sustainable market gains from these valuations is a stretch.
The impressive gains of the large-cap growth segment over the past 10 years makes you wonder if it even makes sense to invest outside of the S&P 500. After all, index funds are cheap and tax efficient. Why waste your time with international stocks that always seem to be struggling with economic malaise, smaller-cap stocks that don’t account for much of the market anyway, or value stocks that seem to perpetually underperform?
The answer, which is hard to see since it has been obscured by years of being wrong, is that diversification does work. While the stock market has risen well over 300% since its low point in 2009, the picture hasn’t always been so rosy. Since the top of the market in 2000, the S&P has gained only 4% on average. Between 2000 and 2011 the S&P gained zero. Between 1968 and 1982 the S&P also essentially stagnated.
During these periods, you would have been glad to have broader diversification, as small-cap, value, and international stocks all would have helped to boost returns. This sort of diversification will likely be valuable in the future as well. We have written before about how market leadership has to change. Market segments beyond the largest technology shares, particularly beleaguered value stocks, trade at more reasonable levels and have room to move higher, despite their disappointing recent performance.
Bonds Surprisingly Strong
Bonds are up more than 6% so far this year. That seemed a highly improbably outcome with interest rates at only 2.6%, as measured by the ten-year Treasury yield at the beginning of the year. Nevertheless, signs of slowing economic growth have led to speculation the Fed could cut interest rates before long. Rates across the yield curve have rallied, and the ten-year Treasury ended the second quarter with a yield of 2.0%. Because prices move inversely to yields, the lower yields boosted bond prices significantly. This also seems unlikely to continue, but an economic downturn could lead to further gains for high quality bonds. We discuss our thoughts on the economy in a nearby article.
Alternatives Tick Up
Alternative investments have been mediocre, as seen in the nearby chart, with returns similar to bonds. However, the funds we use do not mirror this index. Our funds have been more of a mixed bag. Private real estate funds have generated attractive returns. Funds like reinsurance, risk premia, and style premia have lagged. However, there are some encouraging signs. Managed futures are starting to post positive returns, and alternative lending continues to chug along. Overall, we still want to see stronger returns from our alternative funds, but they have been an important diversifier.
A Solid First Half
The second quarter was generally very positive for investors. Indeed, the first half of the year was the best for stocks since 1987. This shows the power of staying the course after what was a very trying fourth quarter in 2018 when stocks dropped double digits. However, the dynamics within the markets are starting to shift, and signs of stress are apparent. It would not be surprising to see changes in market leadership before too long.
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