Portfolio Review – Q3 2018 Newsletter

The third quarter of 2018 was a mixed bag for investors. Stocks, at least domestic stocks, performed admirably. The S&P 500 rose 7.7% in the quarter and is now up 10.6% year-to-date. Small-cap stocks have performed even better so far this year, rising 14.5%.

However, that is where the good news ends. International stock returns have been disappointing, as have REIT returns. Bonds have been flat to negative, and alternative investment returns have been anemic.

While there are some meaningful differences, the current environment is feeling more and more like the late 1990s. During that period, the largest stocks with the greatest growth prospects, mostly technology and internet stocks, drove the performance of the overall market. Stocks rose to historically high levels, and the rally lasted much longer than anyone thought.

Today, we see a similar dynamic. Growth stocks, primarily large-cap technology stocks, have been responsible for the lion’s share of the stock market’s gains. In fact, other market segments, such as value stocks and low volatility stocks have lagged significantly behind the overall stock market for the better part of the last ten years.

This is an unusual dynamic, as value stocks historically have performed better than growth stocks, likely because of their higher risk profile. The same thing happened back in the 1990s.

The market environment changed radically in the early 2000s, unfortunately with a nasty bear market. However, that doesn’t mean we’re due for another downturn now. Back in the 1990s, many technology stocks had negative earnings, and some companies even went public without any revenue. The highflying technology companies today are mostly real companies with positive earnings, solid business models, and tangible assets.

Consequently, we don’t expect another dire market downturn. However, a change in market leadership seems overdue. The market can stay irrational longer than most of us expect, but it appears that the largest growth stocks are close to the limits of how far they can appreciate.

Apple now has a market capitalization of over $1 trillion. Alphabet, the parent company of Google, is worth $800 billion. Amazon is worth over $900 billion. Apple was the first company to achieve a market value of over $1 trillion, which makes you wonder how much further it can grow. Certainly, moderate appreciation in the stock, as earnings grow, is possible and reasonable. Nevertheless, expecting Apple, Alphabet, Amazon, or any of the most valuable tech companies to double or more from here seems extreme.

However, there is ample room for other market segments to grow. Valuations, as we have written previously, are not out of line for most of the stock market. Combined with strong economic growth, stocks could continue to move higher from here, but we expect the stocks driving the next leg of market growth to shift. Value stocks and international stocks, in particular, should be the darlings of the next decade.

There are certainly risks to the stock market. Rising interest rates is a big one. The yield on the ten-year Treasury note has increased to almost 3.25% from around 2.25% a year ago. The Federal Reserve raising short-term interest rates has certainly contributed to this move higher, but the strong economy and inflation expectations are also to blame. Rising interest rates have weighed on bond market returns, which are down 1.6% year-to-date. We reduced the duration (and thus the interest rate risk) of our bond portfolios a couple years ago in anticipation of rising interest rates. We were too early, but that shorter duration is now protecting returns as rates move higher in earnest.

If stocks do falter as interest rates rise, political concerns become more acute, inflation increases unexpectedly, or trade disputes spin out of control, the unloved alternative investments we hold should finally have their day in the sun. It is not so much that falling stock prices result in better alternative investment returns, although in some cases that is true. Rather, the performance of our alternatives should improve as part of their natural cycle. Several of these strategies have struggled the past two to three years. Every investment has ups and downs, and unfortunately, we’ve just lived through a lot of the downs. These strategies all have solid long-term return profiles, and we expect those to start to shine through.

Diversification is one of the main tenets of investing, but lately it has worked against us. It is irrational to build a portfolio of only U.S.-based stocks, but such a strategy would have generated the best performance recently. In a truly diversified portfolio, there will always be good and bad performers, over just about any period. However, yesterday’s losers often become tomorrow’s winners, and vice versa. The key to long-term investing success is hanging in there through the downcycles of solid long-term assets.

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