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ACM Journal - Investment Management
17 Oct

Portfolio Review – Q3 2019 Newsletter

The third quarter was mediocre in terms of investment returns. Large-cap stocks in the U.S. were up 1.7%, but most other stocks lost money. Bonds actually outpaced stocks in the third quarter, with a gain of 2.3%. Real estate was the bigger winner, earning 7.3% as investors sought out more stable segments of the stock market. See full investment returns for the quarter and year-to-date in the nearby chart.

Despite an uninspiring quarter, all asset classes have performed well so far year-to-date. Stocks are generally up double digits, and even bonds have earned 8.5% so far this year.

Given the level of turmoil in the world, gains of this magnitude are surprising. With Brexit, impeachment hearings in the U.S., protests in Hong Kong, and an on-going trade dispute with China, it is remarkable that stocks have performed as well as they have. Even so, all eyes seem to be on the economy now. Volatility has returned to the stock market, particularly on days when economic data releases are too low, signaling an economic slowdown, or too high, which could mean the Fed will stop easing short-term interest rates.

Economic activity does seem to be cooling, particularly among corporations. But the consumer segment of the economy is a powerful one, and low unemployment augurs well for the current expansion to continue at least for a while. And, that is likely why stocks have been so resilient. The S&P 500 hit a new record high in the quarter, and even with recent weakness, is down less than 3% from the high as of this writing.

That doesn’t mean that things are status quo. Market leadership seems to be shifting. The high-flying technology companies seem to be giving way to firms with more stability. Stocks with strong price momentum underperformed the overall stock market in the third quarter, while stocks with low volatility in their returns outperformed significantly. That may be why real estate companies have had such a strong run.

Small-cap value stocks are another sector with strong performance in the third quarter. After a very long and disappointing run of poor performance, small-cap value stocks earned over 3% more than the overall small-cap market. It is too early to know if this is a blip or the beginning of a trend, but the far lower valuations of “value” stocks versus “growth” stocks could be an indication that the tide is turning, as it did after the technology bubble burst in 2000. In the decade of the 2000s, small-cap value stocks returned 8.3% annualized compared with a loss of 4% for large-cap growth stocks.

International stocks have continued to struggle, particularly in the emerging markets. Economies from Germany to China are slowing down, which has weighed on stock markets. Despite their underperformance in recent years, international stocks have historically outperformed U.S. stocks half the time, making them an important diversifier for stock portfolios.

It was shocking to see bonds perform so well, particularly when interest rates were already so low. However, cuts to short-term interest rates by the Fed and a drop in longer-term yields during the quarter from 2% to 1.5% sent bond prices up significantly. Concerns over economic weakness could keep demand for bonds strong, but rates can’t stay this low forever.

Alternative investments are showing signs of life. Managed futures are up almost 5% year-to-date, alternative lending continue to do well, and so far, reinsurance has avoided any nasty surprises during the first half of hurricane season. Private real estate has also been strong.

Despite an anemic third quarter, investment returns have continued their strong run so far this year. The volatility that picked up in the third quarter is probably here to stay, at least through next year’s election. It would not be surprising to see further signs of economic slowdown, and possibly even a recession in the not-too-distant future. Recessions, however, can be mild and short-lived, and should not be a reason to disrupt

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