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ACM Journal - Investment Management
17 Jan

Portfolio Review – Q4 2019 Newsletter

The S&P 500 rose 32% for 2019. Looking at data back to 1926, that was the 18th best year for the stock market, placing it in the top 20% of annual gains. However, that understates the actual achievement, as many of the better years occurred during or in the wake of the Great Depression when stocks fell and rose wildly. Since 1960, 2019 would have ranked 7th for best performance. Interestingly, the better performing years, mostly occurring during the bull market of the 1980s and 1990s, were followed by strong years. For example, the 37.6% gain of 1995 was followed by a 23.0% rise in 1996 and a 33.4% gain in 1997. Of the top seven best performing years since 1960, five were followed by double-digit gains the next year. Two years saw subsequent losses, but those were limited to the single digits.

Does this mean that 2020 is going to show strong returns as well? Not necessarily. Sure, there is historical precedent, and election years have traditionally been good for the stock market. It also doesn’t hurt that the domestic economy is humming along nicely. However, the capital markets continually show us that past is not necessarily prologue. Any economic softness, continued trade tensions, surprises in the national elections, significant military activity, or any number of other exogenous events could lead to a market downturn. That makes 2020 exactly like every other year. There is no way to know in advance what it will bring, but that won’t stop the market pundits and financial media from prognosticating and issuing all manner of dire warnings about the year to come.

Stay in the Market

Indeed, we recently read an article by JPMorgan’s strategist, Michael Cembalest. It showed the lost returns since 2010 you would have experienced if you had listened to a number of high-profile investors’ predictions for the stock market. Noted economist David Rosenberg, professor Nouriel Roubini, famed investor Marc Faber, hedge fund investor George Soros, and activist investor Carl Icahn were all among the forecasters Cembalest looked at. The best-case scenario would have been an opportunity cost of around 30% versus the stock market’s actual returns, and the worst was over 60%. Keep this in mind when listening to year-ahead outlooks in the weeks to come. Even the “best and brightest” don’t know where the markets are heading.

For those non-experts who stayed in the market over the past ten years, things looked pretty good. On the nearby graph, we show returns for the fourth quarter of 2019, the full year, and also ten-year annualized returns. While the red bars representing ten-year performance are dwarfed by the one-year returns, they are still way above historical averages. The Dow Jones Industrial Average was just slightly north of 10,000 at the beginning of the last decade compared with over 28,000 today.

Value: Overdue?

Large-cap growth stocks have been the dominant force in this market. While not unprecedented, that is a fairly unusual phenomenon. Lower-priced value stocks have historically generated stronger returns than growth stocks over longer periods. This dynamic is reminiscent of the 1990s when stock market returns were similarly above average and were led by large-cap growth stocks. Fortunately, the speculative excess of that era has been largely absent today. Nevertheless, valuations on the largest and most expensive stocks have been climbing.

The disparity between growth and value has increased to the point that value stocks now trade at a valuation discount to growth stocks that is just about the widest ever, according to a recent study by Research Affiliates. We have been arguing, wrongly so far, that this cannot continue. Just like in the wake of the 1990s, we expect value stocks to be the star performers of the coming decade. It can take time for market imbalances to reverse, but extreme valuations have historically been a solid indicator of future long-term performance. It would not be surprising to see a role reversal for growth stocks and value stocks in the not-too-distant future.

International Stocks

Beyond large-cap stocks, the rest of the capital markets have also performed well. Just about every segment of the stock market rose in excess of 20% last year. On a longer-term basis, returns have clearly been dominated by U.S. stocks. Developed world international stocks have returned a disappointing 5.5% annualized over the past decade, and emerging market stock returns have been truly meager with only a 3.7% annualized gain.

Stagnant economies overseas stand in stark contrast to the robust GDP growth we’ve experienced in the U.S. Negative interest rates are the norm in many parts of the world, and yet even with this unprecedented level of monetary stimulus, economic growth remains stuck in much of Europe and developed Asia. The bright side of underperforming economies and stock markets is that valuations for overseas stocks are quite cheap. While that has been the case for some time, and foreign stocks have continued to underperform, the disparity can’t last forever. Just like with value stocks, international stocks will likely outperform in the years to come. While diversification away from anything but U.S.-based large-cap growth stocks has been a liability recently, market leadership seems to be turning.

Back to Normal?

When market leadership changes in earnest, smart portfolio management techniques such as diversification and rebalancing will once again add value. Most professional investors, including yours truly, have looked pretty dull the past ten years, as these old truisms of portfolio management have resulted in lower performance than just buying the S&P 500. That was also the case in the 1990s but holding just the S&P 500 during the first decade of the 2000s would have resulted in no returns; whereas a diversified portfolio could have added several percentage points to annualized earnings. We’re going to stick with the tried-and-true portfolio management techniques in anticipation of a return to a more “normal” stock market environment in the years to come.

Bonds Surprise

Bonds had a strong year but were relatively flat in the fourth quarter as interest rates ticked back up from mid-year lows. The bond market’s full-year gain of just under 9% was a surprise to practically everyone as interest rates declined from almost 3% early in 2019 to 1.5% by late summer. With interest rates as low as they have been the past few years, it didn’t seem probable that they could drop even further. But concerns about the economy earlier in the year resulted in a flight to quality, pushing interest rates to very low levels. Since interest rates and bond prices move in opposite directions, the rate drop resulted in an unusually strong year for bond returns.

Interest rates have risen since the lows, to around 1.9%, and it again seems unlikely that bonds will produce outsized returns going forward. The Fed has indicated it expects to keep short-term interest rates stable throughout 2020, making future interest rate declines even less likely. Regardless of what happens in the short term, current interest rates have historically been a strong predictor of long-term future bond market returns. That implies bonds will generate returns of around 2% annualized in the coming decade. Inflation has historically been around 2.5% annually, so bond returns may not be sufficient to hold purchasing power even.

Alternative Investments

Everyone hates alternative investments these days, but they could be the solution to the low-return problem posed by the bond market, and maybe the stock market too. So-called liquid alternatives are investments in securities that are not like stocks and bonds, but that trade in vehicles like mutual funds or exchange-traded funds.

The most popular categories of alternative investments, such as managed futures or multi-strategy funds have been largely disappointing the past several years. These investments generally are far more expensive to invest in than stocks and bonds, offer less tax-efficiency, can have constraints on when you are able to trade in and out, have strategies that can be difficult to understand, and, by the way, their performance has been lousy. Not exactly a recipe for success. And yet, we still think they could be the answer to solid returns in the future.

With the overall stock market trading at fairly lofty levels and bond yields at very low levels, future returns for more traditional portfolios will likely not be as strong as what we have enjoyed recently. Many strategists are predicting stock market returns of 4%-6% in the coming decade. We already discussed how bonds will likely produce 2% annualized gains. These returns are not sufficient to meet the needs of many investors.

Seeking alternative return streams that are uncorrelated to stocks and bonds seems a reasonable pursuit in such an environment. For us, this has meant investments in things such as private real estate, catastrophe bonds, private loans, derivative strategies, and others. The risk of a well-diversified alternative investment strategy is well below that of the stock market, but the expected returns are similar looking forward. While things have not worked out as hoped the past few years, there is still reason to expect alternatives to behave better in the future, and we believe they will become an increasingly necessary component of portfolio construction.

The alternative funds we employ had a mixed year in 2019. It was another disappointing year for catastrophe bonds and the alternative risk premia fund we hold. Both lost money to the tune of 3%-5%. The other funds we use all had positive performance ranging from 2% for managed futures to 5% for alternative lending and all-asset risk premium. Private real estate performed even better. We realize this is still unimpressive when the stock market returned 30% and bonds were up 9%. However, I wouldn’t get too used to those types of gain from stocks and bonds.


Overall, it has been a good time to be an investor. We’ve had some frustrations, but that is the nature of a truly diversified portfolio. There will always be something with strong returns and something else that makes your blood boil. However, on average and over time, these investments smooth out the ups and downs of one another and can lead to a nice long-run return pattern. Also, yesterday’s strong performers are often tomorrow’s dogs, and vice versa. We don’t want to react to recent market moves only to find that they reverse going forward. So, while diversification hasn’t been our friend lately, we suspect this is just a minor tiff and that we’ll be on speaking terms again before long.

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