Sellwood’s November 2019 Market Snapshot is available for download.
Third Quarter 2019: Inversion
U.S. stocks eked out a gain in the third quarter of 2019 despite the yield curve inverting for the first time in more than a decade and continuing trade war tensions with China. After the almost 2% rise in the S&P 500 Index during the quarter, the index is up more than 20% in the first nine months of the year. The broader-based Russell 3000 Index has also risen more than 20% in 2019, so far. Even with the strong recent performance the S&P 500 sits only slightly above its fall 2018 levels. The persistent theme in the last year and a half has been fluctuating market sentiment focused on potential trade wars, slowing global growth, Brexit fallout, and more recently, continued protests in Hong Kong.
Central banks around the world have tried to ease concerns and spur growth by dropping rates, sometimes into negative territory. In Mario Draghi’s final meeting as the president of the European Central Bank, he reduced deposit rates to -0.5%, joining Sweden, Japan, and Switzerland with negative rates. Mr. Draghi also announced an open-ended bond buying program, which should continue to put downward pressure on global interest rates. The spillover from continued global easing has helped drag U.S. long-term rates lower and has pushed the dollar up to its highest level since 2017, much to President Trump’s chagrin. The strong performance of the dollar helps partially explain the relative underperformance of Non-US Equity markets since the start of this year.
The drop in rates has buoyed fixed income, with long-dated bond indices up over 20% for 2019 and 6% for the quarter. Also benefiting has been the real estate sector, with US REITs up over 25% for the calendar year-to-date.
Second Quarter 2019: The Roaring Nineteens
U.S. stocks are off to their best start to a year since 1997, as the S&P 500 rose 4.3% in the second quarter and 18.5% in the first half of 2019. The rally followed a disappointing fourth quarter of 2018, in which investors fretted about trade wars, slowing global growth, and the future path of Federal Reserve policy. Each of those themes had their part to play in the second quarter.
Better-than-expected employment and GDP numbers in April helped buoy equity markets before they swooned on escalated Chinese trade war fears and a surprising threat of additional tariffs on imported Mexican goods from President Trump. By late June, however, the S&P 500 had risen again, as trade war fears dissipated and Federal Reserve Chairman Powell weighed whether an interest-rate cut will be needed in the coming months.
The dovish shift in messaging from the Federal Reserve has done little to appease President Trump, who has repeatedly called for rate cuts over the past several months. Chairman Powell has reiterated the importance of central bank independence, but his hand may be forced, particularly if trade war uncertainty begins to drag down global growth. The bond market is certainly anticipating that the next interest rate move will be down, not up. The 10-year Treasury’s yield has hovered around 2.0%, below the current Federal Funds rate range, and futures markets are betting on the likelihood of three to four rate cuts over the next two years. Bond market returns were positive with the downward move in yields, and longer-dated assets outperformed.
This past March marked the 10-year anniversary of the market bottom that concluded the 2008/2009 Global Financial Crisis. The decade ending March 31, 2019 was a very interesting one for market observers and practitioners. We offer ten market observations from that decade, and, informed by history, ten predictions about what the next ten years may hold.
1. The US stock market rose 338%, or 16% a year, on average, rising in 9 of 10 years.
The US stock market has experienced a fantastic bull market over the last decade. The market’s last ten years were better than 80% of ten-year periods in its own history.
Prediction: This performance could be repeated, but it would be unlikely.
The last 10 years immediately followed the spectacular collapse of both the economy and stock market in 2008 and early 2009. Low valuations at the time provided a springboard for future returns that simply does not exist today. A decade ago, the market traded at a valuation of 13 times trailing 10-year real earnings; that ratio is 30 today.
At the same time, multi-decade periods of even higher return persisted after the Second World War, and throughout the economic expansion of the 1980s and 1990s. One out of every five decades in history has experienced higher returns than those we have just witnessed. An unusually strong and sustained economic expansion might justify current high valuations. On the other hand, it would take an unusually strong and sustained expansion to do so.
2. Non-US equity markets rose only about half what the US market did.
Over the last decade, the stock markets of the world outside the US collectively returned 145%, or about 9% per year. This was less than half of the US equity market’s return. Over the last five years, non-US equity markets have been up less than 3% per year, while US stocks have risen by about 11% per year.
Prediction: Odds are, this disparity won’t be repeated.
Over the long term, US and non-US equity markets have delivered similar returns to US-based investors. Over the longest period for which we have data, the US market has outperformed the rest of the world by 1.1% annually, on average, since 1970. While some US market participants would point to that gap as a testament to the superiority of the US market, the entirety of outperformance has occurred just since 2011. Prior to then, the historical data had shown long-term outperformance of international markets relative to the US market.
Part of the reason for this disparity has been the depreciation of foreign currencies relative to the US dollar since 2011, which has depressed returns to non-US investments (from the perspective of a US investor). Over the longest period for which we have data, it has been the US dollar that has depreciated, providing the opposite effect.
3. US high-quality bonds returned 3.8% per year.
On the back of a mostly declining interest-rate environment, US high-quality bonds earned 3.8% annually, lower than their long-term average of 7.3% since 1976 but still in-between cash and stocks.
Prediction: This will more or less be repeated.
We have written extensively about how future bond returns almost inescapably follow their current yield. The yield for high-quality US bonds today is about 3%. It will be very difficult for their annual return over the next decade to be very different from 3%.
At the same time, it is likely that high-quality bonds will turn in performance somewhere between cash and equities, in-line with their risk. Historically, they have performed this way in 86% of all ten-year periods.
4. Cash returned nearly nothing (0.3% per year).
The Federal Reserve held short-term rates at zero for the majority of the last decade. Consequently, cash didn’t do much better than zero.
Prediction: Cash will perform better in the next decade.
Currently, the Federal Reserve’s Federal Funds Rate is 2.4%. This is a reasonable proxy for what investors should expect from their cash holdings. High-quality US Treasury money market funds currently yield about that rate, less their fees.
5. Active managers disappointed.
According to S&P’s latest SPIVA study, more than 84% of US equity funds underperformed their benchmarks over the last decade. Small-cap and international equity funds did not perform much better, as a group. Measured year-over-year, the trend does not favor active managers.
Prediction: As a group, active managers will continue to disappoint.
As William Sharpe observed nearly 30 years ago, the market is a zero-sum game. “Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement.” The market has become harder to beat, but active manager costs generally remain too high. Consequently, fewer managers can outperform, net of the fees they charge.
6. Hedge funds really disappointed.
Hedge funds, originally sold to investors as sources of high return with low risk, delivered the low risk but couldn’t provide the high return. Over the last decade, hedge funds underperformed US stocks, international stocks, public and private real estate, and even high-quality bonds.
Prediction: We are with Warren Buffett on this one: hedge funds will continue to disappoint.
Given their fee structures, hedge funds, at least as a group, have little hope of doing anything but disappoint their clients. There are simply too many dollars chasing too few opportunities for alpha, and fees remain at levels that are difficult to justify given the opportunity set. Our research shows that hedge fund managers appear capable of adding value with investor money – it’s just that they are equally talented at designing fee structures that keep all that value for themselves, leaving little behind for the client.
7. Value died.
Traditional value investing, as American as apple pie, has lagged significantly compared to investments in growth companies. Since April 1, 2009, US value stocks have returned 294% — an impressive number by itself, but still 110% below growth company stocks over the same time period. As of early 2019, value is in the longest drawdown relative to growth in history.
Prediction: Value is not dead, only asleep.
Hungry for growth in a slow-growth world, investors have bid up growing companies more than their slower-growing but more modestly valued counterparts. Prior to ten years ago, value had historically provided a premium to growth stocks, but not without significant periods of pain for investors. Since 1926, value has beaten growth in 80% of all trailing 10-year periods. Value has been a valuable proposition, just not in this last decade.
8. The “bond bubble” didn’t pop because it didn’t exist.
For all the worries of rising rates, long-term bonds handily outpaced their shorter-duration counterparts over the last decade. Long-term bonds returned 7.3% per year, while short-term bonds returned 2.2%.
Prediction: Investors will continue to be foiled attempting to time rate changes in the bond market.
All the predictions for rising rates were well founded, but the investment implications of those predictions were severely overblown. Since the Federal Reserve began raising rates in December of 2015, long-term bonds have returned almost 20% cumulatively while short-term bonds have returned just 6%. Investors who adjusted their bond portfolio composition to time rate changes suffered. Profiting from timing rate changes has proved nearly impossible, even with a Federal Reserve that has been transparent about its plans, and we don’t see why that should change anytime soon.
9. Noise and temptations for short-termism abound.
Quantitative Easing. Swine Flu. Zero Lower Bound. European Sovereign Debt Crisis. Dodd-Frank. Double-dip Recession. Operation Twist. Ebola. Zika. Detroit Bankruptcy. ISIS. US Government Shutdown. Brexit. President Trump. President Trump’s tweets.
None of these words or phrases existed, at least in common parlance, a decade ago. Each of them offered an opportunity to bail out on what would become the longest bull market in history.
Prediction: The noise will continue, but opportunities to avoid it remain the same.
It is said that markets climb a wall of worry. There will always be things to worry about. We advise clients to maintain a long-term perspective. Among other advantages, it confers the luxury of being able to tune out the noise and participate in market return.
10. Fears of high inflation were unfounded.
In addition to holding short-term interest rates near zero (Observation #4), the Federal Reserve also embarked on a “Quantitative Easing” program which saw the Federal Reserve’s Total Assets increase by almost 5 times (from $900 billion at the start of the financial crisis to a peak of $4.5 trillion in 2015). Quantitative Easing, which is intended to inject money into the economy, was thought to eventually lead to higher inflation as the economy grew. While the US economy has experienced one of the longest economic expansions in its history, inflation has remained stubbornly below the Federal Reserve’s target of 2%. The average Headline Consumer Price Index Year-over-Year change in the last decade has been just 1.6% – well below the long-term average of 3.5%. Although it is difficult to know the exact cause of low inflation, technology, productivity, and (the lack of) wage growth have likely all served to dampen it over the last decade.
Prediction: Inflation will remain as difficult to forecast as bond yields.
Economies are complex systems, and multiple variables affect indicators like the level of inflation. As tempting as it is to predict economic indicators, things like the experience of inflation over the last decade remind us that humility is an important part of an investment process.
* * * * *
Markets offer lessons to students who are patient listeners. Some lessons of the last decade are that crises end quickly, but fear subsides slowly; that changing conditions can introduce new, persistent market regimes; and that a “long-term” view of history is necessarily longer than 10 years.
Note: All returns are presented as of March 31, 2019, using common market indexes. Sources: Sellwood Consulting LLC, Morningstar Direct, Investment Metrics, eVestment, Federal Reserve Bank of St. Louis, and Kenneth R. French – Data Library
“The greatest scientists are artists as well.” -- Albert Einstein
- When was the US Equity market riskier for an investor:
- March 2009. The S&P 500 has just fallen 55% from its peak and the trailing ten-year standard deviation of S&P 500 returns was 21%. The market trades at a valuation of 13 times trailing 10-year normalized real earnings. Or…
- March 2019. A decade later. The S&P 500 has just experienced a 10-year, relatively uninterrupted bull market in which it cumulatively returned 415% without declining 20% along the way. The index’s trailing ten-year standard deviation of returns has been 15%. The market trades at a valuation of 30 times trailing 10-year normalized real earnings.
- At what point in time – March 2009 or March 2019 – would most risk models say that the equity market was riskier?
A Tale of Two Markets
Early 2009 was a fascinating time to evaluate risk. Just about all information available to an investor suggested that the US equity market was riskier than normal. Historical measured risk was higher than average, the market had gone nowhere but down in recent memory, and every sensory input suggested “sell.” But at the same time, valuations were low, and long-term investors can afford to tune out the noise.
Early 2019 is an equally interesting time to model risk. On one hand, following one of the longest bull markets in history, after which prices have accelerated faster than fundamentals, it would seem that the market would be more, not less, risky than in 2009. Higher valuations represent higher risk, all else equal. They leave less room for error. But on the other hand, any model that calculates risk (defined as standard deviation) looking back ten years will, for the first time in a decade, not include the experience of 2008. Any such model will likely understate risk, relative to reality.
One of these market environments appeared riskier than the other; the other actually was riskier than the other.
Looking forward, is an experience resembling 2008 less likely simply because it happened eleven years ago now, rather than ten years ago? Of course not. Behavioral science (specifically, the availability heuristic) suggests that human beings would tend to think so. This is why we invent quantitative models — to help our human brains evaluate hard questions with better context. The problem is: in March 2019, any quantitative model with a ten-year lookback period would have suddenly “forgotten” about 2008. Without adjustment, the model would fall victim to the same inaccurate analysis that imperfect human beings do, as the last salient market event recedes into the past.
You Can’t Model Risk with a Formula
Careful readers of our 2019 Capital Market Assumptions may notice that this year, the “qualitative adjustments” we made to the expected risk (standard deviation) of several asset classes were higher than they have been in the past.
When we calculate a forward-looking risk assumption for each asset class, we model the “risk” by calculating an average of the asset class’s standard deviation of returns over the last ten years, and over the longest period for which we have reasonable data.
As an example, this simple approach would calculate a “risk” for US Equity (the standard deviation of the Russell 3000 Index) of 14.7%, as of the end of 2018. That index, in the last ten years, experienced a standard deviation of its returns of 12.4%. Over the longest time period we can examine, the index experienced a standard deviation of its returns of 17.1%. Averaging these two numbers yields 14.7%.
This risk number, 14.7%, quantifies how uncertain we are about future annual returns. Using our expected annual return for US equity (6.9%, in arithmetic terms) and a standard deviation of returns of 14.7%, our assumptions imply that returns in any future year worse than -22.5% (a “two-standard-deviation event”) would be extremely unlikely, and a return worse than -37.2% (a “three-standard-deviation-event”) would be nearly impossible.
We can draw a bell-shaped curve depicting these parameters. Everything under the curve is possible under the assumed distribution of returns. Real-world events should not fall to the left or the right of the curve – outside the realm of “possible” under our assumptions.
In the real world, it was only eleven years ago that we saw the US equity market decline by 37.3% in a single calendar year. Assuming market risk as calculated above would imply only a 0.1% chance of the 2008 experience happening. It would be saying that 2008’s real world decline should happen only once every 700 hundred years. This would be non-sensical. The US stock market, after all, has only existed for 201 years, and declines worse than -37% have actually happened in three of the last hundred years (in 1931, 1937, and 2008).
This is a problem. Nobody should forecast a level of risk that implies that something that has happened three times in the last 100 years should only happen once every 700 years. When the model tells you something that actually happened couldn’t have happened, it’s not reality that’s wrong; it’s the model.
Our process for designing risk assumptions solves this problem by forcing the model to adapt to actual observed reality. Rather than blindly accepting the output of a calculation, we have always applied a “qualitative adjustment,” upwardly adjusting the assumed risk until the actual worst-case scenario we have experienced, in the modern real world, had at least a 1% chance of happening, and has at least a 1% chance of happening again in the future. This implies that the worst-case scenario for a market, usually 2008, was a one-in-a-100-year event.
To recap, a naïve assumption of the US equity market’s risk, based on calculations of past returns, would yield an expected risk of about 15% and imply that 2008’s experience had a 0.1% chance of occurring. By focusing on real-world downside, and by making a reasonable assumption that 2008 was a one-in-a hundred-year event, we update our risk assumption to better reflect the real world. By increasing the risk assumption by 4.3 percentage points, we increase the validity of our risk assumption – the likelihood of 2008 happening inside of it – a hundredfold.
Still, a 4.3-percentage-point adjustment to the expected risk of a major asset class is unusual for us. It reflects the uniqueness of where we sit today, in early 2019. For the first time in a long time, a major market correction is so far in the rear-view mirror that it doesn’t show up in traditional models.
A year ago, under Sellwood’s 2018 assumptions, half of the risk calculation — the last-ten-years half — included the 2008 market experience. Our calculated risk for US Equity was 18.44%, making the real-world worst-case experience reasonably likely without adjustment.
But as the calendar turned into 2019, the 2008 experience fell off the calculation, and the calculated risk went down. Therefore, a higher adjustment was necessary to bring our assumed risk high enough such that a worst case in the real world is reasonably likely under our assumption set.
If we did not make this qualitative adjustment, our assumptions would tell an unlikely story: that at the tail end of one of the longest bull markets in history, risk has gone down, not up; and that the experience we all lived through just eleven years ago was so unlikely that it won’t happen ever again — not only in our lifetimes, but those of our children and grandchildren as well. We are uncomfortable designing an assumption set that makes these assumptions.
”Risk” is ephemeral, and not easily calculated. Nobody knows what the actual risk of an asset or asset class is. All anybody can do is guess, typically by examining what the past has delivered. Of course, we aren’t designing portfolios for the past; the ultimate goal is to develop reasonable expectations about what the future will deliver. Examining the past is of limited help in meeting this goal.
Our assumptions change as markets do, but the way we construct them includes guardrails to ensure that market anomalies or recent experience won’t contort the assumptions into saying the impossible.
To do otherwise is to surrender judgment to a formula.
Good investors know something that bad investors don’t: that it is often when things appear bleakest that prospects are brightest, and that when things look riskiest that they are safest. Models can help reinforce this truism, but only if the models are intelligently designed, blending art and science. Otherwise, using the models isn’t any more helpful than asking a bad investor for investment advice.