U.S. stocks moved sideways to slightly higher throughout the quarter, ending with modest gains. After gaining about 1.3% in the first quarter, the S&P 500 returned 2.5% in the second quarter and was thus up 3.8% in the first half of the year. In light of the persistently low rate on inflation, that’s actually a very competitive rate of return for a six month time period. The rise in U.S. stocks might seem surprising in light of the fact that the reported earnings of U.S. corporations have been somewhat disappointing recently. The Federal Reserve has reduced its forecasts for U.S. economic growth, and the International Monetary Fund (IMF) sees a similar reduction in worldwide growth.
In a seemingly never-ending story, foreign stocks again under performed U.S. stocks in the quarter. As measured by the MSCI All Country World excluding the U.S. index, developed market foreign stocks fell by 0.6% in the quarter and were down about 1% through the end of June. Foreign shares actually performed rather well until late in the quarter, rising by more than 4% up until the referendum votes began to be counted in the United Kingdom. The surprising result of that election –Brexit– rocked foreign markets, which fell 10% in the aggregate in just the three trading days after the result was certified. Emerging markets did inch forward a bit in the quarter, and were up more than 6% through the end of June.
While global equity markets substantially recovered from the panic following the Brexit vote, yields on bonds were lower all the way through the end of the quarter. Bond yields and bond prices move in opposite directions, and thus lower bond yields translated into positive returns for owners of bonds. The Barclays Aggregate Bond Index returned 2% for the quarter and was up more than 5% year-to-date. Less risky, shorter duration bonds also enjoyed positive returns and were up roughly 2% through the end of June. “Interest rates can only go up from here” has been the common refrain in the markets for several years now. As sensible as this has seemed, it has turned out to be wrong. As long as securities are freely traded, prices can go up or down.
The second quarter saw a continued rise in the price of physical assets. After languishing for the past several years, a diversified basket of commodities was up 13% for the year, with energy up a similar 13% and gold up more than 24%. The price of gold seems very much linked to real interest rates, with lower yields for bonds pushing gold prices higher.
Perhaps most remarkable about the Brexit vote is that a lot of clever people were completely surprised by the outcome. This should not have been the case. There are many reputable, professional polling organizations in the United Kingdom, and in the weeks prior to the referendum virtually all of them agreed that the vote would be close. Yet there was a consistent and substantial disconnect between what the opinion polls were saying (“this could go either way…”) and the published odds of the outcome. The odds indicated that “punters” (what betters are called in the U.K.) overwhelmingly believed that the Remain side would win. When people lean on research to wager real money, such as in markets for securities and even for election outcomes, the data and the odds should closely align – but they did not in this case.
It is therefore not just with the benefit of hindsight that we can say that the referendum offered one of the most lopsidedly tempting risk/return wagers of recent memory. On the morning of the vote the odds had moved decisively to the “Remain” side such that what turned out to be a winning bet on “Leave” offered as much as a $4 return for every $1 wagered. If an unbiased survey of coin flippers suggested that your odds of tossing a “heads” with your flip were close to 50%, you would have to be extremely risk averse not to wager a single dollar for a potential $4 return. Perhaps you would be reluctant to bet only if you thought there was something untrustworthy about the coin you were handed to flip.
The matter of impaired trust seems to have played a role, as evidenced by the fact that 57% of people who had just exited the polling booths told questioners they had voted “Remain,” a statistic conveyed to and believed by not only U.K. Prime Minister David Cameron, who had supported the Remain side, but also Nigel Farage, the proponent of Leave. In fact, Farage actually delivered a concession speech before the vote tallies began to be released. Similarly inaccurate exit polling has occurred in America as well, most notably when John Kerry was led to believe he had won Ohio and Florida and, by extension, the Presidency. It is difficult to weigh the right amount of blame for skewed data: pollsters cannot seem to identify an appropriately representative sample of voters (are they unselfconsciously biased?), and a meaningful number of us apparently lie when asked how we voted five minutes ago.
The extent of the Brexit surprise was likely also a function of cocooning, our tendency to surround ourselves with people who share and reinforce our own worldview. As such, an unbalanced 80% of London hedge fund managers aligned their portfolios to profit from a Remain outcome. Nixon won 49 states in the hugely lopsided 1972 election, but New Yorker film critic Pauline Kael was alleged to have said, “Nixon couldn’t have won. I don’t know anyone who voted for him.” People who for no good reason pay attention to stock market talking heads are familiar with the problem. If your economic worldview is especially downbeat (for example) you are likely to find only those with a similarly pessimistic outlook to be logical and convincing. You might go so far as to think optimists are fools, or perhaps possess a conflict of interest that does not bias the people with whom you agree.
What lesson does the Brexit outcome offer investors? Don’t dismiss data because you know better. No matter how blue the sky, if you are told there’s a good chance of rain, bring the umbrella. Do not believe that your own views (however right or wrong they may be) are likely shared by a majority of others. And because you might be wrong about how things will play out, mitigate risk and volatility by broadly diversifying your bets.
Written by Jeffrey Lancaster, CFP®, Principal; [email protected]
|Index||Market||Last 3 Months||Year-to-Date as of 6/30/16|
|Standard & Poor’s 500||Large Co. U.S. Stocks||2.46%||3.84%|
|Russell 1000 Value||Large Co. Value U.S. Stocks||4.58%||6.30%|
|Russell 2000||Small Co. U.S. Stocks||3.79%||2.22%|
|MSCI All-Country World ex U.S.||Foreign Stocks||-0.64%||-1.02%|
|Barclays 1-5 Year Gov’t/Credit||U.S. Shorter-Term Taxable Bonds||0.98%||2.60%|
|Barclays Aggregate Bond||U.S. Taxable Bonds (Broad-based)||2.21%||5.31%|
|Barclays 1-5 Year Muni Bond||U.S. Shorter-Term Tax Exempt Bonds||0.66%||1.37%|
|JPMorgan Global Ex-U.S. Bonds||Hedged Foreign Bonds||3.31%||7.72%|
Key economic indicators compiled by Jeffrey Blanchard, CFA, Investment Analyst; [email protected]
Data Sources: Morningstar; Econoday; Bloomberg.com
(1) Source: MSCI. MSCI has not approved, reviewed or produced this report, makes no express or implied warranties or representations and is not liable whatsoever for any data in the report. MSCI data may not be redistributed or used as a basis for other indices or investment products.
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