Diversified portfolios generated positive returns in the third quarter as U.S. stocks registered strong gains. Foreign stock returns were modestly positive during the quarter while bond returns were close to flat.
U.S. stocks rallied during the quarter with the S&P 500 gaining more than 7%. Shares were boosted by solid economic growth and big gains in corporate profits. The companies in the S&P 500 reported a 26% increase in second quarter earnings following a similar gain for the first quarter. Earnings were boosted by higher revenues as well as expanding profit margins, which reached an all-time high of nearly 12%. The strong earnings results more than offset worries of potential trade wars and the continued slow but steady rise in U.S. interest rates. Within U.S. stocks, technology stocks continued their strong run, outperforming most other sectors in the third quarter.
Foreign stocks turned in a mixed performance during the third quarter. The broad MSCI ACWI ex U.S. Index, which contains both developed and emerging market stocks, gained slightly less than 1%. Foreign developed country stocks registered modest gains while emerging markets stocks, as measured by the MSCI Emerging Market Index, declined about 1%. As trade tensions mounted, returns were weaker in export-oriented countries such as China and Germany. U.K. stocks declined about 2% in U.S. dollar terms as Brexit negotiations with the European Union turned more contentious. Year-to-date, the MSCI ACWI Index is down 3.0%, underperforming the S&P 500 by more than 13%.
U.S. bond returns were close to flat as Treasury bond yields rose approximately 0.25% across the yield curve. The Federal Reserve continued its approach of gradually raising short-term interest rates, increasing the Federal Funds rate by 0.25% in September. The Fed has taken an incremental approach since it started tightening in December of 2015, implementing eight rate increases of 0.25% each. While these individual increases have been small, the cumulative effect is starting to add up – the Fed Funds rate is now 2% and short-term bonds now yield nearly 3%1. Even when yields were closer to zero several years back, high-quality bonds played a valuable role in diversified portfolios as risk reducers. As yields revert to more normal levels, bonds are beginning to offer investors decent expected returns along with their risk reduction benefits.
Given the underperformance of foreign stocks this year and since the financial crisis, it’s natural to wonder whether one should trim foreign stocks allocations in favor of more U.S. stocks. To the contrary, we recommend maintaining foreign stock allocations and, to the extent allocations have drifted below targets, purchasing more foreign stocks to bring allocations back into alignment.
In general, we are currently targeting a split of roughly two-thirds to U.S. stocks and one-third to foreign stocks. Within the foreign stock portion, we’re allocating about three-fourth to developed countries such as Japan, the U.K. and Canada and one-fourth to emerging countries such as China, India, and Mexico. Our rationale for maintaining these allocations rests on two considerations.
First, foreign stocks are a lot cheaper than U.S. stock given the substantial outperformance of U.S. stocks since the financial crisis. As of August 31, 2018, the cyclically-adjusted price-earnings (CAPE) ratio of the S&P 500 was 332, a level that has been exceeded only once in the past during the latter stages of the 1990s tech bubble. The CAPE ratios of foreign developed country stocks and foreign emerging country stocks, at 19 and 133, respectively, are much lower than the CAPE of U.S. stocks and much more in-line with their historical averages.
We acknowledge that U.S. stocks may continue to outperform foreign stocks and that this valuation gap could get wider still. In fact, it’s not hard to identify reasons why U.S. stocks could continue to provide better returns including potential fallout from the Brexit negotiations, concerns over Italian debt levels, and slowing growth in China. Nevertheless, we believe the odds are good that foreign stocks will outperform U.S. stocks over the next five-to-ten years given the substantial valuation gap. While CAPE metrics tell us little about short-term performance, CAPE has a solid record of predicting longer term performance – low beginning CAPE levels tend to be followed by higher-than-average 10-year returns while high beginning CAPE levels tend to be followed by lower-than average 10-year returns.
Second, independent of the valuation consideration, maintaining a significant allocation to foreign stocks can help reduce overall portfolio risk through the benefits of diversification. U.S. and foreign stock returns have often moved in different directions and this “non-correlation” can contribute to attractive long-term portfolio returns with less volatility. Moreover, from a practical standpoint, no one knows for sure which economies and markets will be the future winners – maintaining an allocation to foreign stocks ensures that the portfolio will own at least some of the top performers in the future.
Maintaining a disciplined, diversified investment approach can be difficult at times. With the highly visible and familiar asset class of U.S. stocks having substantially outperformed other components of the portfolio so far this year, it can be tempting to allocate more assets to U.S. stocks in an attempt to capture more of the gains. This approach of buying high and selling low usually ends badly and we see no convincing reason why this time is any different.
Written by Rich Golinski, CFA, Chief Investment Officer; firstname.lastname@example.org
|Index||Market||06/30/18 – 09/30/18||12/31/17 – 09/30/18|
|Standard & Poor’s 500||Large Co. U.S. Stocks||7.7%||10.6%|
|Russell 1000 Value||Large Co. Value U.S. Stocks||5.7%||3.9%|
|Russell 2000||Small Co. U.S. Stocks||3.6%||11.5%|
|MSCI All-Country World ex U.S.||Foreign Stocks||0.7%||-3.1%|
|Barclays 1-5 Year Gov’t/Credit||U.S. Shorter-Term Taxable Bonds||0.3%||-0.1%|
|Barclays Aggregate Bond||U.S. Taxable Bonds (Broad-based)||0.0%||-1.6%|
|Barclays 1-5 Year Muni Bond||U.S. Shorter-Term Tax Exempt Bonds||-0.1%||0.7%|
|JPMorgan Global Ex-U.S. Bonds||Hedged Foreign Bonds||-0.6%||1.1%|
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