A "Magnificent" Stumble

What started out as a bullish trend in the beginning of Q1 has devolved into a sharp reversal.  It is hard to believe that our most recent all-time high on February 19 has turned so negative so quickly.  Though it is due to a myriad of inter-related global political and economic factors, the cause can be summarized in one word:  tariffs!  The prospect of tariffs has put the global order into a state of uncertainty and the markets do not like uncertainty.

Klaus Baader, Global Chief Economist of Societe Generale, has summarized the key factors impacting the markets on Bloomberg TV.  He retorted that there are “lots of moving parts” and a lot of “fluidity to U.S. policymaking” and it is “very, very difficult to get your head around” it.  He identified the potential for “seismic dislocations” and felt that the U.S. administration is changing the global order in at least three respects:  global trade system due to the tariffs, military and security setup, and fundamentally re-doing the shape of the U.S. Federal govt.  His forecasts now show a “skew of risk dramatically moved to the downside.”

These shifts in global policy have clearly impacted risk assets.  Most of the pullback in Q1 came from the high-flying growth and mega-cap tech sectors (i.e., the “Magnificent 7”, -15.7%) as well as small and mid-cap equities, though international developed equities bucked the trend.  Per the table below, the S&P 500 (IVV) was down -4.2% during Q1, while small- and mid-cap equities (SCHA, -9.2% and SCHM, -5.2%) struggled.  International (SCHF, 6.9%) and emerging market equities (SCHE, 3.5%) showed some strength while bonds were a refuge with core bonds (SCHZ, 2.7%) and short bonds (SLQD, 1.8%) providing modest positive Q1 returns.

My recent blog posts have highlighted the risks of equity markets and the prevalence of drawdowns and their eventual recoveries. As I said in my March 12, 2025 blog:

Though no one likes losses, long term investors have ALWAYS been rewarded with market returns reaching new all-time highs by ignoring volatility and holding through tough times.  Though “they all seemed like the end of the world at the time”, markets have always recovered.

Fear to Opportunity: Part 2

My blog post last week highlighted some market statistics showing that >5% drawdowns are a common occurrence and have ALWAYS been followed by eventual recovery to new all-time highs.  As a reinforcement to that thought, investment thought-leader Charlie Bilello came out with more statistics that ring true for those worried about the recent market drawdown:

“The S&P 500 has returned an average of 10% per year since 1928 despite an average intra-year drawdown of -16%. There's no upside without occasional downside, no reward without risk.” (table below)

Though no one likes losses, long term investors have ALWAYS been rewarded with market returns reaching new all-time highs by ignoring volatility and holding through tough times.  Though “they all seemed like the end of the world at the time”, markets have always recovered.

Though there are troubling economic and geopolitical situations currently occurring at the same time, this reminds me of the book The Rational Optimist: How Prosperity Evolves" by Matt Ridley.  In it, he posits that human innovation, trade, and adaptability consistently drive progress, even through crises and society has always found a way to overcome adversity and lead to better outcomes. 

D&A will continue to follow a globally-diversified, long-term strategic risk-managed approach to portfolio management for clients consistent with their needs and goals and will (almost) never deviate from a strategy due to adverse market conditions.

Fear to Opportunity?

I follow many investment thought leaders like Tom Lee (Fundstrat), Warren Buffet (Berkshire Hathaway), Mark Zandi (Moody’s), and Bill Gross (of PIMCO fame).  Another less well-known thought leader that I follow is Charlie Bilello of Creative Planning.  He is mostly focused on retirement strategies and behavioral finance.  

His most recent post dealt with the current market pullback in comparison to other recent pullbacks.  He looked at the >5% pullback in the S&P 500 from its recent peak back on February 19.  Interestingly, there have been 30 corrections >5% off of a high since the March 2009 low.  In his words, “they all seemed like the end of the world at the time” (see table below).

The point being, of course, is that despite our behavioral bias to be fearful of market pullbacks there is good reason to view them as a normal part of the market.  As we have seen before, it is reasonable to expect that the markets will recover and new highs will emerge over time.  No guarantees, of course, but this is what we have always seen!

D&A is committed to risk-managed long term strategic investing for clients with a long term time horizon.  Clients with a shorter time horizon and lower tolerance for risk are invested accordingly.  The current economic and geopolitical stresses we are seeing now in regard to tariffs and the Ukraine/Russia war are certainly troubling but are not insurmountable.  Patience has always been rewarded!

Wisdom from an Investment Icon

I earned my Chartered Financial Analyst (CFA®) designation a long time ago.  Many of the required readings were authored by Charles D. Ellis, an icon in the investment industry!  He just came out with a new book titled, Rethinking Investing: A Very Short Guide to Very Long-Term Investing.  In his own words, “At my advanced age, I’ve been around for a long, long time… I put down everything I thought was important for someone to know, and it only took 100 pages!” 

CNBC aired a 10-minute interview with him where he highlighted many of the key points in the book.  Readers of this blog will be well aware of some of these truisms that I have often written about.  Aside from a key point about minimizing investment expenses by using low cost passive ETFs as a way to improve “net” investment return, the most important takeaway is the fact that it is almost impossible to time the market!

The following slide highlights the key facts supporting this assertion.  Simply, if you are out of the market on the 10 best days over the past 36 years your average annual compound return declines from +11.4% to +9.2%; the best 20 days it goes down to +7.7%, and the 30 best days it goes down +6.4%!  Interestingly, these “best” days often occur after “worst” days making the timing action even more painful if they are missed. And, no one knows when the “best” days will occur!

Ellis went on to highlight the behavioral biases that negatively impact investment success.  These include things like overconfidence, jumping to conclusions, herd mentality, anchoring, and the endowment effect.  Listen to the video link for more info on these.

Finally, the following bullets summarize his keys to successful investing:

·        Personal discipline to save

·        Long term focus

·        Benign Neglect:  most actions do more harm than good

·        Act consistently with long term goals

Dattilio & Ash is committed to the highest level of investment professionalism as an investment fiduciary and heartily agrees with the points made; they are well worn and timeless.  D&A works with its clients to understand their financial situation and risk tolerance and then structures an investment portfolio to help them achieve their goals.

Unpacking 2024 Performance Trends

One of my favorite charts is the annual Callan Institute Periodic Table of Investment Returns.  I like it because it shows in one chart how all of the major classes have done over time.  Also, it shows the variability of returns such that the chart almost looks random!

The 2024 Table (below) shows some interesting data points.  First, it is no surprise to anyone who follows the news that the S&P 500 Large Cap Equity index led all major asset classes (again!) in 2024 with a total return of +25.02%!  Trailing behind it by a fair amount was Small Cap Equities at +11.54%.

A surprise is that High Yield bonds came in third at +8.19%; certainly a function of Fed easing during 2024 with the requisite narrowing of credit spreads and bullish economic forecast.  Cash equivalents was in the middle of the pack at 5.25%.  Bringing up the rear was Global Ex-U.S. Fixed Income at -4.22%; partly a result of the strong dollar.

Point in time analysis is nice, but the trends also tell a story.  Certainly, U.S. Large Cap Equity took the lead the most recent two years in a row, but also has been in the top spot 4 of the last 6 years! Moreover, looking over a longer horizon it has a 20-year average annual return of +10.3% and an even higher return over the most recent 10-years at +13.1%!   Emerging Market Equities, the darling with outsized 30%+ returns in the mid-2000’s, continues to labor with middling returns in 2024 and a smallish 20-year average annual return of +5.5%.

Readers of this blog post are well aware of me bemoaning the lack of diversification benefits over the past few years.  Certainly, with the S&P 500 loaded with booming mega-cap tech stocks like Nvidia, Microsoft, Alphabet, Meta, Amazon, Tesla, etc. it is hard to fault that index for leading the pack; well-deserved!  Bonds, meanwhile, have been a necessary evil with middling returns to help smooth the risk profile of diversified portfolios.

To that end, D&A client accounts over the past couple of years and currently have been overweighted in equities with a strong tilt to growth and momentum factors to help capture some of that excess return.  We still favor some exposure to small/mid-cap equities and are overweighted there relative to benchmarks but are less interested in international and emerging market equities where we are underweighted.  On the fixed income side, we continue to keep bond duration short to core bonds in order to protect against interest rate risk while the yield curve remains a bit flat, but steepening.

Smart Financial Habits to Adopt in the New Year

It can be customary in a new year to think about upgrades or enhancements to how we live our lives. In other words, to think about our New Year’s Resolutions!  Following below are a few of my favorite financially-related resolutions that I strongly encourage everyone to adopt.

 1.        Secure Credit Card Usage

Credit card fraud continues to be a large problem in our society.  However, there are ways to help protect yourself against this threat.  First, set up your credit card to notify you via text or email EVERY TIME your card is used!  In this way, you can stop unauthorized use of your card sooner than if you waited until the end of the monthly billing cycle.  Yes, you are not liable for any unauthorized charges, but the sooner you stop them the sooner you can get your credit use back to normal.

Alternatively, you can freeze your card so it can only be used each time you unfreeze it.  This process can be a bit cumbersome but is very effective to limit fraud.

2.        Secure your Credit Identity

Identity theft is the next major problem.  This is the case where someone poses as you and uses your credit identity to open new credit cards and accounts in your name.  Fortunately, there are ways to help prevent identity theft.

The most effective way to limit identity theft is to freeze your credit identity with the three major credit bureaus.  This is called a credit freeze and creditors cannot access your credit report. This will keep them from approving any new credit account in your name, whether it is fraudulent or legitimate.  Best of all, to freeze your credit identity is free!  Simply contact each of the credit bureaus (Equifax, Experian, and Transunion) to get it done.  For more information on how to do this go to the official U.S. Government site:  https://www.usa.gov/credit-freeze.

 3.        Have Emergency Fund

Life is full of uncertainty.  To help smooth out the bumps in the road it is good to have an account that is liquid and ready to go for unexpected bills; things like car and housing repairs, medical bills, etc.  With short term interest rates at a good level now, money market funds today pay about 4.2%, it is easy to earn a decent return with almost zero risk. A quick rule of thumb suggests an emergency fund holding about 3-6 months of after-tax income.

I am happy to discuss these and other topics in more detail at your convenience.  Just let me know and we can set up a time to discuss.  Here’s to a financially secure 2025!!

Market Weather Report: Sunny, with a Chance of Fed!

The trend is your friend! Don’t fight the tape. And, If you don’t like the weather, wait a minute! These familiar idioms are often used to describe the ebb and flow of the markets—and they couldn’t be more fitting for 2024 Q4.

The quarter started strong, with core equities and diversifying asset classes like small- and mid-cap equities leading the charge. Momentum was building, and optimism was in the air. But as the saying goes, All good things must come to an end. In this case, the Fed stepped in with hawkish commentary, signaling that its easing cycle in 2025 might not be as aggressive as investors had hoped. The result? Small- and mid-cap equities lost their edge, and the broader market cooled.

Adding to the uncertainty were mixed economic signals. The U.S. Consumer Confidence Index showed signs of weakness while new fears of inflationary pressures emerged. Long Treasury yields climbed by 100 basis points, despite 100 basis points of Fed rate cuts since September—a counterintuitive and somewhat bearish signal for the markets.

As seen from the table below, 2024 Q4 showed a mixed bag of performance with the S&P 500 (IVV), once again, wresting the performance crown from the other major asset classes with a +2.4% Q4 return and YTD return of +24.9%.  The strong showing of small/mid-cap equities disappeared post-Fed comments but they still eked out a small Q4 return.  International markets continued their multi-year malaise with a very weak Q4 and a positive, but uninspiring, full year 2024.  Long bonds struggled with modest negative returns with long rates rising, while short bonds ended the quarter mostly flat.

In the end, Q4 proved to be a reminder of the unpredictable nature of markets. As we move into 2025, the focus will remain on balancing the optimism of early gains with the caution warranted by a shifting economic and monetary landscape.  As I said back in my blog post in early December,

In the meantime, D&A is sticking with its long-term strategic approach managing client accounts to their customized strategies targeted to their risk profile, time horizon, and their special considerations.  We still mostly prefer globally-diversified portfolios of low-cost passive exchange-traded funds (ETFs) suited to those needs. As I am wont to say when someone asks me what the market will do; I say “Beats Me!”

Market Volatility Returns

Last week’s blog post highlighted the phenomenal market performance of the S&P 500 over the last two years.  Many of the statistics quoted implied that the market is currently considered “rich” and could be ripe for a pullback.  In that blog post I posited that a potential trigger could be “turmoil in the bond market”.  Surprise, surprise - that is what we saw after the Fed meetings and announcement on Wednesday! 

The Fed cut the Fed Funds rate by 0.25% and Chairman Powell indicated that there was a chance for “only” two rate cuts next year instead of the market expectation for four.  This prompted the market to worry about a pickup in inflation, driving long term rates up 0.37% from 4.18% on December 2 to 4.55% today.

 The markets reacted with a significant pullback.  Small cap stocks (SCHA), making a strong push so far during Q4, were down 4.2% in one day while the S&P 500 (IVV) lost 2.9%.  The increase in interest rates caused core bonds (AGG) to lose 0.8% and short bonds, having less interest rate risk, only lost 0.3%.

 So, what does this mean for you? While the market’s reaction may seem abrupt, this level of volatility is normal in investing.  At D&A, our disciplined approach to rebalancing ensures your portfolio remains aligned with your goals despite short-term market movements.  If you have questions about how these developments affect your investments, feel free to reach out—we're here to help.

The Gift That Keeps on Giving: Will the Market Stay Merry?

Market commentators are all abuzz about the phenomenal performance of the S&P 500.  This year the market has reached 56 new all-time highs.  We are on track for the S&P 500 to produce two consecutive years of over 20% returns for the first time since 1998.  It was up +26.1% in 2023 and so far is up +28.1% this year.  The last time this happened was in 1998 and over the last 75 years there were only 8 other times when stocks jumped 20%+ for two years in a row; the index finished positive in six of the following years and fell only in 1977 and 2000.

Also, the S&P 500 price-to-book ratio is at the highest level since March 2000, the peak of the Dot Com Bubble.  Another interesting tidbit; whenever the S&P 500 has been in a bull market this long at 26 months, it has always persisted, sometimes years, longer!

Finally, let’s not forget the rest of the world’s capital markets.  The U.S. is historically “rich” compared to the rest of the world trading at 22x forward earning versus 14x for international stocks; the largest gap in history!

Nothing more needs to be said about how strong the S&P 500 has been the last two years!  Looking into the component stocks, we see the “Magnificent 7” (Nvidia, Apple, Microsoft, Amazon, Alphabet, Meta, Tesla, and Netflix) who have led the charge with an outsized +55% total return this YTD and +126% over the last 2 years (see chart below, red line for Magnificent 7 compared to blue line S&P 500 (IVV).  Other lesser known names like Palantir, Vistra, Texas Pacific, and Axon Enterprises are all up over +145%!

What could cause the market to selloff?  Maybe turmoil in the bond market, but certainly the bond market has been well-behaved so far this year.  After all, year-to-date core bonds (AGG) are up +3.1% and high yield bonds (HYG), one of the supposedly riskiest fixed income sectors, has done phenomenally well being up +9.0% due to a large narrowing of credit spreads to almost historic lows.  Shorter bonds (NEAR), with less interest rate risk, are up about 5.0% YTD.

Other things that could derail the market are a spike up in inflation, geopolitical turmoil, an oil supply shock, or an “unknown unknown” (a “black swan” event).  We shall see!

In the meantime, D&A is sticking with its long-term strategic approach managing client accounts to their customized strategies targeted to their risk profile, time horizon, and their special considerations.  We still mostly prefer globally-diversified portfolios of low-cost passive exchange-traded funds (ETFs) suited to those needs. As I am wont to say when someone asks me what the market will do; I say “Beats Me!”

While markets remain unpredictable, D&A’s focus on disciplined, long-term strategies ensures our clients stay well-positioned, no matter what lies ahead.

Shrinking Credit Spreads

I was head of U.S. Portfolio Management for Sun Life Financial for twelve years.  In that role I spent a lot of time worrying about interest rates and the fixed income markets.  Whether it was corporate bonds, securitized assets, private debt or commercial mortgages, we always focused in on the “spread to treasuries” as the measure of ‘rich’ or “cheap” and relative value.

Credit spreads today are narrowing in on historical lows.  Per the chart below from the Federal Reserve Bank of St. Louis, you can see that credit spreads for investment grade corporate bonds and high yield bonds are at 10-year lows of 0.80% and 2.72%, respectively.  Though not all-time narrows, this secular shift down can be implying an important message to us.  

Most thought leaders look at the narrowing of credit spreads as a positive indication of economic strength.  Certainly, if businesses have good earnings and are well able to cover their debt service then there should be less chance of default.  Thus, the part of the credit spread reflecting default risk would be reduced.  Narrow credit spreads also reflect a supply and demand factor indicating increased demand for income-generating assets from investors.

This is good news for equities, too, since a narrower credit spread indicates reduced borrowing costs for debt issuers and improved net earnings.  In this regard, equities and fixed income markets are on the same page; all-time highs in the equity markets and 10-year lows in credit spreads both reflect the same positive story.

This single data point supports the thesis that the “bull” case for capital markets remains strong.  Anything can happen, of course, including geopolitical turmoil bubbling up overseas in Ukraine/Russia and Israel.  As always, an investment strategy targeted to an investors risk tolerance and time horizon should help an investor achieve their goals.

Trump Victory and the Market Rally: What’s Next?

My blog posts hardly ever delve into politics.  Today, however, is an exception.  In the wake of Trump’s election victory last night, the pre-markets are rallying strongly.  One thing is clear, Trump’s pro-business, America-first mantra resonated strongly with the electorate and that has translated into a strong market reaction pre-market this morning.

Pre-market, the broad S&P 500 is currently up +1.2% and the NASDAQ is up +1.4% while more focused sub-sectors like small cap is up +1.9% and financials (XLF) are up +5.7% (perhaps due to anticipated increased banking activity in a growing “Trump economy”)!  Signs of a Fed easing earlier this year combined with stable labor markets, good earnings growth and moderated inflation stoked markets leading up to where we are today.

Other diversifying, but more risky, asset classes have also performed well YTD with gold (GLD) up +33% and bitcoin (BITO) up +55% - not counting today’s large pre-market rally! Fixed income markets have been mostly tame, but core bonds have struggled.

As I have reported most of this year, most D&A clients have been overweighted large cap, high quality, growth equities and been short bond duration; a strategic position that has benefited client performance this year.  Most client accounts are easily beating their benchmarks this year.

As I’m accustomed to say, if you ask me where the market is headed, I’ll say ‘Beats me!’ But the anecdotal—and perhaps behavioral—evidence gives us reason for a bullish outlook. For now, this solid strategic positioning benefits clients and aligns with current market conditions. Barring any changes in clients’ goals or needs, we’re sticking with this approach.

Portfolio Balancing Act

Back in April I wrote a blog post titled Portfolio Management Decision-Making that highlighted the difficulty in developing an effective risk-managed portfolio of investments to meet client goals.  On the one hand, it could be a very simplistic approach with just two holdings:  the S&P 500 for the equity piece and the Bloomberg U.S Aggregate Bond Index for the fixed income piece.  But, we all know that the investment universe is much more complex than that and is made up of a multitude of different sectors and sub-sectors.

Many investment managers provide “model” investment portfolios that attempt to target risk profiles by adjusting the sector and sub-sector weightings of equities and fixed income.  A typical model portfolio can be comprised of 60% equities and 40% fixed income with some diversifying allocations to other sub-sectors.

The main difference between any of these models is the allocation to the equity and fixed income sub-sectors.  The equity sub-sectors most often seen are small- and mid-cap equities, international developed and emerging market equities, and growth or value style.  In the fixed income space it is common to see high yield bonds, corporate bonds, and emerging market bond sectors.  Needless to say, the allocations to the sub-sectors are the factor most driving investment performance.

I took a look at a few of the large investment model providers:  State Street, Vanguard, and WisdomTree (see table below).  They each provide long-term strategic model portfolios comprised of equity and fixed income sectors.  I analyzed two specific strategies:  the 60% equity / 40% fixed income growth strategy and the 80% equity / 20% fixed income aggressive strategy.

As seen below, none of the models consistently beat their naïve benchmarks (iShares Core Growth for the 60%/40% strategy and iShares Core Aggressive for the 80%/20%).  Though all of the models target the overall equity/fixed income allocation, it is the underlying sector allocation that drives the difference.  In these cases, sometimes they win (green highlight) and sometimes they lose (no highlight)!

D&A model portfolios are most usually customized for each client depending upon their specific unique preferences.  Model portfolios offer frameworks, but customization is key to achieving client goals.  Most accounts are made up of some core holdings in the S&P 500 and Core bonds, but most usually over 50% is allocated to diversifying positions.  Also, some weighting is often given to thematic or other positions in the investment factor, technology, or other sub-sector.

As I said in that April blog post,

There are literally an infinite number of combinations of equities and fixed income to create a portfolio with similar levels of risk, so SOMEONE needs to make an investment decision and invest in SOMETHING!  That is my job, as an investment adviser, to use my experience and knowledge of the markets to understand client objectives and goals to create an appropriate diversified portfolio with a target level of risk.

Winning with Diversifiers: A 2024 Market Breakdown

What has worked in 2024?  The S&P 500 has reached many new all-time highs this year being up +23.7% YTD through October16, but what else has performed well to help diversified portfolios beat their bogies?  I write a lot about the use of diversifiers in portfolios, so let’s take a look.

We talk a lot about small- and mid-cap equities as a way to diversify away from the mega-cap tech companies that make up a large part of the S&P 500.  YTD those asset classes still lag the S&P 500, but they are making up ground since mid-July (see table below for ETFs that could be held by a typical D&A client account).  For example, small- (SCHA) and mid-cap (SCHM) equities are up +5.7% and +6.7%, respectively, over the past 3-months compared to the S&P 500 (IVV) that is up +5.7%.  Likewise, equities with momentum (MTUM) and minimum volatility (USMV) factors have performed relatively better being up +8.7% and +7.9%, respectively.  Also, emerging market equities (SCHE, +7.4%) have started to join the party with some outsized returns helped with some stimulus we have seen in China.

We have seen the same phenomenon occur in the fixed income space with diversifying sub-sectors in fixed income outperforming core fixed income.  For example, over the past three months, core fixed income (SCHZ, +2.6%) has lagged other major fixed income diversifiers like investment grade corporate bonds (LQD, +3.8%), high yield bonds (HYG, +3.7%), emerging market bonds (EMB, +4.9%), and preferred stocks (PFF, +6.7%).  This relationship held fairly strongly on a YTD basis, as well!

This recent relative outperformance in diversifiers is helping D&A portfolios move strongly against their benchmarks on a recent and longer term basis.  Most D&A portfolios focus on core asset classes like the S&P 500 and U.S. aggregate bonds, but a good allocation away from those core holdings should allow those portfolios to outperform over time.  D&A will continue to manage portfolios with a focus on “long-term strategic asset allocation as the main driver of portfolio returns and diversification amongst asset classes as the primary means of managing risk.”

Cautious Optimism to Record Highs

Two weeks ago, when I wrote my blog post on the 2024 Q3  review titled “Stimulus, Stocks and a September Surge”, I was careful to not be too zealous with my assessment of the economy and the markets.

I opened that blog post with these thoughts:

Easing inflation, mostly stable employment, good economic growth, and an accommodative Fed are all bullish indicators for a stock market to perform well and that is what we saw during 2024 Q3

And closed it with this thought:

If you asked us what we think the market will do we would say “Beats Me!”, but most client accounts would have some exposures to the asset classes that are leading the markets at most any time. 

So, it goes without saying that I am pleased that the markets have delivered on expectations carrying forward the momentum from Q3.  The S&P 500 (IVV) has now reached another all-time high yesterday with a 2024 year-to-date return of +24.2%; on top of a 2023 YTD return of +26.3%!  Also, we are starting to see some good broadening of strength in the other diversifying asset classes that I always talk about including small/mid-cap equities, some factor exposure, and international and emerging markets.  Plus, fixed income has mostly behaved and has not been too much of a drag while smoothing performance.

As I have reported, most client accounts have been overweighted to equities during 2024 and fixed income has been managed to a shorter duration to reduce interest rate risk.  Clients have reaped the benefits of these strategies.  D&A is a long term investor and we target investment portfolio strategies to help clients achieve their goals.  We avoid behavioral bias, do not try to time the market, and stay-the-course as long as conditions warrant it. 

Stimulus, Stocks and a September Surge

Easing inflation, mostly stable employment, good economic growth, and an accommodative Fed are all bullish indicators for a stock market to perform well and that is what we saw during 2024 Q3; fittingly, with the S&P 500 reaching an all-time high at quarter-end!  Based on easing inflationary measures, the Fed initiated its well-anticipated Fed Funds rate cut on September 20, 2024.  Though the 50 basis point cut was larger than expected, the Fed assured markets that the large cut was simply a move away from the previous restrictive monetary conditions and was not indicative of any anticipated crisis; further cuts likely would be more moderate.

As expected, the markets rallied on the news and recovered nicely from a mild sell-off during late-July/early-August.  Separately, China announced robust stimulus measures into its economy in mid-September prompting a large rally in that and other emerging markets.

Notably, the Fed actions had an impact on the broader markets as we saw most diversifying asset classes rally and overtake the S&P 500 during Q3, though still lagging over the YTD horizon (see table below).  During Q3, the S&P 500 (IVV, +5.8%) still had a robust return but was surpassed by its diversifying brethren small- (SCHA) and mid-cap (SCHM) equities with 8.9% and 7.2% returns, respectively.  High dividend equities, represented by iShares Select Dividend ETF (DVY, +12.9%) rallied, too, demonstrating more broadening of the rally.  International (SCHF, +7.0%) and emerging market equities (SCHE, +9.9%) followed suit with outsized returns.

Fixed income, on cue from the Fed actions, generated good returns during Q3 as short rates eased and credit spreads narrowed with recession fears melting away.  Core bonds (SCHZ, +5.3%) and high yield bonds (HYG, +5.7%) buoyed as shorter bonds (SLQD, +3.4%) kept pace.

Most of my blog posts during Q3 had a bullish bias and we are happy that markets have responded positively to economic trends per my July 26 blog post, Small Caps Rising?:

If you asked us what we think the market will do we would say “Beats Me!”, but most client accounts would have some exposures to the asset classes that are leading the markets at most any time. 

Buckets, Benchmarks and Risk

I had lunch with an old friend recently and the conversation led, inevitably, to money!  As an investment adviser and Chartered Financial Analyst (CFA) holder, I usually find myself chit-chatting about investment management and retirement planning.  Some of the topics we focused on included:  how much is too much cash, how to determine a personal risk profile, and how to determine an appropriate personalized investment strategy.  Following below, I will summarize how I addressed these conversation points.

How much is too much cash? 

Readers of this blog post will know that most investment decisions are driven by the specific goals and needs of the client, so there is never one single right answer for every individual.  For example, if you are young, gainfully employed, and with a largish nest egg your needs for cash are very different (quite low need) than if you are elderly, in poor health, with only modest savings (quite large need).

Aside from “emergency fund” cash that most people should have equal to about 3-months of living expenses, I like to think about cash needs using the “bucket” approach.  Sometimes it is useful to think about your investment portfolio by putting your investments into buckets consistent with your time frames.  For example, if you think you will need $50k of cash each year over the next 5 years, put $250k of short term investments into your “conservative” bucket.  The balance of your investable assets can be allocated to risky assets as your “aspirational” bucket; maybe a blend of stocks and bonds for years 5-10 and then mostly risky stocks for 10+ years out.

How do we determine our risk profile?

A lot of times we throw the term “risk” around thinking people know what we are talking about.  For example, I will often quote numbers related to the “standard deviation” of return that reflect a statistical measure of risk.  When I say an investment has a risk of 17%, I mean that historically that investment has a high probability of being either up or down by 17% over any given year.  Another measure of risk is “drawdown” risk; the risk that reflects how far down an investment fell over a recent time horizon.  It is important to recognize that “loss” described here does not reflect “unrecoverable” loss, but loss simply due to market volatility.

For example, the S&P 500 has had the most phenomenal recent 15-year return profile since the dot-com craze producing an avg. annual compound rate of return of +14% with a “risk” of 17.3% with a -33.9% drawdown.  The 17% risk might not mean too much to an investor, but the -33.9% drawdown should strike a chord.  Imagine having $1 million one day and then seeing it is down $339k!

For clients with large investment portfolios and a long time horizon, sometimes they can “afford” to tolerate the drawdown risk since they have plenty of capacity and time to recover from the risk.  And, if they have used the “bucket” approach highlighted above and have a cash cushion, they have an extra bit of security.  For investors, with smaller portfolios and a shorter time horizon, exposure to risky assets should be curtailed.

How to determine an appropriate personalized investment strategy?

All clients of D&A have an investment benchmark that I manage against.  No benchmark is perfect since no benchmark can capture the nuances of how an investment portfolio is built to support the goals of a client.  Instead, I use the benchmarks as a rough guide on where we are headed.

For example, I like to use the iShares core allocation exchange-traded funds (ETFs) as benchmarks for many of our client accounts.  These ETFs target a long-term strategic asset allocation of stocks and bonds from conservative to aggressive allocations.

As a starting point, these benchmark ETFs have good core positions but are mostly naïve and do not include any dynamic aspects of the financial markets like investment and style factors on the equity side and high yield or short term bonds on the fixed income side.  And certainly, they include no client customization.  

Most D&A client accounts vary by a wide margin to the benchmarks due to these additional investment aspects.  Factoring in client-specific factors such as time horizon, quantum of wealth, tax considerations, life situation, and other things ultimately gets us to where we need to be.

Now What? Redux!

Back in January, I posted a blog titled “Now What? A Futurist View” dealing with long term market views. Some of those thoughts remain very relevant as the market has reached new heights back in July and taken dips down most recently.

I encourage a re-read of this blog to understand the potential for new technologies to transform the global economy. Specifically, Cathie Wood (of infamous tech fame) proffered this dynamic view of the future:

In it, she focuses on her identification of “five innovation platforms” that are evolving at the same time: artificial Intelligence (AI), robotics, energy storage, blockchain, and multiomic sequencing. The growth potential “reminds us of Amazon, 20-25% compound growth over 20-25 years” that potentially could be “sustained forever”.

The time frame for changes like this are indeterminate and market volatility is sure to accompany the construction and destruction of economic realities. As I said back in January:

D&A believes in long-term strategic investing to help investors achieve their goals consistent with their time horizon, risk tolerance and special considerations.  The views of Cathie Wood are compatible with our philosophy as we both have a long term time horizon.  A fully diversified exposure to US and global equities will allow investors to capitalize on this view without adverse idiosyncratic risk exposure.

A Balanced Growth Strategy

The S&P 500 index, represented by the iShares Core S&P 500 ETF (IVV), consists of the 500 largest stocks in the U.S. and broadly reflects the sectors and businesses within the U.S. economy. These stocks exhibit different characteristics, often referred to as "styles." The two primary styles are "growth" and "value," with a combination of the two known as "blend." Growth stocks typically have higher price/earnings ratios, justified by their larger expected earnings growth rates. In contrast, value stocks usually have lower growth rates but more stable earnings.

Over the past decade, growth stocks have significantly outperformed value stocks. Growth stocks, as represented by the iShares S&P 500 Growth ETF (IVW), returned +14.76%, while value stocks, represented by the iShares S&P 500 Value ETF (IVE), returned +9.17%. The broader S&P 500 (IVV) returned +12.82% during this period. Much of the recent outperformance in growth has been driven by mega-cap tech companies like Nvidia, Microsoft, Apple, and others.

How does D&A manage this relationship within the context of client goals and risk profiles? There are several ways to capture the excess returns from the growth style, including buying individual stocks, active mutual funds, or passive ETFs. At D&A, we generally favor passive ETFs as a way to gain diversified exposure to this style.

Some active mutual funds have performed exceptionally well in the growth space. For example, the T. Rowe Price Blue Chip Growth Fund (TBCIX) achieved a 1-year price return of +31.45%, slightly outperforming the passive growth ETF (IVW), which returned +29.93% (see chart below). During the same period, the value style continued to lag growth, with a +17.76% return, and the core S&P 500 (IVV) returned +24.09%.

So, why doesn’t D&A exclusively invest in the T. Rowe Price Blue Chip Growth Fund? The answer lies in risk management. Upon closer examination, this mutual fund excels in up markets, with an upside capture of 106%, similar to the growth ETF. However, it has a concerning downside capture of 128% compared to the growth ETF's 117%, and a maximum drawdown of -39.61% compared to -30.49% for the growth ETF. In essence, when the market rises, this mutual fund provides 106% of the index's return, but when the market falls, it captures 128% of the loss. While this could balance out over time, the higher short-term volatility doesn't seem like a favorable tradeoff for clients with anything less than a very long-term investment horizon.

At D&A, we start almost every client portfolio with a core holding in the S&P 500 passive ETF. By its nature, the S&P 500 includes exposure to the growth style. We then assess the client's risk profile and allocate an appropriate portion to a growth style ETF to overweight growth in client accounts. Additionally, most client portfolios already include an allocation to a passive ETF targeting the momentum factor, which in today's market is also overweight in growth.  As a result, most client portfolios have a double overallocation to the growth style.

Why ETFs?

Most people are familiar with the mutual fund structure.  These are “pooled” funds of diversified investments managed by investment professionals and regulated by the Securities and Exchange Commission (SEC).  Investors buy shares in the mutual funds and share in the investment performance; both up and down.  At the end of each day, all holdings in the fund are valued and a “net asset value” (NAV) is calculated and used for all activity in the fund that took place that day.

Exchange-traded funds (ETFs) are just like mutual funds except they are traded on an “exchange” just like regular stocks.  ETFs also have a net asset value except it is calculated continuously during the day allowing the ETF to be traded all day long.  But, the ETF does not necessarily trade at the NAV but usually trades at bid/ask prices that are a bit higher/lower than the NAV to compensate the exchange.

ETFs have several advantages over mutual funds.  Most importantly, the ability to trade during the day is a major advantage for risk management purposes.  For example, let’s say you had a portfolio of mutual funds and you wanted to rebalance to a different strategy.  In this case you would sell the mutual fund on the night before and would not have the proceeds to reinvest until the next day!  There are ways to minimize this risk, but this structure still exposes the investor to basis risk because the markets could move overnight and you would be forced to reinvest at a higher price than expected.

Another major advantage is the broad selection of passive diversified ETFs that track major indices, thus eliminating behavioral bias and active management that could hurt performance.

Also, because of the mechanism used to create/redeem ETF shares, most ETFs avoid the need to pay capital gains distributions; a major benefit for investors in taxable accounts.  Another benefit is the generally lower investment expenses compared to mutual funds, though this benefit is slowly disappearing due to competitive pressures.

The major disadvantage of ETFs is the aforementioned bid/ask structure.  For ETFs with low volume or other unique characteristics, the bid/ask spread could be very large thus costing the investor a high “implicit” fee on transactions.

D&A favors ETFs for most client accounts because of the benefits indicated above; especially the risk management aspect and the ability to invest in a broad selection of passive diversified ETFs to help target investment strategies tailored for our clients.  Also, because D&A usually invests only in the most liquid ETFS and trades relatively infrequently, the potential for higher bid/ask expenses is reduced.  And finally, the generally lower investment expenses embedded in ETFs is an advantage for our clients.

Small Caps Rising?

On July 13 I wrote a blog post titled “Small Caps’ Big Week”, and I applauded that brief trend as long overdue.  The big story this week, so far, is more of the same, per the CNBC graphic below.

As I have been reporting for a while, it’s been a tough run for small and mid cap equities over the most recent 10+ years, but maybe we are starting to see the beginning of a long term trend similar to the 2001-2010 period when small cap regularly led large cap?  In fact, historically over a very long time horizon from 1926-2023, small cap equities returned +11.8% compared to +10.3% for large cap equities (Morningstar).

I am a follower of Tom Lee, outspoken bull from FundStrat, who recently commented on CNBC on the merits of the small cap space.  He covered many of the virtues of small cap including the Russell 2000 having a relatively low P/E of 11 and faster earnings growth. From a technical standpoint he highlighted a historical perspective that 10 out of the past 11 days the Russell 2000 has moved more than 1% and the 9 times that it did that since 1979 the average 12-month gain was +40%!

Some of the other rationales for his bullishness include a political perspective, which in my mind is highly suspect because the election is still three months away, where the market is projecting a Trump presidency that will benefit M&A, deregulation and regional banks that would benefit small cap stocks.

From our website, the “D&A investment philosophy centers on long-term strategic asset allocation as the main driver of portfolio returns and diversification amongst asset classes as the primary means of managing risk.”

If you asked us what we think the market will do we would say “Beats Me!”, but most client accounts would have some exposures to the asset classes that are leading the markets at most any time.  Client accounts have benefitted from exposure to large cap equities during their great historical run and we expect that client accounts will benefit again as other asset classes take over market leadership.  The challenge is to know when the lead changes, and that is very difficult to do except by luck.