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.

Small Caps' Big Week

As readers of this blog post are well aware, I have been bemoaning the tribulations of small cap stocks for the past few years.  Performance of this major asset class that we use a diversifier has lagged and been mostly dismal against its large cap brethren recently.  For example, the large cap S&P 500 (IVV) is up an annualized +10.4% return over the past 3 years while small cap (SCHA) is flat at 0.0%!

So, it is with great joy that I report that small cap stocks had a great week (see picture below)!  Last week, small caps made a big leap forward with a robust +5.2% return versus a +0.9% return for the S&P 500. Likewise, mid cap stocks popped, too, with a +3.7% weekly return.

We have seen this before, of course, when I last trumpeted some hope for small caps back in the fourth quarter of 2023.  At that time, both small and mid cap stocks led the S&P 500 for that brief period of time.  That rally was short lived, however, as its momentum lagged into this year; until last week!  Before its rally last week, small cap continued to struggle with a YTD return of 0.0% against +17.5% for the S&P 500; that is not a typo!

In addition to significant allocations to large cap stocks, D&A has consistently held moderate allocations to small and mid cap stocks for most client accounts as a means to diversify risk away from increasing client exposure to the mega cap tech behemoths like Microsoft, Apple, Nvidia, etc.  This strategy has caused a drag on performance for those accounts, but the idea, of course, is to hold complementary asset classes that “zig” when the others “zag”.  We have certainly seen that recently, but so far mainly in one direction!

So, the question is why now?  What is the impetus for this shift and the feeling of a “broadening” of performance into the small cap space?  Some market commentators say it is the growing prospect of a Fed rate cut in September.  Others say it is merely a rotation into small caps after mega cap tech stocks have moved too far and too fast leading to rotational profit-taking. Regardless of the cause, D&A will “stay the course” keeping client accounts broadly diversified in order to smooth the risk profile and performance over the long term.

Nvidia: 10x Tech Titan

I hardly ever write blog posts about individual stocks (see my DISCLAIMERS below!)  However, the astounding performance of Nvidia (NVDA) over the last two years has been absolutely amazing and is certainly worth an update.  From its recent trough on October 14, 2022 as the Fed tightening cycle was heating up through Friday, the stock is up more than 10x (split-adjusted price of $125.8 / $11.2 = 1,022%) per chart below!

 During its ascent, there were daily blips where the stock was down as much as -10%, but it countered that with nice rebounds.  Its daily standard deviation of return was +/-3.5%, meaning there was a very high probability that the stock could go up/down by 3.5% in any one day.

 What makes this performance even more astounding is that this is not some penny stock with limited coverage going from $0.25 to $2.50.  Nvidia is a large cap stock with billions in gross revenue and a large following of institutional and retail analysts and ownership. 

 I last wrote about Nvidia in February 2024 when it was only amazing!  At that time, I highlighted its situation as follows:

This tech company, in the old days simply known for its high-performance graphics cards for gaming and video, found itself in an almost amazing business situation.  Perhaps serendipitously, Nvidia found itself with a chip architecture and design that made it perfectly suited for a multitude of new applications other than gaming!

The new applications started with crypto and crypto mining… then, it migrated to self-driving cars, other devices and robotics needing video recognition.  And now, the beginning of the AI revolution finds Nvidia with another large product niche that makes its chips highly in demand.

Combine this product demand with the very scalable manufacturing process of computer chips and you come up with drivers of both top line and bottom line growth.  Sort of analogous to a drug maker who finds out that its one drug cures not only headaches, but many other maladies – all while production is hugely scalable!!

 Since then, it has continued its upward trajectory with higher revenue, earnings and market share.  The company has already disclosed product plans for the future, thus building up anticipation for new chips with better capabilities and energy efficiency.  The reported 85% market share is a built-in market for its proprietary next-generation chips and services.

Plus, given its astounding growth, new additional technical market factors come into play.  For example, Nvidia went from the third to the second largest holding in the $72 billion SPDR Select Technology ETF (XLK) with a 20% allocation.  So, 20% of every new dollar invested in that popular ETF will be invested in NVDA; a built-in market demand for that stock as new money flows into technology.  Likewise, NVDA has a 14% weighting in the $77 billion Vanguard Information Technology ETF (VGT), a 14% weighting in the $20 billion iShares U.S. Technology ETF (IYW), and a 20% weighting in the $20 billion VanEck Semiconductor ETF, not to mention its 6.5% weighting in the $500 billion iShares Core S&P 500 ETF (IVV) and others.

As a Chartered Financial Analyst (CFA) charterholder, I am well aware of the methods used to estimate equity values of companies.  However, I am also well aware that pure fundamental and technical analysis does not guarantee that a stock will be anywhere near what an analysis could indicate.  But, if someone wanted to write a story about a stock that had the best prospects for continued growth and return potential, then Nvidia might be IT!

This report is for informational purposes only.  The information, data, and analyses contained herein include confidential and proprietary information and other information from third parties.  The information provided is believed to be accurate, but the accuracy and completeness of the information is not guaranteed.  Past performance is not indicative of future performance.  This report is not an offer or a solicitation of an offer to buy or sell any security.

2024 Q2 Market Update

The U.S. economy has defied all fears of recession and over blown inflation since the Fed tightening cycle that began in March 2022.  In fact, Fed Chairman Jerome Powell coyly remarked in response to a “stagflation” comment on May 1 that he has not seen the “stag-“ or the “-flation” that would cause him concern.

The capital markets have agreed with this belief as U.S. markets continue to show pockets of strength and many new all-time highs in Q2, led once again by mega-cap tech stocks in the S&P 500 (IVV) with a robust YTD performance of +15.3%.  Though it is tempting to call this “irrational exuberance”, in most cases earnings growth has met/exceeded expectations validating the price strength of the large cap companies in that index.

However, many U.S. capital market sub-indices continue to lag the S&P 500 and produced negative performance during Q2.  Per the table below, small and mid caps (SCHA and SCHM) lag the most in Q2 (but still positive YTD) with high-quality dividend (DVY) struggling to stay even.

We are happy to finally see emerging market equities (SCHE) push forward due to some new strength in China and Taiwan and lead the broad capital markets during 2024 Q2 with a return of +5.3%, though still lagging the U.S. on a YTD basis. Lastly, fixed income, in the final throes of the Fed’s tightening cycle, are still seeking a firm ground from which to build.  Core bonds (SCHZ) are flat on the year, with shorter bonds (SLQD) and high yield bonds (HYG) a bit better.

My 2024 Q2 blog posts focused on three major themes:  investment strategy, portfolio diversification, and economic indicators.  Each of these themes is expressed in my role as an investment adviser per my blog post, Portfolio Management Decision-Making:

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.

My 5-year Blog-A-Thon!

I started writing weekly blog posts way back in late 2018!  I target one every week, but sometimes it’s every two weeks.  I write them because it’s a way for me to focus and summarize my thoughts on the markets and to express what I think is important.  It is also a way for me to let my clients know that I am always thinking of them!

As you may be aware, I have been playing around with the artificial intelligence utility called ChatGPT to see if it has any direct business uses for D&A.  Right now, it is mostly a fun toy to play around with but I don’t doubt that one day its power will make it invaluable for all aspects of business and society. 

One of the major uses of ChatGPT is to analyze and summarize large blocks of text and data.  It can also “write” blog posts on selected topics, but I have not used it for this purpose and will continue to write my own original blog posts.  However, one good use of this ChatGPT functionality is to help me analyze all 260 blog posts I have written over the past 5 years to help me summarize the main themes I have covered. 

Per the table below, I think it did a good job summarizing my focus over the last 5 years!  I am happy to report that the lion’s share of the thoughts expressed from my blog posts centered on market analysis and investment strategies (50%) since that is where I strive to provide the highest level of service to our clients. The second tier of focus dealt with specific asset classes (20%) and then retirement planning (15%) with the remainder dealing with behavioral finance and other topics.

Occasionally, I will write blog posts pertaining to a specific client concern or situation (anonymously, of course!)  So, if there are any unmet needs for clarification on certain strategies I have employed or if anyone simply would like to read my thoughts on a certain topic, please reach out and I will work on it for you.  Thanks!

Federer, Forehands and Finance!

My daughter lives in Hanover, NH and is a big tennis fan, as am I.  We were thrilled to learn that Dartmouth University invited tennis star Roger Federer to speak at their commencement on June 9 this year!  He focused his talk on “tennis lessons” that made me think about how playing tennis and investing have many parallels.

Certainly, both involve strategy, planning, adaptability plus a bit of luck!  In tennis, you need to anticipate your opponent’s moves and plan your shots accordingly.  Similarly, in investing you must anticipate market trends and make strategic decisions about where to allocate resources.

Both also demand continuous learning and adaptability.  In tennis you constantly refine your skills and adapt to different playing styles.  Hitting a strong inside-out crosscourt forehand to your opponent’s weaker backhand is a path to probable success.  Likewise, in investing you need to stay informed about market changes and be ready to adjust your strategies.  When the Fed telegraphs a dovish interest rate forecast, it is best to modify strategy accordingly.

Also, patience and discipline are crucial in both areas.  In tennis, staying calm and composed helps you make better decisions on the court.  Don’t rush that put-away volley, or you might hit it out or into the net!  In investing, maintaining a disciplined approach can help you navigate market volatility and avoid impulsive decisions.  Don’t chase that high-flying investment theme unless there is a strong case supporting it.

And finally, luck is also a factor in tennis and investing!  There are many unpredictable aspects to tennis like “net cords” where the ball just trickles over the net, gusty wind conditions, or bad ball bounces.  In investing, sometimes the markets move in unpredictable ways that are either to your detriment or benefit.   The timing of cash flows into the market could also be a positive or negative factor depending on when you entered the markets.  Also, unexpected economic or geopolitical events can significantly impact market returns.

While luck can influence outcomes in both tennis and investing, skill and preparation often mitigate its impact.  Both in tennis and investing, a well-prepared investor is better prepared to capitalize on lucky breaks and to recover from unlucky events.  Just like having a diverse selection of shots and skills in tennis helps your game, likewise diversification in investing helps mitigate risk.

And Still Champ!

The facts cannot be overstated!  The S&P 500 (IVV), as a broad-based stock index of the largest companies in the U.S., reached new all-time highs last week and has continued its phenomenal run of outperformance over the past 15 years!  Amongst the major asset classes like small- and mid-cap U.S. equities and international developed and emerging market equities and others, not one has beat that index at best return AND lowest risk!

Per the chart below, we can see that the S&P 500 (IVV, the green line) had tracked close to the other major indices until pulling away starting in 2021 where other broad indices lagged. Amazingly, it has achieved its pack-leading compound annual growth rate of +14.4% per year with the lowest volatility amongst its group at 17.3%.

Numbers like these have led some to question the value of diversification. Simply put, owning anything other than the S&P 500 in a broadly diversified global portfolio has hurt performance. However, it's important to remember that no one could have forecasted this impressive streak of outperformance, and there was still a high degree of risk, albeit less than other competing asset classes.

 Over the last several quarters D&A has committed more client assets to the S&P 500, depending upon the client portfolio objectives, while also keeping bonds duration shorter than the benchmark and has thus reaped some benefits.  However, the remaining allocations to some diversifying positions have been a drag thus far this year.  Like I said in my most recent blog post, Strategic Insights for Market Success, we are patient long term investors and are committed to our outlook:

 “The U.S. growth picture remains robust and is broadening globally, with parts of Emerging Markets showing promise. Central bankers expect inflation to decline gradually, with no signs of widespread acceleration. We continue to favor the momentum and other factors and are sticking with small- and mid-cap as market breadth has started to gain traction.

In conclusion, while the S&P 500's performance has been exceptional, it's crucial to maintain a balanced perspective and consider long-term strategic investments to navigate future market conditions successfully.

Strategic Insights for Market Success

As a dedicated investment advisor at D&A, my primary focus is to ensure that our strategic and tactical positioning remains sound for our client portfolios. This requires extensive research and analysis of current market conditions. Over the past several quarters, our strategy has included overweighting equities, enhancing the quality of our equity positions, and maintaining a shorter duration in fixed income relative to core benchmarks. However, the dynamic nature of the markets necessitates continuous evaluation to determine if adjustments are needed.

Recently, I took part in a Northern Trust webinar titled "What’s the Market Missing?" which provided valuable data and insights influencing my current views. Here are some key takeaways:

Real Wage Growth and Consumer Spending:

Real wage growth in the U.S. is on the rise, likely supporting consumer spending going forward. However, high interest rates have increased the interest burden, especially for lower-income groups. This mixed impact on disposable income warrants close monitoring.

Inflation and Interest Rates:

Inflation remains a challenge for the U.S. economy, though it has been steadily declining. Notably, "core services ex-housing" inflation is on an uptick, attracting the Fed's attention.  With U.S. equity valuations elevated but within normalized bands, the "higher for longer" interest rate scenario could be a key determinant of future market moves.

Volatility:

Volatility has been unusually low, with recent averages well below the historical norm of 20%. Historically, volatility spikes can lead to asymmetric returns—markets tend to be more volatile on the downside than on the upside. Factors like value and momentum, which prefer volatility, have shown mixed performance. Since 2022, momentum has been the best-performing factor. We should be cautious, as volatility is unlikely to remain at these depressed levels for long.

Current Tactical Views and Recommendations

Currently, we maintain an overweight position in stocks over bonds.  The U.S. growth picture remains robust and is broadening globally, with parts of Emerging Markets showing promise. Central bankers expect inflation to decline gradually, with no signs of widespread acceleration. We continue to favor the momentum and other factors and are sticking with small- and mid-cap as market breadth has started to gain traction.

In the fixed income space, we continue our shorter duration bogey and underweight in investment grade bonds and overweight in high-yield bonds, aligning with the strong growth outlook. This positioning also hedges against the risk of being wrong about the inflation trajectory, especially given the negative correlation between stocks and bonds observed in Q1.

Conclusion

Our investment philosophy hinges on thorough market analysis and strategic adjustments based on emerging data. The insights from the Northern Trust webinar reinforce our current positioning but also highlight areas for vigilance, such as volatility and inflation dynamics. By staying informed and adaptable, we aim to continue delivering strong, risk-adjusted returns for our clients.