All's Well That Ends Well...

…If it’s not Well, then it’s not the End!  I’ve seen this quote, or something like it, on greeting cards and miscellaneous memes. I did a Google search and it seems that John Lennon, of all people, is attributed a version of this quote!  I have thought this way about the capital markets since the recent lows on March 23 and a decent rally since then.  The question of the day:  when will we know we are Well AND at the End?

I wrote a blog post last year back on December 16 titled, 20/20 Foresight? (https://www.dattilioash.com/our-blog/2019/12/16/2020-foresight).  In it, I recounted the difficulty thought leaders have with forecasting capital markets.  Though I’m not going to hold them to it, Wells Fargo forecast a decent 7% return for the S&P 500 in 2020; we shall see!  It goes without saying that no one saw this coronavirus pandemic coming and could have predicted the market turmoil, never mind the winners and losers.

It is clear to me that we are currently subject to significant “headline” risk, i.e., the risk that either good or bad news will be released and impact the markets accordingly.  Market returns, thus, are “scenario dependent” and there is no way to hedge this risk – the best we can do is stay broadly diversified, including a cash allocation in your diversified portfolio. 

Though the market has recovered quite a bit from its recent lows, the S&P 500 is still down -12% year-to-date.  So, we are certainly not Well; we could re-test the lows or go higher from here (i.e., the “W”-shaped recovery versus the “V”-shaped recovery, the latter).

It doesn’t seem like the End, either.  Many areas of the capital markets still suffer from significant dislocations; high yield bonds come to mind (see chart below).

High yield bonds (“junk bonds”) are now trading off their recent high spread of 1,000 basis points, down to “only” 785 basis points; we started the year at about 350 basis points (wide spreads are bad, narrow spreads are good!)  So, one measure of the End for me is to see high yield bonds start performing better; we should be hopeful that there is enough already-enacted and available fiscal and monetary policy to help us get there.

Also, it goes without saying that as long as Covid-19 is with us and uncontrolled, we will be in some state of turmoil some distance from the End.

When asked what the market will do, though it is interesting to go through all the story lines, I still repeat the famous words uttered from my favorite CIO: “Beats Me!”

New Ball Game

Wow!  Today, the Fed has pulled out all the stops to protect the U.S. economy.  The new stimulus measures announced today, in addition to the $2 trillion fiscal CARES program and prior Fed rate cuts and buying programs, includes some new lending facilities to municipalities and small- and mid-sized business.  Also, and perhaps most importantly, the Fed is now putting some market price support on below-investment grade bonds and other risky asset classes (and perhaps equities, if needed!)

No one can predict the length and depth of the coronavirus crisis, but these new huge Fed actions certainly have the potential to fill a critical role to keep businesses and municipal governments functioning and support the pricing of risky investment assets.  Due to this, and pending any additional unforeseen events, it is difficult to see a larger drawdown of financial assets than we have seen thus far.  With the lows of the markets potentially taken out, certain classes of U.S. risky assets are likely to exhibit normal volatility and can be now be held.  Consequently, tactical positioning that sold U.S. risky assets can now be reversed over the near term.

The Q1 Crisis

The coronavirus took center stage at the end of February and blossomed into a full-blown health and financial crisis.  It is a foregone conclusion that there will be a worldwide contraction in economic activity of huge proportions that will negatively impact capital markets.  No one knows the depth and length of this crisis, but we are all hoping for a quick resolution.

During Q1 the benefits of diversification failed to materialize.  Exposures in asset classes held to cushion large drawdowns failed to perform; they either followed the market down, or worse, underperformed the markets.

The S&P 500 (IVV) fell -19.6%, but other broad equity markets fell more including small cap (SCHA) -31.6%, international developed markets (SCHF) -23.2%, and emerging markets (SCHE) -24.4%.  High dividend equities (DVY, SCHD, SPHD) suffered, as well, with worse performance due to concerns about dividend cuts.  Some diversifying exposures bucked the trend, including low volatility (USMV) -17.2% and momentum (MTUM) -14.8%, but those were the rare exceptions.

The bond markets were dominated by an extreme flight to quality with broad core bonds (SCHZ) up +2.0%, led by U.S. treasury exposures, but credit exposures were severely impacted with even investment grade corporate bonds (LQD) suffering with a -3.0% return and high yield bonds (HYG) returning -11.6%.

I took extreme action to raise cash (and other safe assets) in most client accounts, as I reported in my March 18, 2020 blog post, The 20% Solution, (https://www.dattilioash.com/our-blog/2020/3/18/the-20-solution):

It is a foregone conclusion that the economy will show significant weakness in the wake of this crisis.  Most of the factors that “tactical asset allocators” use to signal a “risk-off” environment are certainly signaling risk-off; either now or when the statistics are calculated and reported.

For this reason, I have taken most all of our client accounts to a 20% cash and U.S. Treasury position to help smooth the volatility.  For now, I have sold the riskiest asset classes including real estate investment trusts, international developed equities and emerging market equities with the expectation that they would suffer the most in a protracted situation.  I may do more selling depending upon how the situation evolves. I expect to reinvest the proceeds once the negative factors begin to turn positive.

No one can predict the future, but taking a position like this telegraphs my outlook that more downside risk is present.

The 20% Solution

In uncharted territory, like now, you need to think creatively and solve problems within a rationale framework.  Performance against a benchmark is interesting, but the ability for an investor to meet their financial and life goals is most important.  Though my investment philosophy is firmly grounded in the realm of long term strategic investing, these are special times. For this reason, I have implemented some important risk management processes into my investment strategies.

Regardless of your risk profile, the current coronavirus crisis is causing significant financial pain to all investors.  Uncertainty of the depth and length of this crisis has caused financial markets around the world to large losses.  Year-to-date through yesterday, the S&P 500 was down -22%, international developed markets were down -29%, and emerging markets were down -25%.  U.S. Treasury bonds have been a safe haven, but investment grade corporate bonds have sold off being down -9% due to the potential for increased bond defaults.

It is a foregone conclusion that the economy will show significant weakness in the wake of this crisis.  Most of the factors that “tactical asset allocators” use to signal a “risk-off” environment are certainly signaling risk-off; either now or when the statistics are calculated and reported.

For this reason, I have taken most all of our client accounts to a 20% cash and U.S. Treasury position to help smooth the volatility.  For now, I have sold the riskiest asset classes including real estate investment trusts, international developed equities and emerging market equities with the expectation that they would suffer the most in a protracted situation.  I may do more selling depending upon how the situation evolves. I expect to reinvest the proceeds once the negative factors begin to turn positive.

Be safe!

The Optimist View

Barry Sternlicht, billionaire and Chairman and CEO of Starwood Property Trust, was on CNBC on yesterday morning and presented a hugely positive and optimistic view of the current situation.

Yes, this is a serious situation, and Yes, economic growth and corporate earnings will be severely impacted in the short term.  But, he cited that China appears to be close to normalization.  He mentioned that Apple is opening their 44 stores in China and Disney is re-opening their park there.  He fully expects this to be a “V” recovery where GDP growth in Q2 will approach 2.5-3.0% and the markets will follow that trend up.

See the full video clip and story here: https://www.cnbc.com/2020/03/13/barry-sternlicht-stock-market-is-going-to-come-ripping-back-quickly.html

The Ignominious Power of 1.0

For those who followed the Financial Crisis of 2008/2009, we all remember how there was no place to hide (except U.S. Treasuries).  All asset classes struggled with steep losses and their correlations with each other all approached 1.0; a situation where diversification did not help portfolio performance.  A well-built portfolio will have some asset classes with low correlation and some with negative correlation to help weather volatility of returns.  The environment today has shown similar characteristics with most all asset classes “selling off”. 

Per the table below, you can see the year-to-date negative drawdowns of the S&P 500 and investment grade bonds that are usually negatively correlated; the S&P 500 (IVV) is down -14.78% and investment grade bonds (LQD) are down -2.71%.  The only safe havens with YTD positive returns are short treasury bonds and aggregate core bonds (that is made up mostly with U.S. Treasuries).  Other diversifying positions like in U.S. factor exposures (i.e., minimum vol, momentum), international markets, real estate, and bank loans have all suffered steep losses.

Just like the Financial Crisis, I expect this situation to rectify itself over time.  Like I said in my previous post, I have done some selective tax loss selling and de-risking in some portfolios that cannot tolerate steep losses due to a shorter time horizon than 5 years.  For accounts with a time horizon greater than 5 years, I expect to “sit tight”, but I will continue to look for selective opportunities to potentially rebalance into other opportunities to improve performance going forward.  

New Phase of Crisis

The capital markets were performing badly enough when the coronavirus threatened to quell global growth and potentially lead to a global recession.  However, the markets turned down in a new phase over the past few days when the oil markets collapsed with crude oil sinking 20% to about $30 per barrel due to a combination of decreased demand and a price war between Russia and Saudi Arabia.  The consequential crushing of oil patch debt due to potential cash flow gaps for debt coverage has spilled over into the high yield bond market and some investment grade bond markets.

High yields spreads have widened significantly with month-to-date total returns for high yield bonds (HYG) at -5.8% and even investment grade corporates (LQD) have weakened with a -4.9% MTD total return.  The energy equity ETF, XLE, has been crushed with MTD and YTD total returns of -25.5% and -43.9%, respectively.

Additionally, causing more pain to the market, today the WHO officially declared this situation a pandemic.  The Dow today has now fallen 20% from its recent high on Feb 19 and we are now technically in a “bear” market.  A bear market is just a name, but it certainly reflects some steep losses across most sectors in the equity (and bond!) space.

I have done some selective tax loss selling and de-risking in some portfolios that can not tolerate steep losses due to a shorter time horizon than 5 years.  For accounts with a time horizon greater than 5 years, I expect to “sit tight”, but I will continue to look for selective opportunities to potentially rebalance into other opportunities to improve performance going forward.

The Best Performing Asset Class Since 2017: Stocks or Bonds?

I updated one of my favorite charts with the periods from the beginning of 2018 through yesterday.  In it I show the cumulative value of $10,000 invested in the S&P 500, Core Aggregate bonds, and risk-managed Dow Jones Index portfolios from conservative to aggressive.

You can see from the chart that the S&P 500 (black line, mostly on top) looked like a big winner until the end of February!  The winner?  Core bonds (green line intersecting at the end)!  The balanced portfolio DJ indices lagged severely due to the extraordinary equity market drawdown during this time horizon.

I do not expect this situation to persist and there is no telling how long this situation will last, but it is worth noting to display the current market dynamics.    

What Now, Part 2?

The word “historic” is way overused, but today was a historic day.  Equities around the world sold off in all-time record numbers due to fears about the coronavirus and the consequential impacts on global growth (slower), oil prices (very much lower), high yield bonds (prices lower and spreads much wider) and safe treasury bonds (prices very much higher, yields very much lower).

Everyone has read the headlines, so no need to recount everything here.  Certainly, oil prices (including some geo-political intrigue), oil companies, and travel-related industries are leading the markets lower, but all sectors and markets are suffering.  The question everyone wants answered is, “What now?”; a question I already posed last Thursday, March 6, here:  https://www.dattilioash.com/our-blog/2020/3/5/what-now.

The last time the markets come close to this much volatility was the Financial Crisis in 2008.  That period of time saw a “drawdown” of -55% in the S&P 500 and lasted 1.4 years from “peak-to-trough” before heading back up.  So, it was painful then and it feels painful now; but we recovered from that crisis and I expect we will recover from this crisis. 

Unlike the Financial Crisis, however, this is a unique economic shock where actions taken by policy makers will dictate the depth and duration of the shock.  Aside from activities needed to quell the coronavirus, I expect there to be fiscal actions to support economic activity and capital markets in the U.S. and around the globe.

No one could have forecast the developments of the past week and no one can forecast when the markets will recover.  In situations like this it is best to “sit tight” and let the market psychology work itself out; certainly, that is what happened during the Financial Crisis and this is what I expect will happen during this crisis. 

As always, it is critical to have your investment portfolios managed to the appropriate risk profile for your specific personal situation.  If you have a long term time horizon with a well-diversified risk-managed portfolio that is consistent with your risk tolerance, I expect that this situation will just be an unfortunate blip in your financial life.  Aside from some small amounts of tax-loss selling that could benefit taxable accounts, I am not selling equities right now; best to let the dust settle before participating in this current market.

How Bad has it been for an Average Investor, so far?

Risk to investors can be defined in many ways.  A traditional measure of investment risk, standard deviation of returns, tells us what the historical variation of return has been around an average return. That is a good textbook measure but is a bit academic for real life investors.  Instead, most investors now like to look at “drawdown”, a measure that shows a percentage lost from recent highs, i.e., “peak-to-trough”.

The Great Recession emanating from the financial crisis in 2008 produced a well-documented drawdown of -55% in the S&P 500 hitting its low on March 9, 2009 retracting from its high on Oct. 9, 2007.  The duration of that drawdown lasted 1.4 years.

How does this drawdown compare, so far?

As far as duration goes, we have just started!  The recent S&P 500 high was on February 19 and the low was hit on February 28, so this drawdown period has lasted just 9 days – and we are currently off the lows!!  The drawdown percentage so far is -12.4%.

But, most investors have a diversified portfolio of stocks and bonds.  How have these portfolios done compared to an all-equity portfolio made up of just the S&P 500.

I like to look at a series of relative risk indices produced by S&P Dow Jones Indices.  They provide index values for global risk-based model portfolios ranging from Conservative (20% stock and 80% bonds) to Aggressive (100% stock) in 20% increments.  As you can see below, thanks to the impact of the rallying treasury and investment grade bond markets, as of now the drawdown percentages are modest compared to an all-stock portfolio.  A moderately conservative diversified portfolio is down only -3.3% from its recent high, a moderate portfolio is down -6.4%, but a moderately aggressive portfolio is down -9.2%.  

No one knows what the long term impacts of the coronavirus will be and how long this capital market turmoil will last.  Certainly, fear has gripped the market as demonstrated by the volatility and 1,000-point swings on the Dow and the tremendous flight to quality we have seen in the treasury bond market.  We continue to monitor the situation closely and continue to be hopeful for a relatively quick resolution as we have seen in other health crises. Actions by the Fed are helpful, but we look to prudent actions from local, state, and federal governments in the U.S. and around the globe to alleviate the situation.

What Now?

When I wrote my blog post titled The Quiet Rally on Feb. 21 about the historically strong bond market, I had no idea that the bond market would move so quickly to further strength.  As I said back then,

However, there are some strong fundamentals currently supporting a continuance of a low rate environment including the strong and rallying dollar, modest and stable U.S. growth with low inflation countered by tepid global growth, as well as external factors like the coronavirus.  Alternatively, there seems to be a less convincing case for rates to rise per an accelerating global economy and inflation that seems less likely in the near term.

Since then, the Fed came forward with a special rate cut of 0.50% to help head off negative economic effects emanating from the coronavirus.  The 10-year Treasury yield continues to plummet through today at a new all-time low of 0.93%.  Global equities are a rollercoaster with 1,000-point up and down days on the Dow becoming commonplace. 

So, what now?  If you had some fresh cash to invest, where would it go?  Is today the right time to enter the market? 

In a low rate environment, bonds are always held more for their negative correlation to risky equities than to generate total return.  Mathematically, current yield to maturity of a bond is a rough proxy for total return over the duration of the bond, so any allocation to 10-year Treasuries is only likely to return about 1% over the next 9-years!  Not a good way to grow a retirement portfolio!  Of course, there are other bond classes that offer higher yield and total return potential like investment grade corporates, U.S. high yield bonds, and emerging market bonds, but those investments involve taking some credit risk.

Income-generating equities like high dividend stocks and real estate investment trusts are currently yielding much more than bonds while providing some long-term upside total return potential, but are risky (as we know!!)  The FANG stocks were market leaders and certainly have a strong investment thesis, but as we have seen, are susceptible to drawdowns just like any stock.

Warren Buffet, renowned investor, is known to prefer buying when others are “fearful”, so perhaps this is the time to buy?  Maybe, except that Buffet’s Berkshire Hathaway is known to currently have their largest cash position in their history at $128 billion!

I refer back to my recent post Invest All-at-Once, or Over Time? where I advocate a methodical dollar-cost averaging approach into an appropriate risk-based globally-diversified multi-asset investment strategy to help smooth out these bouts of market turbulence.  This is despite the research that shows “on average”, investing all-at-once produces higher long term returns.

Panic-Stricken

When I wrote my Special blog post, Rally, Disrupted, on Monday describing the market events emanating from the coronavirus outbreak, no one had any idea that the market psychology would balloon into a full-grown panic.  The idea of “sell first, ask questions later” took hold.

Punctuating this thought, the World Health Organization Director-General Adhanom Ghebreyesus was quoted in the media today saying “Global markets should calm down and try to see the reality.  We need to continue to be rational”.  Also saying, “Based on the facts on the ground, containment is possible, but the window of opportunity for containment is narrowing.  So, we need to prepare side-by-side for a pandemic”.

Of course, no one knows how this situation will play out.  Containment consistent with the SARS and other outbreaks would bring things back to normalcy relatively quickly; whereas, unknown dire consequences are being priced into the markets.

U.S. equity markets sold off from all-time highs only a week ago being down -12% from that high and down -8% for the month of February.   Other markets followed suit, as well, with emerging markets down -8% and international developed equities down -7%.  Offsetting these losses in the capital markets were core bonds and investment grade corporate bonds both up about 2% that acted as a flight to quality.  Moderate risk balanced portfolios of stocks and bonds were down about 5% during the month of February.

Outlooks from investment thought leaders gives some perspective to the situation and only a few are recommending selling.  Jeremy Siegel, noted investor and academic from University of Pennsylvania, was on CNBC a few times during the week and continued to feel that though we are suffering short-term losses, a long-term investor will be rewarded by sitting tight.  Arguably, if you are not a long term investor you should not have an undiversified position in risky equities in any event.  Also, most of the tactical managers that I follow (i.e., the managers who have models to get in and out of the markets) were still “risk on” through Friday night.  That includes Beaumont Capital and Julex (my previous firm that I co-founded). 

So, it is really two questions: when (if?) to get out and when to get back in.

For a long term investor, I currently believe staying the course is a prudent approach.  I think there is a strong risk of getting the sell (and buyback) decision wrong.  This would be the classic “whipsaw” effect where you sell and buy at exactly the worst times as the trends move against you.  I have kept all client positions intact thus far.  I expect if we start seeing some demonstrated fundamental (and technical) economic and capital market statistics pointing to a further large market drawdown (such as diminished industrial PMI, depressed earnings, pronounced negative price momentum, etc.) that could develop into something akin to the Great Recession, I will take everyone to a less risky profile.  The environment is not there yet.

Lastly, in order to avoid having misinformation cause you undue stress, the most reliable source for information right now is from the Centers for Disease Control and prevention (CDC) that can be accessed at https://www.cdc.gov/coronavirus/2019-nCoV/index.html. I will be following this developing story very closely and will post frequently as appropriate.

Rally, Disrupted

My recent blog post on Feb 21 titled “The Quiet Rally” highlighted how bonds had continued to improve on strong returns garnered in 2019.  I made the point that “market timers” might view the bond market as near a top, but that there were many factors, including “external” factors, that could continue to support a low rate environment.  Then, Monday Feb. 24 happened!

The Dow was down -3.56% (-1,033 points), the S&P 500 was down -3.35% (-111 points) and the NASDAQ was down -3.71% (-355 points).  Meanwhile, the flight to quality supported bonds with the 10-year Treasury bond price being bid up to force yields lower by 10 basis points for a yield of 1.37% and broad aggregate core bonds (SCHZ) rallied with a daily total return of +0.31%.  All of this was due to news on the coronavirus turning worse over the weekend with reports of new cases in Italy and South Korea.

The human tolls are high with over 77,000 infections and 2,529 deaths through today; mostly centered in China.  But, rapidly expanding infections around the globe seem to be developing quickly such as reports of infections in northern Italy.

The economic and financial impacts have not gotten a hold yet, but most forecasts are starting to portend the potential for a large realized impact.  Most of the potential problems are centered on industries dependent on supply chains from China, but other industries like tourism and airlines are also subject to problems due to potential quarantines and travel restrictions.

Certainly, there is a good level of uncertainty as to how the coronavirus problem will play out.  It appears that the coronavirus is more contagious and more prone to incubation periods than other flu epidemics.  Its impact on the economic and financial situation is not a complete unknown, but any attempts to gauge an expected outcome is prone to be wrong with a large margin of error.  So, as one market observer said, “sell first, ask questions later!”

What needs to happen for there to be a “sell” trigger?  I would look for a prolonged disruption in earnings and earnings growth to portend a deep sell off.  Also, we would need to see any disruption to be material.  Stock values are dependent on earnings; and forecast earnings are one thing; realized disruption in earnings is another.  Also, we will be watching closely for other factors and unknown “black swans” that could disrupt the markets.

Invest All at Once, or Over Time?

If you got a lump sum of money all at once, what would you do?  Would you invest the money immediately, or invest it slowly over time?  This decision point comes up all the time, especially in the case of large employment bonuses, cash inheritances, or any other “liquidity event”.

A common rule of thumb encourages a methodical “dollar-cost averaging” approach over some time horizon, like 3 or 6 months, where parts of the cash is invested to a target strategy.  The idea, of course, is to avoid “market timing” and investing the entire balance at an inopportune time; for example, at a market top before a selloff.  Dollar-cost averaging keeps the uninvested balance in cash, so the net result is an overall “less risky” profile compared to being fully invested.

There are some exceptions to this rule of thumb.  For example, if the investor has a long time horizon and has a high risk tolerance there is no reason to be overly cautious getting invested to a target investment strategy.  Also, if the new cash is a relatively small component of the investor’s total portfolio and not expected to impact the risk prolife, there is no reason to move slowly.

For every rule of thumb, however, there is a contrary view.  Morningstar recently published an article titled, “The Dollar-Cost Averaging Myth” (Morningstar Magazine, 2020 Q1), where they attempt to debunk this approach.  Through statistical simulations, they showed that dollar-cost averaging actually was a form of market-timing and, depending upon the scenario path, would produce less return and be more risky compared to a lump sum approach.  Over a series of 10-month investment scenarios, the authors showed that dollar-cost averaging outperformed lump-sum investing only 27.8% of the time.

This is a logical conclusion since the market usually goes up and we would expect the “less risky” dollar-cost averaging approach to underperform “on average.”  Importantly, however, the authors did not address a drawdown event that could wipe out 10%, 20% or 50% of a portfolio if the lump sum is timed incorrectly; something most investors are very concerned about!

So, best to be mindful of your risk tolerance and ensure that your investment approach is consistent with it to help ensure you will achieve your investment goals.

The Quiet Rally

Stock market news gets reported every day on the mainstream media and usually gets a headline when new all-time highs or big losses occur.  Bonds, on the other hand, rarely get a headline.  The current environment, however, has prompted some notice! 

Just when you thought the bond market couldn’t get any stronger, bonds are quietly hitting new all-time highs.  As reported in a Bloomberg article last night (https://www.bloomberg.com/news/articles/2020-02-20/vanishing-spreads-are-ringing-alarm-bells-in-risky-debt-markets), many types of bonds including U.S. investment grade and high yield debt continue to trend higher with strong bond returns.  As reported in the article, U.S. investment grade corporate bond yields set a new all-time low of 2.56% with 10-year treasury yields bottoming at 1.49% overnight.

Some of the most popular bond ETFs are putting up strong year-to-date returns.  The iShares Investment Grade Corporate Bond ETF (LQD) is up 3.02% and the Schwab U.S. Aggregate Bond ETF (SCHZ) is up 2.21% so far in 2020.  This is against a backdrop of strong, yet volatile, equity returns where the S&P 500 (IVV) is up 4.72% YTD.

The strong bond market so far in 2020 follows a surprisingly strong bond market in 2019 where U.S. investment grade bonds (LQD) were up an astounding 17.4% and the broader core bond category (SCHZ) was up 8.6%.

Though behavioral biases may lead many investors to shy away from investing at the perceived “top” in this market, a long-term strategic investor should not make market calls.  However, there are some strong fundamentals currently supporting a continuance of a low rate environment including the strong and rallying dollar, modest and stable U.S. growth with low inflation countered by tepid global growth, as well as external factors like the coronavirus.  Alternatively, there seems to be a less convincing case for rates to rise per an accelerating global economy and inflation that seems less likely in the near term.

Long-term strategic portfolios that are broadly diversified to include a broad mix of stocks and bonds of different types and managed to the appropriate risk target to achieve goals will be rewarded over time. 

Investments 101: Why REITs?

Real estate has historically been a great investment for long term price appreciation, income generation, and inflation protection; but, it is risky!  For investors who want liquid exposure to this asset class, the capital markets provide the real estate investment trust (REIT) legal structure.  When you buy a REIT you are buying into the REIT organization’s management skill to manage the properties successfully to generate price and income return.

The major real estate sectors include industrial, office, retail and residential, but there are other minor sectors like resorts, health care, self storage, and timber.  For example, if you want to have investment exposure to large shopping malls in the U.S., you could buy shares of the giant retail REIT, Simon Property Group (SPG), that owns and manages over 200 retail malls and properties.  Or, if you preferred cell phone towers, you could buy shares of American Tower Corp. (AMT).  And the list goes on, including almost any other type of real estate you can think of!

However, as we all know, real estate goes through boom and bust cycles and is a risky asset class.  Moreover, just like with regular stocks, buying an individual REIT exposes the investor to “idiosyncratic” risk, i.e., a risk unique to that specific investment that can not be diversified away.  Because of this, it is much preferable to own real estate through a portfolio of REITs.  There are a few very large low-cost passively managed exchange-trade funds (ETFs) that provide good diversified exposure to the REIT sector.

REIT offerings from Vanguard, Schwab, and iShares round out the top few passively managed REIT ETFs.  As seen from chart below, their performance over the past five years has lagged the S&P 500, while having more risk!  REITs still have a place in a balanced portfolio due to its low correlation (about 0.5) to the S&P 500 and its historically relatively high income generation (as shown from their higher SEC yield compared to SPY).

A key component driving returns are the underlying sector exposure of each of the ETFs.  As can be seen below, VNQ and IYR tend to underweight the Residential sector compared to SCHH, thus impacting the return profile.  There is no reason, however, to believe that one weighting approach is better than the other over a full business cycle.

As always, our philosophy is to have a well-diversified global multi-asset class exposure that includes the real estate asset class through the liquid low-cost passively managed ETF structure.  We expect to be rewarded over a long term time horizon.

Lucky Than Smart

Occasionally, it works out that you are more lucky than smart.  That is the way I feel about an A-class mutual fund I bought for my 4-year old son as a custodial account way back in 1989!  This was before exchange-traded funds (ETFs) and the proliferation of passive strategies.  I knew I was getting a better deal than otherwise since my employer allowed me to buy it without a sales charge, but I had no foresight that the fund would continue to perform as well as it did… right through today!

We still hold the fund, MFS Growth Fund (MFEGX), in my son’s name.  It is hard to calculate the exact total return over the past 30.5 years, but according to Yahoo Finance Adj. Close Prices from the earliest date available (January 3, 1993), its cumulative total return is 999.83% ( +129.01/11.73) that compares very favorably to an S&P 500 index fund (VFINX) of 1,172.04% (+309.87/24.36)!

Over the past 10 and 15 years, however, its return has been more extraordinary against the S&P 500 and even against its growth benchmark, the Russell 1000 Growth Index.  From the table below per Morningstar data, you can see the extraordinary 11.98% annual return and its +1.40% per year advantage compared to its growth proxy (IVW) over the past 15 years!

For an impressive MFEGX visual story (the blue line on top), just take a look at the chart below from Morningstar; $10,000 invested 15 years ago would have grown to over $54,000 today compared to only $28,000 for SPY or $36,000 for IVW.

The message here is two-fold.  First, congratulations to me for picking a winner over 30 years ago and seeing it continue to be one of the top growth funds in the mutual fund industry over the recent 15 years.  Secondly, and more troubling, is the fact that it was more luck than skill because I bought it 30 years ago in an environment of active management and high fees and history shows that this combination more often than not leads to underperformance (check SPIVA reports at https://us.spindices.com/spiva/#/ for pertinent analysis of this point)!

At that time I most likely would have bought a laggard and would be bemoaning the situation today.  Instead, I am quite happy that I ended up on the positive side of the ledger with the odds stacked against me.  Given what we know now, best to play with the odds stacked in your favor by focusing on low fee and passive strategies with minimal carefully selected exposure to high fees and active management.

Random is as Random Does

Capital market returns are often viewed as random.  The classic book by Burton Malkiel, Random Walk Down Wall Street, originally published back in 1973 with multiple updated editions, covers this in a readable format.  How can we observe this graphically?

Callan Associates is a well know consulting firm that publishes their annual “periodic table” of asset class returns.  The table arrays different asset class returns over different time horizons against each other.  In this way, you can graphically observe the rotation of returns compared across asset classes.

In the following exhibit I have plotted the monthly returns for 20 different asset classes (represented by their appropriate ETF) that cover a broad spectrum of the capital markets.  Each monthly return is sorted by highest to lowest monthly return.  I highlighted with arrows how the S&P 500 (light blue) and Small Cap Equity (bit darker light blue) rotated during 2019 through January 2020.

As you can see, both the S&P 500 and Small Cap Equity moved up and down the chart.  As expected, the Small Cap Equity showed more movement and, thus, more volatility (risk) than the S&P 500. 

I added Apple stock (AAPL, dark gold) for comparison.  As you can see, Apple stock mostly occupied the top three rows for the past thirteen months!  This does not mean it does not have risk; it is just that the time horizon is too short.  Likewise, Tech (dark red) occupied the top three rows over this time horizon (probably because Apple is a large component of that ETF).  The same logic can be traced for the other color-coded asset classes like REITs, investment grade bonds, and emerging market equity.

Can anyone predict how these asset classes will transition month-to-month?  NO!  Best to be well-diversified across all the major asset classes to capture the returns when they emerge over time.

January Smorgasbord

Between the U.S. attack in Iran, the escalation of the Coronavirus, the lead up to the Brexit effective date, and the impeachment hearings, January was certainly chock full of potentially market moving events.  None of those events, however, stopped the S&P 500 from hitting new record highs in the middle of the month.  Unfortunately, the end of the month (especially the LAST DAY!) showed a retraction to erase all the gains of 2020! 

The positive factors of good economic growth, good corporate earnings and “easy” fed policy led capital market results before the markets eventually ceded to the culmination of all those foreboding events.  The risk of “uncertainty” is a strong behavioral bias that leads markets in the face of an otherwise positive fundamental situation.  Certainly, any one of those events could lead to a deteriorated market condition; put them together and you have a good recipe for “uncertainty soup!”

For every weak idiosyncratic stock story (e.g., ExxonMobil, Chevron, 3M, and Boeing), there seemed to be an equal and offsetting positive story (e.g., Amazon, Alphabet, Apple, IBM, and Tesla(!).

Likewise, there was a broad dispersion of broad asset class winners and losers during January.  The S&P 500 (IVV) ended January 2020 exactly unchanged, whereas utilities (XLU) and technology (XLK) held their returns being up 6.7% and 4.0%, respectively.  Factor positions such as momentum (MTUM) and low volatility (USMV), similarly, regained market leadership with respective returns of 3.7% and 2.4%.  High dividend stocks struggled to keep up with mostly neutral returns, whereas the most aggressive sectors of the global economy such as emerging markets (dealing with the China Coronavirus issue as “ground zero”) were down the most at -6%.

In the global capital markets that turned to “risk-off” at the end of January, fixed income assets regained favor with core bonds (SCHZ) being up 2%.  Investment grade corporate bonds (LQD) did better by recapturing their “rally hat” during January with returns of 2.5%.

During times of heightened market uncertainty, when there appears to be the creation of a market “inflection” point, there is often pressure to make a market call and go to “risk-off.”  It is my view that it is way too early for that view; but certainly anything can happen.  Alternatively, this is an excellent time to affirm your risk profile and be assured that you are exactly where you should be to achieve your goals. 

MAGA? 4 Trillion-dollar Companies!

I follow about 400 investment thought-leaders on Twitter.  One of them, Charlie Billelo from Compound Advisers, made an interesting observation today.  Namely, with the great price rally in Amazon (AMZN) today, there are now 4 stocks with a trillion-dollar market capitalization (share price times shares outstanding) and the tickers all spell out MAGA (Microsoft, Amazon, Alphabet (GOOGL), and Apple)!

I have commented before on this idiosyncrasy of a cap-weighted index (such as the S&P 500).  From my blog post back in October 2019, I noted that the top 10 stocks in the S&P 500 made up 22.1% of the index; today that percentage has grown to 23.6%.  It almost goes without saying that exposure in the S&P 500 is less diversified than otherwise; especially since there is a strong growth style and tech/communication sector bias – and even stronger tech bias if you include Amazon in that category!

As I said in October, and it is worth repeating today,  “Though it is nice to capture the “upside” of the large overweight to “growth” stocks, it will not be so nice to experience the downside risk that is sure to follow it someday; growth stocks tend to exhibit more volatility of return than the S&P 500.  Best to stay broadly diversified across all market sizes and characteristics to capture the inflection points when they occur.”