"Black Swan of Black Swans"

This has been a great weekend for reading investment news.  Starting with Barron’s and ending with the many newsletters I get via email, there are a vast dichotomy of opinions.  I say opinions because no one can predict the future!

Let’s start with the thoughts of Michael Gayed, CFA, a leading portfolio manager and tactical asset allocator at Toroso Investments.  He has been fairly successful and makes his living by going risk-on and risk-off depending upon the triggers indicated by his models.  His investment strategies have been pummeled this year by markets that are exhibiting anomalous behavior.  As he said on Saturday,

At precisely the time when many investors would likely be turning to Treasuries for safety, government bonds posted one of their sharpest and steepest declines in history. Treasuries should be behaving like a risk-off asset, but they’re not.

He terms this situation the “Black Swan of Black Swans”; the worst case of when highly unpredictable events occur beyond what is normally expected with potentially severe consequences.  He goes on to say that his model is not wrong, it is simply the environment that is wrong, per below:

This is not a situation necessarily where it's the signals that aren't working depending on the Fund. It's the opportunity set that isn't.

Consequently, his funds that are supposed to immunize investors from these kinds of weak markets have lagged significantly year-to-date with one fund being down -37.42% (ATAC US Rotation ETF, RORO).  He does go on to say,

 All I can say with confidence is that this is an incredible dislocation happening in markets, and that generally, the best returns tend to come from buying after a large drawdown.

So, he offers hope and a belief that we all live in a small “sample” of a much larger universe of investment performance.  He closes with the final thoughts:

I believe everything is about to change in a way that at least allows for the potential for the funds, and opportunity set, to revert to historical behavior.

With an ominous caveat, 

At some point.

Special Blog Post: "Vortex of Downward Misery"

Tom Lee of Fundstrat Global Advisers, a frequent guest on CNBC financial news and persistent bull, had some interesting comments during his appearance yesterday on CNBC.  His positive comments were a telling counterpoint to the “vortex of downward misery” we are all seeing in the markets.

He correctly pointed out that the market declines have accelerated downward over the past week, but bonds have been fairly stable and the volatility index has risen and stabilized, but not “spiked”.  Also, he felt for this market to deteriorate further, he would expect high yield bond spreads to widen and get “crushed”, but that has not happened [yet, that I need to note here!].

He also put forward an interesting set of statistics.  Since 1940 there have been 16 occurrences of markets down 16% in 4 weeks; of these 16 occurrences, 12 of the 16 were higher by double digits 6 months later, and 14 of the 16 were higher 12 months later with an average return of 20%.  We shall see!

So, though there are plenty of reasons to be bearish not the least of which is heightened inflation and the Russia/Ukraine conflict, as I have highlighted ad nauseum in previous blog posts this year, there are some reasons to have a positive view going forward.  As we all know, though there are no guarantees, the markets have always rebounded to new highs given enough time.  In fact, don’t forget that our most recent all-time high was not too long ago on January 3, 2022!!

Update Your Retirement Plan Now!

Last week’s blog post, “Do or Die” Redux, recounted previously posted thoughts to consider during weak markets.  As I said then, “As long as we are comfortable with your time horizon and risk appetite, I do not recommend selling now.  If you sell now, it will be more difficult to recover the lost market value. Given the recent weakness in the markets, this is a good time to evaluate your lifestyles and to do more planning for the future…”

To that end, please see my short 5-minute video blog from last November where I quickly preview the investment planning for retirement that I do for Dattilio & Ash clients.  In it, we model projected income, expenses, goals, and investment assets across 1,000 different investment scenarios to calculate your personalized “probability of success”. We are happy to create or update a plan for you as needed.

"Do or Die" redux

As I have reported to clients, this is the worst beginning of a year since 1942!  Of course, that is no solace to me or you or anyone who has lost money in the market!  As I have been reporting in my recent blog posts, there is a culmination of economic and political events all converging at the same time to increase “fear” and cause caution in the markets.  From the “hawkish” Fed, increasing interest rates, heightened inflation, still-disrupted supply chains, and the Russia/Ukraine conflict, there are many reasons to be cautious.

S&P 500 large cap equities (IVV) are down -12.5% YTD (with small cap, international, and emerging markets down more) and investment grade corporate bonds (LQD) are down -15.0%, a highly unusual relationship that is fostered by the Fed threatening to move too fast with its tightening cycle.  As bad as this feels, the beginning of the Covid pandemic during March 2020 saw stocks lose -35% (but bonds did provide some negative correlation at that time, unlike now).  Over time, I do expect bonds to recover and produce a long term rate of return equivalent to its current yield of about 4%.  Likewise, stocks are struggling now, but unless we all start to live in caves, have upside in the future.

As long as we are comfortable with your time horizon and risk appetite, I do not recommend selling now.  If you sell now, it will be more difficult to recover the lost market value. Given the recent weakness in the markets, this is a good time to evaluate your lifestyles and to do more planning for the future, as recounted in the following D&A blog post “Do or Die” from July 20, 2020:.

The New York Times published a book review on July 12, 2020 that bears noting.  It has an ominous title, “Die With Zero”, but it does highlight an interesting perspective on retirement planning.  As the review states, the book covers important concepts on “why you save and how you live.”

Most financial and investment planners will tout the benefits of tax-deferred saving.  The benefits of compounding of returns within tax-deferred accounts are well-documented and, everything else being equal, tax-deferred accounts always beats taxable accounts on an after-tax total return basis over any time horizon.  So, if that is the case, keep the money invested in tax-deferred accounts as long as you can.  But, for what purpose??

Certainly, as I have indicated in previous blog posts (“Is there a Number for You?”, https://www.dattilioash.com/our-blog/2020/4/30/is-there-a-number-for-you), cash flow testing of expenses and income overlaid with your investment portfolio is important to help you determine your probability of retirement success.  If you have a high probability of success and a good amount of excess “cushion”, then you owe it to yourself to think about how you want to deploy the excess – whether save it for your heirs, gift it currently, or spend it currently on something that you value.

These are very personal decisions and only you can decide on the best answer for you.  My role, as an investment planner, is to bring this point to your attention and identify the pros and cons.

Strategic Bond Math Explained

It seems obvious now!  Hawkish Fed, huge fiscal stimulus, big pickup in inflation; everyone knew interest rates were going to go up and short bonds were going to outperform long bonds!   But, it wasn’t obvious!  The Fed is moving to control inflation and simply getting interest rates closer to a “normal” level, the fiscal stimulus simply replaced private sector economic activity that was diminished by the global pandemic, and the pickup in inflation, though serious, is simply catching up to a 2.25% long term trend line from its sub-2% levels of the last 10 years.   

Bonds with a short “duration” have less interest rate risk, i.e., the risk of prices going down when rates go up, compared to long bonds.  For example, a bond with an effective duration of 2 years will fall in value by 2% when rates increase 1.00% (e.g., from 2% to 3%), compared to a bond with an effective duration of 9 years that will fall by 9%.  This is simple bond math.

But, just like in the stock market, no one can predict the bond market. Per the table below, though short bonds (NEAR) have outperformed long bonds (LQD) on a year-to-date and 2-year time horizon, over longer 3- and 5-year horizons long bonds have outperformed short bonds.

Underweighting long bond exposures was a prudent strategy over the last two years given the risk-return tradeoff when rates were at historic lows, but re-targeting bond exposure to shorter bonds over a longer time horizon would have missed some of the longer-term positive return.

So, going forward there is plenty of risk in the market, but as I am known to say, best to stick with a long-term strategy attuned to your risk profile and targeted to help you achieve your goals.

What's With Bonds?

Like I wrote last week, so far during 2022 bonds have generated large negative returns.  Bonds are supposed to be less risky alternatives to stocks, so what goes?  Following is a brief discussion.

Bonds are financial obligations of a legal entity, either a government (e.g., the U.S.), a corporation (e.g., Verizon), or some other structure.  In the most basic form, they are analogous to a bank certificate of deposit in that they have a fixed principal amount upon which interest is paid over a set term.  In bond parlance, the par value of a bond earns a coupon rate that is accrued and paid periodically over a set term.

For a bond that pays a fixed 3% coupon on a fixed par value for a term of 10 years to yield 3%, any change in the general rate of interest will impact the value of the bond; either up or down!  A bond yield has two component parts:  the risk-free rate (e.g., the U.S. treasury yield) and a spread over the risk-free rate termed the “credit spread”.  Since the coupon is fixed, any increase/decrease in the general level of rates will cause the value of the bond to go down/up, so that the obligation continues to offer a yield that is competitive with the general market.  Complicating things further, if risk-free rates are rising AND the bond is issued by a corporation with a weakening financial condition, the underlying credit spread (as a proxy for risk) would widen (i.e., go up) compounding the rate increase so that the bond value would go down ever further. This is what we have seen happen so far this year, per the chart below.

As seen from the above chart, the 10-year constant maturity U.S. Treasury (the red line) started the year at a yield of 1.52% while the credit spread for a common investment grade bond index (the blue line) was a tame 0.98% implying a total yield for an average corporate bond at 2.50%.  During the year the 10-year treasury rate trended higher increasing by 1.31% to peak recently at 2.83% while credit spreads similarly increased by 0.28% to 1.26% implying a total increase in yields of a whopping 1.59% and a total corporate bond yield of 4.09%!  Historically, this is a large jump in rates!

Looking over our shoulder, it is easy to decipher the cause; a hawkish Fed tightening monetary conditions to help slow down heightened inflation and cool down an economy that may be overheating.   Other factors like the Russia/Ukraine conflict, persistent supply chain issues, and technical aspects also had an impact.  Higher interest rates caused the value of bonds to decline; in fact, investment grade corporate bonds (LQD) with a duration of 8.9 years are down -12.7% year-to-date through April 14, 2022.  Correspondingly, U.S. equities (IVV) are down LESS at only -7.5% over the same time horizon, but other diversifying equities like small- and mid-cap, international developed and emerging market equities are down more.

The Fed has telegraphed that more monetary tightening and rate increases are in the plan, depending upon how things develop over the near-term horizon, so more pain could be in store.  For clients with a long time horizon and higher risk tolerance, D&A has been underweighting bond allocations by up to 10% over the past year and on a narrow basis this was the right thing to do.  No one knows how the future will emerge, but sticking with a long-term strategy to achieve your goals is still the prudent thing to do.

Most Interesting to Me

The drumbeat since the beginning of the year has been loud and strong.  Run for the hills!  As I have reported since January, the news has pointed consistently to dire straits.  After two years of huge fiscal/monetary stimulus to protect the economy from the effects of the pandemic, we see a hawkish Fed telegraphing a new monetary tightening cycle to cool an overheating economy, increasing inflationary pressures, persisting supply chain issues, and the Russia/Ukraine conflict; plenty of reasons to be a bear!

But, running for the hills is not the answer!  No one can outguess the market!  As you can see from the chart below, except for bonds that have been on a consistent downtrend from the beginning of the year (the black line, AGG, and the red line LQD), despite the downtrend, there have been pockets of recovery that elicited some hope for a recovery.  In fact, if you were clever (or lucky!) enough to have bought the S&P 500 (IVV, the green line) at its low on March 8 and sold it on March 29, you could have garnered an +11.3% return; such is the nature of volatile markets!   

What continues to be most interesting to me is how the bond market (AGG, -8.2%) has “underperformed” the stock market (IVV, -7.1%) on a year-to-date basis.  For accounts with a long-term focus that could tolerate more risk, D&A took a position to underweight core bonds by up to 10% of target and it has worked out on a narrow basis, but other equities (e.g., small cap, international developed, and emerging market equities) have taken a bigger fall leading to some total portfolio underperformance on a year-to-date basis. As always, we expect a long-term focus will reward those investors who stay the course with the diversifying equity sectors that are currently out of favor.

Still, Relatively Well-behaved!

My Feb. 2, 2022 blog post, titled It’s Always Something!, highlighted the fact that it is always something!  No sooner did we begin to emerge from the grasp of the global pandemic then plenty of fiscal stimulus combined with Fed easy money and supply chain disruptions finally caused inflation to begin to accelerate.  And then, we watched as global geopolitical turmoil surfaced with Russia invading Ukraine; all while interest rates started to perk up and touch multi-year highs!  Consistent with these troubling situations, the markets have been volatile and down pretty much across the board, but still relatively well-behaved; especially when compared to the -35% drawdown that accompanied the beginning of the covid pandemic!

As seen from the table below, large cap U.S. equities (IVV) are only down a bit at -4.57% during Q1, though they we down as much as -12.9% during the quarter.  Small- and mid-cap equities (SCHA and SCHM) struggled a bit more, down -7.37% and 5.46%, respectively.  Likewise, international developed and emerging market equities (SCHF/SCHE) were down about a relatively well-behaved -6%; surprisingly tame given the turmoil overseas!  Bringing up the rear were core bonds (SCHZ, -5.84%), inv. grade corporates (LQD, -8.38%), and high yield bonds (HYG, -4.73%) as victims of higher rates/widening credit spreads due to fears of a weakening economy.  So, the traditionally LESS risky bonds underperformed MORE risky core equities.

Strategically, and mathematically(!), underweighting bonds was the right move during Q1, but bonds continued to be a drag on total portfolio performance.  A slow rise in rates will hurt bond returns in the near term, but will normalize over time; over a long time horizon, bonds should be less risky than equities and serve as a ballast when equities fall.

As I wrote in my Feb. 2, 2022 blog post, It’s Always Something!,

If you have a long time horizon and can tolerate market volatility, a larger equity content has been shown to reward investors.  D&A strives to ensure that client accounts are carefully managed to the appropriate level of equity content and risk suitable for each client.

When to Sell?

It is natural to get worried when the value of your investments goes down; no one likes to lose money!  But, as we all know, that is part of the process; markets go up and markets go down.  So, assuming you have a long-term investment strategy that is attuned to your risk profile, when do you sell, if ever?

Every down market is different, but our most recent experience with the market reaction to the COVID pandemic in 2020 is telling.  At its worst, from the chart below, the global equity markets (VT, the green line) tumbled -34.2% due to fear and the economic effects of the pandemic.  However, as we all know, markets recovered strongly once the situation got under control and became normalized and markets reached new heights in January 2022.  U.S. markets (IVV, the blue line) had a similar drawdown, but reached higher highs than the global equity markets.  Core U.S. bonds (AGG, the gold flattish line) meandered aimlessly during this time frame to a mostly flat-line profile.  In the context of the pandemic, this latest Russia/Ukraine crisis has a long way to go with global equity markets (VT) showing a recent drawdown of only -13.2%.

So, when do you sell, if ever?  It is really two decisions, when to sell to get out and when to buy to get back in; each decision is critically important, and no one can outguess the market.  Clearly, selling did not make sense during the pandemic since the market recovered and reached new heights.  Yes, you could have sold at the recent high and bought back at the recent low, but that is all market timing and study after study shows that no one can consistently outguess the market except by luck. 

I sound like a broken record (for those who remember what a broken record sounds like!), but best to stick with a long term investment strategy that matches your risk profile to achieve your goals.

Special Guest Blog Post - The Fed's Next Move: Ukraine Changes the Picture

As all of you know, I usually write weekly blog posts on the Dattilio & Ash Capital Management web site.  These blog posts are usually about 3- or 4-paragraphs long and reflect my views on current investment topics including investment strategy, retirement planning, economic events, etc.

However, this week I read a thoughtful market commentary from Charles Schwab & Co., Inc. titled “The Fed’s Next Move:  Ukraine Changes the Picture” that I agreed with and felt it would be appropriate to share it this week. 

The article highlights the patience shown by the Fed to head off inflation with a slow and methodical tightening of monetary policy, only to have the Ukraine-Russia conflict complicate matters with a shock to the economic outlook.  War in the Ukraine has caused a surge in some commodity prices that potentially could slow growth and financial and other sanctions could disrupt financial markets. The article ends with a familiar refrain that sounds like something I wrote: “Despite the uncertainties in the outlook for the economy and Fed policy, we believe investors should continue to hew to their “best-laid plans”.  Those with a long-term strategy that suits their risk tolerance and capacity should stick with their plans”.

What Next?

January was a tough month due to Fed tightening and inflation fears and February deteriorated further as the Russian invasion of Ukraine rattled global markets.  My blog post on February 2, “It’s Always Something!” highlighted the fact that managing risk is part of the investment process and as long as your risk profile matches your investment time horizon and goals, your chances for success are improved.

Per the table below, most every asset class (including bonds!) was down for the first two months of 2022 with the only major exceptions being gold and energy; gold as a traditional safe harbor and energy due to potential supply disruptions causing an historic price spike.

Going forward, there continues to be significant risk in the market.  Financial sanctions imposed on Russia from the western countries can pose a serious threat to economic growth and financial market stability around the world. This is mostly due to Russia’s large energy exports to the European markets and global supplies but also due to the curtailing of money flows through SWIFT and other systems.

From a portfolio management perspective, the turmoil has caused most asset classes to move into negative territory and diversification, once again, leading to underperformance. For example, key diversifiers like emerging market bonds, REITs, and factor exposures in momentum and minimum volatility (of all things!) have been a drag on total portfolio performance. Over time, of course, we expect these exposures to revert to a more normal profile.

Inflation Risk

My last two blog posts dealt with “risk” and justifiably so given the collective psyche we all face.  Of all the risks, perhaps inflation is the most concerning.

“U.S. Inflation hit 7% in December, fastest pace since 1982” (Wall St. Journal, Jan. 12, 2022) and “Red-hot Inflation Data Headlines Volatile Week for Wall Street” (NASDAQ, Feb. 11, 2022) are two recent headlines prompting fear in the capital markets and on Main Street!

But, alternate views are starting to show up!  The New York Times, perhaps with a clearer head, reported that possibly a “duller” and more reasonable headline could read “Inflation Remained Stable, Well below its October Peak” in “Inflation May Have Already Peaked.  The Fed Needs to Step Gingerly.” (New York Times, Feb. 11, 2022).  This is due to the fact that the monthly rate was up only 0.6% in January and over each of the past few months, down from the recent high 0.9% monthly rate in October 2021.

As shown in the table below, over the past 9 years prior to 2021, inflation was quite subdued with an average inflation rate of only 1.6%.  Including the large 7.1% inflation rate in 2021, the 10-year average inflation rate is still only 2.12%; a number that is quite benign and at the Fed long term target.

None of this is to imply we have nothing to fear from inflation since we all see it in food, energy and almost everything we buy every day and large inflation is disruptive to a normal functioning economy. The supply chain problems due to the pandemic and the huge Fed and fiscal stimulus have been well-documented triggers to the current heightened inflation.  Going forward, we are hopeful that market forces can help solve the supply chain issues and the Fed can ease slowly to a more “normal” interest rate environment with a complementary dose of fiscal restraint.  

In the meantime, there is no benefit trying to time the market!  As I ALWAYS say, best to ensure that your investment strategy is consistent with your risk tolerance and matched to your objectives to help you achieve your goals.

It's Always Something!

Many years ago I recall an advertisement by a major insurance company with the tag line, “It’s Always Something!”  The ad was accompanied by a picture of the earth with earthquakes, blizzards, hurricanes, and other natural disasters causing calamity.  The financial markets have a little bit of that now with inflation fears, rising rates, dropping stock prices, not to mention the turmoil in the Ukraine, all contributing to a discouraging January!  But, how bad is it?

Last week I posted a blog dealing with drawdown risk, the amount of value lost from a recent peak to trough.  The drawdown for the S&P 500 (IVV) through January 26 was a notable -9.3% (that recovered somewhat through today).  Given that the S&P 500 was up +28.8% last year, it took only less than one month to give up about 32% of last year’s gains!

Based on a statistical analysis over the last 10 years, assuming a normal distribution for stock returns, the S&P 500 index delivered a monthly standard deviation of return of 3.77% and average monthly return of +1.19%.   This means that for a 1 standard deviation (SD) event, there is a 68% chance of a monthly S&P 500 return being between -2.58% and +4.96%, for a 2 SD event a 95% chance being between -6.35% and +8.73%, or for a 3 SD event being between -10.12% and +12.5%.  The S&P 500 January 31 monthly return of -5.3% turns out to be a -1.41 SD event; not common, but certainly not a crazy extraordinary “tail” event.  

Per the table below we can see other returns and standard deviations of return for different investment strategies. For investors wanting, or needing, a lower risk strategy, the Dow Jones Moderate Portfolio Index with a 60% equity and 40% bond allocation delivered a historical average monthly return of +0.71% and a standard deviation of 2.44%; less return, but also less volatile than the 100% S&P 500 equity strategy.   The Dow Jones Moderately Aggressive Portfolio Index shown with an 80% equity and 20% bond allocation produced commensurate level of return and risk between the 60% and 100% equity portfolios.

So, no surprises here!  The risk/return tradeoff is alive and well; more risk has produced a higher level of return over the past ten-year horizon.  If you have a long time horizon and can tolerate market volatility, a larger equity content has been shown to reward investors.  D&A strives to ensure that client accounts are carefully managed to the appropriate level of equity content and risk suitable for each client.

Risky Business

The recent market volatility and decline has been disappointing and has highlighted the problem with “drawdown” risk; the risk of a decline in portfolio value from a recent high.  Other measures of risk like standard deviation of return measure the statistical volatility of returns, but drawdown risk is more easily understandable and observable (and hurtful!)

As seen from the bottom half of the chart below, we have seen a recent drawdown in the S&P 500 (IVV, the green line) of -8.3% drawdown from a recent high and a maximum drawdown experienced during the last twelve years of -33.8% due to the COVID outbreak in March of 2020!  But, the offset to this is that IVV has also shown a cumulative total return over this 12-year period of +390.5%; one could argue that is a fair tradeoff of return versus risk.  Other less risky portfolios that include varying allocations to bonds, like the iShares Core Aggressive ETF (AOA), iShares Core Growth ETF (AOR), and the iShares Moderate ETF (AOM) have shown less drawdown and a commensurate lower total return.  The portfolio with the least risky profile, the iShares U.S. Aggregate Bond ETF (AGG, the blue line towards the bottom) as a 100% investment grade bond portfolio, has shown very low risk and the lowest return.

As I have recounted many times, for clients that have a long time horizon with sufficient income and net assets to cover their lifestyle and can tolerate the potential for large drawdowns, a portfolio with a large allocation to equities has proven to be an effective strategy to earn higher total returns during this time horizon.  Clients with a shorter time horizon or unique circumstances are better off maintaining a portfolio with reduced equity exposure to target a “smoother” ride shown by the portfolios with reduced equity exposure (AOA, AOR, or AOM).

Journey to "Nothingsville"

The theme from the early parts of 2021 persisted into Q4 with broad capital markets continuing to set all-time highs in the face of a persisting global pandemic, higher inflation, supply chain disruptions, and pockets of political gridlock.  Most thought leaders attribute this to the “re-opening” mindset and the fact that the economy is learning and adapting to the new reality of operating within the global pandemic.  Continuing fiscal support and an accommodative Fed (again, despite some hawkish rumblings) with interest rates staying within a narrow trading range completed the picture to support higher stock prices.

However, all is not rosy!  The broad capital markets like the S&P 500 continued to surge during Q4 and for all of 2021, but the strength was not universal.  Diversifying asset classes like U.S. small and mid-cap equities and emerging market and international developed equities lagged; some by a wide margin.  Core bonds continued their mathematical journey to “Nothingsville” as historically low yields continued to produce low total returns.  [For clients who can tolerate more risk, D&A continues to underweight bonds by up to 10% of target.]

Per the table below, the S&P 500 (IVV) has been on a tear with 2020 and 2021 annual total returns of 18.40% and 28.66%, respectively, easily beating every other major asset class over the last two years.  Other major asset classes like small- and mid-cap equity (SCHA and SCHM) produced strong returns in 2021 of 16.35% and 19.33% but was a drag on total portfolio performance.  Emerging market equities (SCHE) were a disappointment in 2021 with a -0.72% return.  Finally, not unexpectedly, core bonds lagged with a total return of -1.74% in 2021.

The array of disparate quarterly returns in the table above once again highlights the difficulty in predicting capital market returns.  From my blog post Are you Spooked? on October 27, 2021:

As readers of this blog well know, no one can call the market and our view is that a long-term strategic investment strategy developed to achieve your goals is the best approach.  If you have a long time horizon and income/net worth sufficient to support your needs and wants, stay in the market and wait it out.  If not, we can develop a strategy that recognizes the risks and positions you for a high probability of success.

A Thousand Words

Through Friday, December 10, 2021, the global capital markets have shown a bumpy ride.  Amidst the global pandemic, supply chain impacts, governmental and Fed responses, and resultant economic effects, we have seen very volatile, and varied, results.

Per the chart below of the five major asset classes, U.S. large cap stocks (IVV), U.S. small cap stocks (SCHA), developed markets (SCHF), emerging markets (SCHE), and U.S. core bonds (SCHZ), you can clearly see the dispersion of returns.  In the equity universe, U.S. large cap stocks are the big winner so far in 2021 with a robust +27.2% return (the green line at the top) and emerging market equities the big loser with a 0.0% return (yes, 0.0%!).  In the bond space, U.S. core bonds lagged with a -1.8% total return.

As has been the case over the last three years, diversification has mostly hurt portfolio performance because U.S. large cap stocks have been the undisputed top cumulative performer with all other asset classes lagging, often by a LOT!  Diversifying positions in international and emerging markets has been a drag, as has any exposure to core bonds. 

As we have said here many times, bonds have been a bad bet to make recently purely due to the math!  Historically low interest rates provide almost no yield and very little potential for bond price appreciation.  Recognizing this fact, D&A client accounts that can afford to take more risk have been underweighted bonds by up to 10%.

All is not lost, however!  Even with diversification being a drag on performance, a naïve diversified portfolio with a 60% equity and 40% bond weighting like the iShares Core Growth ETF (AOR) has generated a total return of +10.43% so far in 2021.  This is strong portfolio performance that exceeds the current inflation rate and carries much less risk than a 100% equity portfolio.  Of course, past performance is no guarantee of future returns!  As we all know, markets can turn on a dime and disappoint!  Best to ensure that your risk profile is consistent with your objectives and you are invested accordingly to achieve your goals.

Beats Me! (Again!)

On the surface, there are plenty of positive signs about the current economic situation.  For example, in the post-pandemic environment the unemployment rate has fallen from 14.8% in April 2020 to 4.6% in October 2021, a recent low but still much higher than the recent pre-pandemic low of about 3.5%.  Economic growth has picked up, too, with real GDP recovering nicely from the pandemic lows with quarterly growth rates of +6.7%, +6.3% and +2.1% over the past three quarters in 2021.  So why are we all worried about the future?

Though we live in an uncertain world, the capital markets don’t like uncertainty!  The largest uncertainty we all face is the potential for a re-emergence of covid-19 in a potentially more-onerous mutated form.  That is still to be seen, but the omicron variant announced last week is certainly causing a stir in the capital markets.

Aside from the externalities like covid impacting the markets, the potential for rampant inflation seems to be on everyone’s mind as they leave the gas station and grocery stores seeing much higher prices!  Certainly, inflation has picked up with the Consumer Price Index showing a +6.1% increase from prices a year ago.  Even excluding the more volatile prices from food and energy, inflation still shows a spike of +4.1%.  As seen from the chart below, after the drop in prices during the pandemic, we have seen a marked increase in prices from the beginning of the year, “transitory” or not!

Just like trying to predict the capital markets, no one knows if rampant inflation is on the horizon.  The period after the Credit Crisis back in 2008/09 likewise saw many thought leaders postulate much higher inflation due to extreme Fed easing and fiscal stimulus, which, of course, we never saw!  This time there are supply chain issues and other factors that very likely will be solved by market forces and time so there is good reason to be bullish on the inflation front.

This situation reminds me of insights from my favorite Chief Investment Officer at a former employer.  At every quarterly investment review meeting he would lead off the discussion with a lengthy discussion about the current economic situation and capital markets telling a good story about where we are.  He would close by saying, “So, what is the market going to do? Beats Me!”

Finally, from my blog post, Beats Me!, from way back in August 2019:

As I am wont to say, plenty of reasons to be cautious, but no reason (yet!) to run for the hills.  New money should go into the market slowly, since that is ALWAYS the low risk approach to get market exposure.  Investors with a long term strategic approach properly diversified and positioned in the risk profile appropriate for their situation should stay the course.

Investment Planning for Retirement (VLOG)

Retirement planning is a complicated process dealing with innumerable unknowns. It is best handled with advanced computer modeling software to stress test different assumption sets and investment scenarios.

Please watch my 5-minute video where I present a high level overview of a sample retirement case with our industry-leading software, MoneyGuidePro. We are happy to prepare and present a completely customized analysis for you. Please contact me at tony.ash@dattilioash.com for more info.

The EM Puzzle

If everyone loves EM, why isn’t it outperforming??  “Emerging Markets Look Poised for a Good 2021”, “…the case for emerging markets is looking more attractive…” and “Emerging Market Equities Set for Outperformance” was the battle cry as thought leaders ruminated over prospects for 2021.  The consensus views from Lazard Asset Management (April 20, 2021), Barron’s (October 6, 2020) and The Outsourced Chief Investment Officer (February 16, 2021) and many others all carried the same message: this is the year for emerging markets (EM) to outperform!

With EM equities underperforming the U.S. markets in 8 of the last 10 years, including year-to-date 2021, many prognosticators had been predicting this on a somewhat annual basis! What has been going on and where do we go from here?

The emerging market equity space is usually defined as countries where the financial markets are less developed than in the U.S. or the major European financial centers.  The list of countries usually includes the largest names such as China, Taiwan, India, South Korea (but not always), Brazil, Russia, Saudi Arabia, and Mexico.  Other parts of Asia are also considered emerging markets, but Japan is considered developed.

During the post-Covid period, U.S. markets rallied strongly and the thought was that emerging markets would follow suit.  The reasoning went that EM equities were relatively much cheaper on a value basis than U.S. equities and that would encourage the flow of capital to those markets, all while overseas factories geared up to replenish stockpiles depleted by the pandemic.

Of course, that is not what has happened; so far! As seen from the chart below, many of the largest countries in the emerging markets, including China, South Korea, and Brazil have racked up large negative returns YTD detracting from the overall EM market (the IEMG ETF, second from right) producing a +3.60% YTD total return compared to the robust +26.27% total return shown by the U.S. large cap market (IVV, rightmost column).  Other EM ETFs that do not include South Korea as EM equity still underperformed miserably, including SCHE with a +4.13% total return.

Philosophically, Dattilio & Ash believes in long term strategic investing and does not try to time the market.  We certainly believe and understand that EM equities are relatively “cheap” compared to U.S. equities, but that does not mean we can time when that value will show up!  We believe that a well-diversified, global, multi-asset approach will reward long term investors over time.

Is "The Trend Your Friend"?

“Don’t fight the tape!” and “The trend is you friend!” are well-known idioms that persist in the financial world.  The idea that a stock price will keep going up since it has been going up has been around for a while.  And it seems logical, too!  Who wouldn’t want to buy a stock that has been doing well?  Have you ever heard someone ask about buying a stock that has performed poorly?

This phenomenon is specifically termed momentum and bucketed in the financial lexicon as a factor.  Academic studies into it have shown it to be a broad factor that encompasses other factors and it has a history of driving investment returns.  As the theory goes, the momentum factor serves as a diversifier and has the potential to add extra return to a portfolio.

A well-diversified passive portfolio, over the long term, will produce returns that mimic the broad indices. This is not necessarily a bad thing since active management has been shown to underperform a passive approach over time (check out the S&P Indices versus Active, SPIVA®, papers here for more info).  Consequently, it pays to seek out low-cost passive additions to a portfolio to potentially push performance ahead of the broad indices.

Over the recent time horizon, the momentum factor has put in good performance helping it achieve that goal.  Let’s take a look at the recent performance.

The iShares MSCI USA Momentum Factor (MTUM) exchange-traded fund (ETF) is one of the largest passive ETFs that follows a momentum investing strategy with assets under management of $17.2 billion.  It is low-cost (0.15% expense ratio) and follows a rules-based approach to investing.  It mechanistically rebalances twice per year (May and November), swapping out stocks that lag in momentum for stocks that have gathered momentum.

As deduced from the chart below, over the last 3.9 years from January 1, 2018 through November 9, 2021, the MTUM ETF (the orange line, mostly on the top) has generated an annualized total return of 18.26% compared to the S&P 500 (IVV, the blue line) of 17.47%.  The MTUM ETF showed some significant outperformance during the latter half of 2020, but gave back some of it during the beginning of 2021 before rallying again recently.

Dattilio & Ash Capital Management strives to achieve investment results to help its clients achieve their goals.  We continually monitor the capital markets for investment instruments and strategies that help us do that.