Over the past several weeks we have continued to have conversations with clients about market conditions, and one recurring theme is the question of how the stock markets have returned to such elevated levels so quickly. Economic forecasts vary, but most show that after a period of several quarters of lost income we will return to an environment where quarterly GDP returns to a positive space, and continues on in a direction not too dissimilar from what we have considered in the past to be “normal.” Having priced in a temporary setback, the market seems to be acting as though brighter days are on the horizon. However, we continue to see big swings such as on Thursday, June 11th when the US Stock Market as measured by the Russell 3000® Index dropped by just over six percent in a single day. And yet, this month has also had held such a strong positive streak that the US market is still positive for the month of June (2.55% as of this publishing). From one year ago, the measure has reported a positive 8.83% growth rate, and for many it may be hard to imagine that most traditional diversified stock and bond portfolios that were fully invested over the past twelve months are up in value. For most investors it’s the volatility that is the cause of much of our concern. As tracked by the above referenced index, a height of 2000 points was achieved earlier this year that then fell to a low of 1249 before recovering to 1900 and subsequently falling over 150 points by Thursday’s market close. This roller coaster ride can be witnessed in the chart below, which captures the change in market value of approximately 98% of the investable US equity market.
Russell 3000 Index snapshot courtesy of Google
Remember our investment mantra that we must focus on what we can control, and not to overly focus on that which is out of our control. Over the past few months, financial markets have rapidly priced in new information that has reflected a variety of expected future outcomes. This data has flowed in at such a volume and speed that we are seeing volatility that can be uncomfortable at times to watch. The equity markets appear to have reacted more as we might expect to that of a natural disaster rather than what we saw with the partial economic collapse of our financial system in 2007-2008. This has led to “experts” thinking out loud about whether the market comeback is real or temporary. The following is an analogy that may help to resolve the initial perceived disconnect between the market comeback and the continued volatility and uncertainty within our economy. For a moment, let’s pretend that instead of owning a portfolio of companies, you are the owner of an apartment building complex. If future rental income is suddenly called into question, especially if these losses are outside of your control, then a financial appraisal of your building would result in a markdown to the overall value of the investment property despite no structural damage being sustained to the building or the property. As a property owner it’s important to maintain a long-term view with respect to the valuation of your investments, and unless you’re forced to sell your investment at a reduced price, you’ll likely want to hold onto that building until your rent rolls have stabilized and you can sell the building for a much better price. Whether you’re an income-producing property owner, or you own a variety of income-producing businesses through the mutual funds in your portfolio, volatility is the cost that we accept as a trade-off for higher expected returns than less risky alternatives like bonds and cash.
Though it may be tempting to feel at times that it is a “good” or a “bad” time to be in the market, I direct you to review the track record of the financial experts, as plotted by an economist that has diligently tracked the annual market predictions and results from notable hedge funds and other investment companies featured in Baron’s magazine over the past 13 years. Their record has shown that their predictions, on average, offered no added value at all, and often their most hopeful prospects turned into the poorest performing sectors of market. On the whole, we find similar long-term underperformance in the actively managed funds of the world, who tactically pursue opportunities that promise to outpace the performance of the overall market, and yet on average they tend to fall short of their comparative benchmarks over time. Dimensional Fund Advisors annually publishes a report that keeps track of this public data, and we can provide you with a copy, if you would like to review the subject further.
If the underlying value that drives performance isn’t coming from getting in and out of the right investments at the right times, then the price appreciation of the business over time may be largely attributed to the profitable ventures of the businesses themselves, along with inflation of the money that is being used to value the company share price. Aside from the complex subject of inflationary monetary policy, the value of a company ebbs and flows primarily in step with its future ability to earn an income stream, much like an apartment building is valued based on its future expected rental income. As news events are released about how the pandemic is expected to affect our society, the expectations about future income streams for our economy also change.
Taking this concept a bit further, the future income stream of each individual company does not come with an equal degree of risk. As one example, in time we have learned that smaller companies tend to be riskier than their larger counterparts, and in accordance with that risk they have experienced significantly greater long-term performance. Recent measures of time have shown large companies have outperformed, which is counter to our long-term expectations, and yet the wealth of statistical data that we have on the subject confirms that we should still expect to achieve higher returns from this riskier asset class. As you’ve probably heard in some way through the legal department of every investment company, “past performance is not indicative of future performance.” That is to say, the factors that govern future returns are many, and past performance is not a reliable summary of what one should expect in the future. Because of the factors that lead to our higher expectation of return, we maintain exposure to small companies, and as a hedge in accepting the inability to know the course of future events, as well its volatility dampening benefits, we maintain exposure to every asset class amongst every major sector. As an investor it’s important to decide how much of your wealth you wish to expose to risk in exchange for a higher expected return. Once that decision is made, it should be revisited as one goes through various phases of life and life events, and our philosophy has always been that life circumstances and therefore investment goals should be the driver of changes to your risk exposure rather than an attempt at market timing.
As an aside, similar benefits of diversification and exposure to assets with higher expected returns may be achieved, while an additional layer of consideration is paid to eliminate from the investment portfolio those stocks that one may wish to remove exposure from due to philosophical, or environmental reasons.
Lest we forget, this market volatility began roughly three months ago with a pandemic threatening our economy, and more recently a national conversation has been sparked about systemic inequalities in this country that threaten life, liberty, and the pursuit of happiness to many. I mention this not in an effort to elaborate on and to persuade you to adopt my perspective on current events, but rather to acknowledge that the stock and bond markets are incorporating all of our perspectives into market prices, and to the degree that we have a divergence of opinions on matters that affect our economy, as well as an influx of new information, we will continue to experience price volatility. For better or for worse, our society and our economy are inextricably linked and we see the uncertainty of the future reflected in the price of today’s companies. As uncomfortable as this volatility may be, it is indicative of a healthily functioning marketplace. Remember that for every fearful seller, there is a buyer on the other end of the deal who sees opportunity for growth. I encourage you to remain optimistic for our society, and the economy as an important component of that society.
Greg, Jim, and the team at TBS.
Chart obtained from Google.com on June 17, 2020. Index values and month-to-date, year-to-date, and year-over-year performance obtained from ftserussll.com, owner of the Russell US Indexes.
Please note that the financial data in the above posting is sourced from publications believed to be reliable. Neither TBS nor APFS nor APA make any representation as to the completeness or accuracy of information provided by these publications. Nor are any of the above entities liable for inaccuracies in the original source material.