Asset Class Summary: Second Quarter 2016
One of the cornerstones of our investment philosophy is that asset allocation is the most important decision in designing an investment portfolio. By combining uncorrelated assets, we believe the reliance on market timing, a futile exercise, is reduced. Combining different investment assets may produce a less volatile return than an individual investment. This in turn provides an ability to more readily resist the urge to sell in periods of high volatility.
Of the different asset classes (stocks/equities, fixed income/bonds/cash and alternatives), stocks seem to get the most attention when there is a market pullback and the urge to sell increases. Ned Davis Research produced an interesting chart (provided below). As shown in the chart, from the end of 1945 up to just before the Brexit shock, the S&P 500 (large U.S. company stocks) experienced 114 declines of 5% or more (most between 5-10%). Each of these declines recovered, most within one month. Many were initiated by some kind of market shock. Even declines in the 10-20% range had relatively rapid recoveries averaging about 4 months. However, it is usually more advantageous to hold tight (and maybe even add to) stock positions.
The S&P 500 closed the second quarter up 2.46% and 3.8% year-to-date. The two greatest contributors to the increase were the energy and telecommunication sectors while information technology and consumer discretionary were the two greatest detractors. We continue to see current U.S. stock prices in the reasonable (average) to slightly overvalued range. Using the 20-year average of their price/earnings ratio, stocks considered “value” stocks appear slightly overpriced while “growth” stocks appear somewhat underpriced. In terms of the decision by Great Britain to leave the European Union, we expect a minimum effect on U.S. stocks as, according to FactSet, U.S. companies derive less than 3% of their revenue from Great Britain. (For more commentary on the Brexit vote, go here.)
At -1.19%, developed international stocks (per the EAFE) continue to lag U.S. stocks in the second quarter. Given the lower valuation multiples of international stocks compared to U.S. stocks, they may offer higher potential future returns given they have more room on the upside. However, international stocks, particularly European stocks post-Brexit, are facing stronger headwinds than U. S. stocks and will require patience. Currently, we are maintaining our U.S. bias in our equity allocations as we watch to see if the global economy (excluding the U. S.) has reached an economic turning point. About 70% of our equity position is in U.S. and 30% in international positions. (For more on our international fund, please read here.)
Stocks from emerging markets (economic developing countries) ended the second quarter advancing .80% (per the MSCI EM Index). With the pace of the strengthening U.S. dollar slowing and favorable performance from commodities, we believe emerging markets can offer a positive influence to portfolios.
With an increased concern for a possible economic slowdown, mid-cap and small-cap stocks may offer opportunity, as these companies have the greatest exposure to the resilient U. S. consumer. Another opportunity may be with high quality stocks with a history of growing dividends. In the past, these stocks have served investors well in times of volatility and market pullbacks.
Bonds continue their long, slow trip to nowhere. During the second quarter, the yield on the ten-year U.S. Treasury Bond declined from 1.79% on April 1, 2016 to 1.49% on June 30, 2016 as a flight to quality continued.
We do not anticipate a significant rise in interest rates in the near future. There was already a flight to safety into U.S. Treasuries from low (and negative) interest rate debt of other nations. Add to this that European banks/governments are gearing up to help offset any economic crisis from the Brexit vote we expect the attraction to U.S. debt to increase. This in turn will help keep pressure on interest rates from moving up. The current rates of 10-year bonds globally indicate the markets expect low inflation and low rates may persist for several years.
With current bond interest rates remaining below their long-term averages, we continue to find them less attractive than the stocks and alternative asset classes. As a result we continue to maintain a bond allocation at the lower end of our target allocation. Within our bond allocation we are favoring short term maturities with some exposure to intermediate maturities. Despite the low interest rate environment, we still believe bonds play an important role in most portfolios as they can offer protection during periods of market downturns.
Offsetting our lower-than-average bond allocation, we are maintaining a higher alternative investment allocation. Alternatives can help protect from market volatility. The managed futures investments we added at the end of 2015 are performing as we anticipated during times of market volatility. With a goal of being uncorrelated to stocks and bonds, these funds may not experience the same negative performance during pullbacks. Where there is negative correlation, alternatives may provide a positive return when equity or bond performance declines. We believe market volatility can offer opportunities for portfolios with alternative investments an important tool to take advantage of these opportunities.
For more information from the second quarter edition of Your Family CFO Report, check out these articles: Economic Overview, Market Overview and Living Trusts. You might also enjoy commentary from Tim Agnew on our international fund and currency hedging, available here. As always, please call us at 404-874-6244 with any questions.
All references in this publication referring to our average allocation or “typical portfolios” reflect those of the fully discretionary accounts of clients with moderate risk profiles. Actual client portfolios are tailored to individual client circumstances and asset allocations may vary. Any reference to returns reflect the performance of asset classes, are for illustration purposes only, and do not reflect the returns of any specific investment of Smith & Howard Wealth Management. No representation is made that any investment decisions discussed herein have been profitable in the past or will be in the future. Past performance is no guarantee of future results. A list of all recommended investments is available upon request.