2018 Third Quarter Market Commentary

Written by: Ethan Pollard

With Q3 in the books, we find ourselves looking back on another quarter where US stocks outperformed all other assets, and portfolio diversification is again on trial. The debate over the merits of diversification are certainly not new in the investment community. Before the rise of the fabled FAANG stocks (Facebook, Amazon, Apple, Netflix and Google), there was good old General Electric, which in its’ heyday was a leader in everything from home appliances to power generation to computing and beyond. Both employees and the general public alike gobbled up the conglomerate’s stock through the years and watched it trounce the performance of the broad market. From 1988 through 2007, GE outperformed the S&P 500 by roughly 25x: $100 invested in the S&P in 1988 would be worth $896 in 2007, whereas that same $100 was worth $23,000 when invested in GE stock. At that point it would have been fair to say that GE stock was a better long-term investment than the broad market, and diversification was wholly unnecessary.

Unfortunately for GE investors, the party did not last forever. GE stock was hit twice as hard as the overall market in 2008, and ten years later the picture has not gotten any better. The company is looking at its third CEO in as many years. The stock is worth half now what it was worth in 2008 and was recently ousted as a member of the elite Dow Jones Industrial Average after being a founding member of the Dow in 1896. Those same investors who enjoyed the outsized returns of GE stock and shunned diversification prior to 2008 have lagged the market and missed out on wealth creation in the ten years since.

GE is not the most dramatic story of an investment darling falling from grace. Lives were destroyed over the Enron scandal in the early 2000’s, for instance. While we hope those who are overexposed to the FAANG stocks or the next hot investment of the day do not suffer the same ruinous fate, our job as advisors is to help our clients avoid as much downside risk as possible while still providing competitive investment returns to help achieve their goals and live full and purposeful lives. Diversification remains the most proven tool within portfolio construction to achieve those aims. Our core portfolios are diversified at several levels, including:

  • Security Selection: We aim to hold Exchange Traded Funds and Mutual Funds, which track indexes of hundreds or even thousands of positions, instead of individual stocks and bonds, reducing our downside in case of the demise of an individual company
  • Asset Classes: For all but the most aggressive of our clients, we seek to diversify portfolios across equities, fixed income, and alternative assets, so that even if one broad class of securities sells off, we hold other asset classes with low or even negative cross-correlations to help counterbalance declines in one area with potential gains in other areas
  • Geographies: We feel blessed to live in the land of the free and the home of the brave, and we believe that the United State is a great place to invest, but we also view investing in overseas equities as yet another way to provide diversification within our portfolios and a potential source of differentiated returns when the rally in US stocks falters

Looking at trailing returns on a quarter-to-date and year-to-date basis, diversification outside of anything other than US equities has been a headwind to portfolio performance. Domestic equities gained +7.1% QTD and +10.6% YTD as measured by the Russell 3000 index. No other major asset class has approached that level of returns in 2018. International equities, as measured by the MSCI ACWI ex-US index, gained +0.7% QTD but are down -3.1% YTD. Bonds were flat on the quarter and have lost -1.6% YTD per the Bloomberg Barclays US Aggregate Bond index. Gold prices, a traditional diversifier with negative correlation to equities, fell by -5.1% QTD and have lost -8.0% YTD.

In investing as well as in life, patience is a virtue. Most damage (in the context of investing) is incurred when acting reactively with short-sited perspective and goals, rather than developing a principled approach and maintaining a long-term investment philosophy. One way that our Firm helps clients invest in a principled and diversified manner is through our propriety Three Dials investment framework. Below are some helpful data points to consider in the context our firm’s Three Dials: 

  1. Economic Fundamentals: Positive

While we won’t get the advance estimate of Q3 US GDP until October 26th, the Atlanta Fed’s “GDPNow” model predicts 4.1% real annual growth as of October 1st. This would represent the second consecutive quarter of GDP growth above 4%. This number is also in line with the International Monetary Fund’s most recent estimate of 3.9% global GDP growth, indicating that the rest of the world is experiencing a healthy growth rate alongside the US.

  1. Market Sentiment and Momentum: Positive

After a rocky first few months of the year, domestic stocks have experienced no shortage of buying activity as major equity indexes reached new all-time highs during Q3. Meanwhile, despite their recent struggles, international equities have managed to overtake their short-term moving averages, suggesting that the mid-year selloff may be behind us as overseas investments appear poised for a strong finish to the year.

  1. Valuation: Negative

The flip side to strong buying activity amongst US stocks is that valuations have become stretched such that this represents the second most expensive market in US history. International valuations range anywhere from “fair” in parts of developed Europe and Asia to “downright cheap” in certain emerging markets with high growth potential.

On a composite basis, our “Three Dials” are still in a moderately aggressive position.

Sources:

https://yhoo.it/2y0IJ0G

https://www.frbatlanta.org/cqer/research/gdpnow.aspx

https://www.imf.org/external/datamapper/NGDP_RPCH@WEO/OEMDC/ADVEC/WEOWORLD

https://www.starcapital.de/en/research/stock-market-valuation/

 

Ethan Pollard serves as Senior Analyst and Wealth Advisor with Archetype Wealth Partners. He handles many of the research, trading and financial planning responsibilities at Archetype Wealth Partners, including the development of our economic and portfolio risk sensitivity models. Originally from Houston, Ethan currently resides in Chapel Hill, North Carolina with his wife Katie. Archetype exists to help families thrive across generations.

 

Disclaimer: Our intent in providing this material is purely for informational purposes, as of the date hereof, and may be subject to change without notice. This article does not intend to constitute accounting, legal, tax, or other professional advice. Visitors and readers should not act upon the content or information found here without first seeking appropriate advice from a trusted accountant, financial planner, lawyer or other professional.

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