Q3 Key Takeaways
Despite some choppiness in September, the S&P 500 Index rose 8.9% during the third quarter and has recovered all its losses for the year. Underneath the U.S. market surface, mega-cap growth names continue to lead. Without the astonishing 42.5% year-to-date price return of the so-called FANMAG stocks (Facebook, Amazon.com, Netflix, Microsoft, Apple, and Google/Alphabet), the S&P 500 would still be down for the year. The strong outperformance of these top names also now means they dominate the index. Market concentration is not unusual, but it’s extreme today.
The important investment takeaway is to not be lured into chasing the returns of what has worked well in the recent past. These companies outsized past returns have come from their ascension to the top, not from owning them once they were already there. Over time, owning the largest stocks has badly lagged owning the diversified index. The economic value these large U.S. growth firms have created is real. Yet the durable economic recovery taking hold could be the catalyst for investors to turn away from these highflyers and favor undervalued stocks in out-of-favor industries and overseas markets.
Nevertheless, this U.S. mega-cap growth effect has been driving the outperformance of U.S. stocks over foreign stocks for most of the year. For the quarter, developed international stocks gained 6.0%, almost three percentage points behind U.S. stocks, though, emerging-market stocks outperformed U.S. stocks with a return of 10.2%. Both developed international and emerging-market stocks trail U.S. stocks year to date.
Bond markets were calm throughout the summer, thanks in large part to the Federal Reserve’s extremely accommodative monetary policy. Fed officials say they are now targeting “average inflation” of 2% and have signaled that they do not expect to raise the federal funds rate at least through the end of 2023. With Treasury yields unchanged, core investment-grade bonds gained 0.6% in the third quarter.
A unique U.S. election approaches in November. The market doesn’t like uncertainty, so the weeks leading up to the election and afterward may be volatile. But history shows the political party in power is not a significant driver of long-term investment returns. Political views have little to no impact on our investment process, and we don’t try to predict the short-term market reaction to elections (or any short-term event). Instead, we stick to our long-term analytical framework.
Beyond the election, though, there are reasons to be cautiously optimistic. An economic recovery is underway. Economic data and forecasts are improving. On the virus front, the speed of progress in vaccine development is promising. Success would allow economic activity to fully return to pre-pandemic levels. Supportive monetary policy from the Fed and other central banks has supported the speedy recovery in markets and the global economy. That doesn’t guarantee the absence of volatility, another bear market, or recession, but central banks can step in to help again if volatility returns or economic setbacks occur.
There are also reasons for caution. It’s unclear how strong the economic recovery really is. If markets are pricing in too rosy of an outlook, there is room for disappointment. The potential remains for a large resurgence of COVID-19 in the fall and winter months, which raises the risk of renewed shutdowns. More fiscal support from Congress is likely needed, but it’s not clear whether more help will come in 2020. Finally, we recognize there is always the potential for a negative geopolitical shock.
OJM Portfolio Update
The watchwords of our current positioning remain balance and resilience. OJM portfolios are balanced across multiple dimensions, with prudent levels of diversification in both their stock and bond allocations. We believe they can provide strong returns in our base-case and more optimistic economic scenarios, while maintaining resilience in a more challenging scenario.
On the equity side, we were underweight U.S. stocks going into 2020 and the early days of the pandemic. In March after their initial large decline, we began adding to U.S. stocks. Our team continued to increase domestic stock exposure throughout the spring and summer at attractive prices. We are currently at our long-term target for U.S. stocks, reflecting a neutral view on domestic equities. Since that time, U.S. stocks have appreciated strongly, gaining more than 50% from the March low.
U.S. stock valuations may look expensive relative to history; however, they look attractive relative to bonds. Bond yields are extremely low, which forces investors to allocate more to stocks, pushing stock valuations even higher for longer. Cheap relative valuations, in addition to a supportive Fed and plausible optimistic scenarios in which U.S. stocks can deliver decent returns, are preventing us from wanting to trim stocks, even at these price levels. An underweight to U.S. stocks could create a significant opportunity cost if they continue to perform well.
Our allocation to developed international stocks and emerging-market stocks were reduced to help fund our U.S. equity position. We have elected not to further reduce our global diversification as we continue to see attractive five-year expected returns for foreign stocks. They are cheaper than U.S. equities and provide an opportunity for outperformance if domestic earnings require multiple quarters of growth to justify current prices. If foreign currencies were to also appreciate against the U.S. dollar due to Fed-repressed interest rates, that would further enhance returns for U.S. dollar–based investors.
On the fixed-income side, core bonds are an important shock-absorber in a negative economic or geopolitical shock. However, their expected returns are low and a modest increase in interest rates could lead to negative short-term returns. Our bond holdings focus on high quality, while providing an income stream superior to more defensive cash equivalents. We have elected to accept the moderate risk associated with rising rates, when weighed against the benefits of additional income and potential appreciation if equity markets were to sell-off.
Overall, we are very comfortable with how we have constructed our portfolios. At this time, we have proactively decided not to make additional shifts in our portfolio positioning prior to the election. We like our portfolios’ balance between return potential and risk management. Our actions in March and throughout the Summer show we will not hesitate to take advantage of compelling opportunities when they arise. We believe we are tilted in the direction markets are headed, electing to remain both disciplined and diversified rather than follow the trends of the last six months. Mega cap stocks and growth companies are an important component of an investment strategy; however, they should not represent the only holdings of a portfolio given the cyclical nature of the market.
Partnering with You
While we are constantly making decisions about what actions may be needed in portfolios, we are also working behind the scenes to grow our clients’ wealth and bolster their financial position in ways which may not be visible on the surface. One specific example is tax-loss harvesting in taxable accounts, which can offset realized gains in 2020 and possibly into the future.
Please keep in mind our advisors can help with broader planning areas beyond designing tax-efficient investment strategies. Consider accepting our offer to perform education planning, retirement modeling, or a review to design a tax-efficient distribution strategy. Financial planning has taken on additional complexities this year, as we work through the rules and opportunities presented by the SECURE and CARES Acts. These Acts created opportunities for waiving required minimum distributions, planning for IRA beneficiary changes, rolling over traditional IRA accounts to Roth accounts, and reviewing existing estate plans.
As always, we encourage you to contact us with any questions about your specific situation.
–OJM Group Investment Team (October 12, 2020)