Tag Archives: emerging markets stocks

Analyzing This Year’s Market Returns

Many investors assume their accounts have achieved good returns this year. After all, the S&P 500 Index is up nearly 9.5% through October 8, including dividends. But that doesn’t necessarily mean your account has an inflation-beating return for the year depending on your bond and international stock exposure.

And while bonds and foreign stocks have been drags on portfolios this year, owning them is no reason to change your allocation. But now is a good time for a portfolio assessment or a moment of understanding what you own and why – and how asset class returns have diverged this year.

A Tale of Two Balanced Portfolios

Let’s say you’re a balanced investor (around 60% stocks and 40% bonds) and you have all your money in one fund – the Vanguard Balanced Index fund (VBINX). That fund keeps 60% of its assets in U.S. stocks and 40% of its assets in U.S. bonds, and it’s up 4.29% for this year through yesterday. That’s a decent return, but it seems far away from the 9.5% return of U.S. stocks.

If you’re guessing that bonds have been a drag on portfolios this year, you’re right. The Bloomberg Barclays U.S. Aggregate Index, the main U.S. bond benchmark is down 2.53% for the year. When 40% of your portfolio is down it will necessarily damp the effect from the part of the portfolio that has done well. And while that can make you wish you didn’t own any bonds, your bonds will save you the next time the stock market tanks – especially if they are government bonds. A 100% domestic stock portfolio – especially when the S&P 500 is trading at expensive valuations – probably isn’t a good idea for any investor. Most people can’t handle the volatility of a 100% stock portfolio even when the market is cheap on reliable long-term metrics like the Shiller PE. And you own bonds as a kind of insurance policy that happened not to pay off this year. That’s fine; you’re not supposed to make an insurance claim every year. So if you’ve captured a 4% return from your balanced portfolio so far this year, that’s a good return.

If you own a balanced portfolio that’s diversified into international stocks, your returns are less appealing (though still not awful). That’s because the global stock market, measured by the MSCI ACWI Index, is up only 1.56%, a far cry from the 9.5% return of the S&P 500 Index. International stocks, both developed country and emerging markets, have posted losses this year in U.S. dollar terms. And since U.S. bonds are down 2.53%, a balanced portfolio of global stocks (assuming unhedged currency exposure) and domestic bonds is down 0.76% for the year. That’s a modest loss, but any loss feels worse than a 4.29% gain or a 9.5% gain.

But, again, nobody should make dramatic changes to their portfolios or fire their advisor if their balanced portfolio has posted a loss. Many good investors have argued that foreign stocks are cheaper than U.S. stocks. They are likely to outperform over the next 7-10 years, so there’s a good reason to hold them. Also, as recently as last year, international stocks outperformed U.S. stocks. In 2017, the S&P 500 Index delivered a 22% return including dividends. But the MSCI EAFE Index for developed country foreign stocks returned 25% and the MSCI EM Index for emerging markets stocks returned a whopping 37%, both in U.S. dollar terms. So sometimes diversification benefits you, and sometimes it doesn’t. Sometimes owning a cheaper asset doesn’t pay off immediately. And it could happen that international stocks outperform domestic stocks next year again, despite a slowing global economy and currency issues for emerging markets due to a rising U.S. dollar. As it happens, Lance Roberts, who manages portfolios at Clarity Financial, has avoided international stocks for most of the year, and that has been a benefit to portfolios. He has written about his avoidance of international stocks here.

Above all, remember also that you’re not in this for one year’s worth of returns. It’s true that analysts and pundits focus on ridiculously long periods of time that no normal human being has for investment purposes – 100 years, for example. But you don’t have one year either if you have stock exposure. You probably have at least 10 years, maybe 20, and possibly even 30, if you’re about to retire. That doesn’t mean poor years should be taken cavalierly, especially early in retirement. But If you have bond exposure and international stock exposure, understand why you have them and that it’s not always easy to predict how any asset classes will perform from year to year.

Overall, if you have any kind of positive return from a balanced portfolio this year, you’re doing reasonably well. Please feel free to contact us if you have questions about this year’s returns, asset allocation, or retirement planning.

Q3-Market Performance Review

Yesterday was the first day of the Fourth Quarter of 2018, so it’s a good time to assess where markets are for the year. Nobody should change their portfolios radically based on recent market moves, and, to the extent that anybody does, the long term bias should be gently adding what has dropped and trimming what has surged, keeping in mind that catching absolute tops and bottoms is difficult. But, from time to time, it can be useful to observe recent trends.

The first thing to notice about market returns through the first three quarters of 2018 is that U.S. stocks are up again. The S&P 500 Index closed the Third Quarter up 10.58% for the year, including dividends. Mid-cap stocks were up too, though less dramatically. The Russell Midcap Index gained 7.45% for the year through the Third Quarter. Small-cap stocks have gained about as much as the S&P 500, with the Russell 2000 Index up 11.51% for the year. And the Russell Megacap 50 Index also has a similar gain for the year of 11.69%.

Two Discrepancies

If U.S. stocks are having a good year, international stocks aren’t. The MSCI EAFE Index, which tracks stocks from developed countries, lost 1.43% for the year through the end of the Third Quarter. The MSCI Emerging Markets Index (MSCI EM NR) has done ever worse, shedding 7.68% for the year through the end of the quarter. Much of those losses are attributable to the dollar’s surge against foreign currencies, especially those of emerging markets. When U.S investors buy foreign stocks or a foreign stock fund, they typically get two sources of return, the stock’s return in its own market and the foreign currency’s return versus the U.S. dollar. That second return has hurt U.S. investors in foreign stocks this year, as the dollar has surged. A dollar surge also puts emerging markets under a cloud because emerging markets countries and companies borrow in U.S. dollars, making a dollar surge especially burdensome for them.

A second discrepancy is the difference in value and growth stocks. Value stocks tend to trade with lower price-earnings and price/book ratios, while growth stocks tend to trade with higher ratios precisely because of their anticipated growth in earnings and/or book value. The Russell 1000 Value Index rose a tepid 3.92% for the year, while the Russell 1000 Growth Index surged by 17.09%. the top-5 holding of the Russell 1000 Growth Index are Apple (AAPL), Microsoft (MSFT), Amazon (AMZN), Facebook (FB), and Alphabet (GOOG). The only one of the so-called “FAANG”s that it’s missing is Netflix, and the FAANG stocks have gained more than the overall market.

Bonds and REITs

Bonds, represented by the Bloomberg Barclays U.S. Aggregate Index dropped 1.6% for the year through the end of the Third Quarter. Interest rates have been rising in fits and starts. The yield on the 10-year U.S. Treasury has spiked up above 3% (where it rests now) during the year, but also fallen back at times. Bond yields move in the opposite directions of prices.

Volatility in the bond market has also likely influenced REIT returns. REITs pay out 90% of their net income as dividends in exchange for having tax-free status at the corporate level. The high dividend yield, low-growth companies often trade with some correlation to bonds. REITs (MSCI US REIT Index) tumbled in January and February of this year, the soared in March, May, and June. But in September they shed more than 2% to give them a roughly 2% year-to-date gain. That’s not terrible, but it lags the broader market’s return considerably. Large REIT companies that have declined for the year include paper and forest products company, Weyerhaeuser (WY), office landlord Boston Properties (BXP), and medical space REIT Ventas (VTR).

Judging Your Portfolio

If you have a lot of REIT exposure, that has probably been a drag on your portfolio. That’s why gunning after the highest yielding stocks is sometimes not a good idea. Additionally, if you have a lot of international stock exposure, that’s also been a drag. The discrepancy, for example between the year-to-date returns of the Vanguard Balanced Index Fund (5.6%) and an index consisting of 60% MSCI ACWI (All Country World Index) and 40% U.S. bonds (1.7%) is large.

That doesn’t mean you should exit all your international stock positions. What does badly one year can do better the next. In 2017, for example, international stocks outpaced domestic stocks, and emerging markets stocks, the dogs of this year, gained 37% versus the 22% gain of the S&P 500. Picking a single year’s winners isn’t easy.

Overall, investors should know that domestic stocks are considerably overpriced by any valuation metric one chooses to use. That doesn’t mean they can’t get more expensive, but nobody should be anticipating robust long-term returns from U.S. stocks.

It’s Okay To Hold Some Cash

The great sage and baseball legend, Yogi Berra, once said:

“It’s tough to make predictions – especially about the future.”

But financial planning is all about contemplating how much money will result from a particular savings rate combined with an assumed rate of return. It’s also about arriving at a reasonable spending rate given an amount of money and an assumed rate of return. In other words, plugging in a rate of return is unavoidable when doing financial planning. Perhaps financial planners should use a range of assumptions, but some assumption must be made.

The good news is that bond returns stand in defiance to Berra’s dictum; they aren’t too difficult to forecast. For high quality bonds, returns are basically close to the yield-to-maturity. Stock returns are harder, but there are ways to make a decent estimate. The Shiller PE has a good record of forecasting future 10-year stock returns. It’s not perfect; low starting valuations can sometimes lead to low returns, and vice versa. But it does a decent job. And the further away the metric gets from its long-term average in one direction or another, the more confident one can be that future returns will be abnormally high or low depending on the direction in which it has veered from its average. Currently, the Shiller PE of US stocks is over 30, and its long term average is under 17. That means it’s unlikely that future returns will be robust.

The following graph shows end-of-April return expectations for various asset classes released by Newport Beach, CA-based Research Affiliates. One will almost certainly have to venture overseas to capture higher returns. And those likely posed for the highest returns – emerging markets stocks – come with an extra dose of volatility. Along the way, there will be problems caused by foreign currency exposure too, though Research Affiliates thinks foreign currency exposure will likely deliver some return.

Hope for a correction? Move some money to cash?

Given this return forecast, investors will have to contemplate saving more and working longer. But investors who continue to save should also hope for a market downturn. As perverse as that sounds, we are in a low-future-return environment because returns have been so good lately. We have basically eaten all the future returns over the past few years. And nothing will set up financial markets to deliver robust returns again like a correction. That’s why the Boston-based firm Grantham, Mayo, van Otterloo (GMO), which views the world similarly, though perhaps a bit more pessimistically, to Research Affiliates has said that securities prices staying at high levels represents “hell,” while a correction would represent investment “purgatory.” If prices stay high, and there are no deep corrections or bear markets, there will be little opportunity to invest capital at high rates of return for a very long time.

Investors who aren’t saving anymore should hold some extra cash in anticipation of purgatory. If we get purgatory (a correction) instead of hell (consistently high prices without correction), the cash will allow you to invest at lower prices andva higher prospective return. How much extra cash? Consider around 202%. The Wells Fargo Absolute Return fund (WARAX) is run by GMO, and 81% of its assets are in the GMO Implementation fund (GIMFX). Around 6% of the Implementation fund is in cash and another 16% of the fund is in U.S. Treasuries with maturities of 1-3 years, according to Morningstar. So more than 20% of the Implementation fund – and nearly 20% of the Absolute Return fund — is in Treasuries of 3 years or less or cash.

Around 52% of the Implementation fund is in stocks, most of them foreign stocks. So around 40% of the Absolute Return fund is in stocks. (The other holdings of the Absolute Return fund are not invested in stocks as far as I can tell.)

If you normally have something like a balanced portfolio with 50% or 60% stock exposure, it’s fine to take that exposure down to 40% right now. There is no question that this is a hard game to play. The cheaper prices you’re waiting for as you sit in short-term Treasuries or cash, with roughly one-third of your money that would otherwise be in stocks, may not materialize. After all, as Berra said, “It’s tough to make predictions.” Or the lower prices may materialize only after your patience has expired, and you’ve bought back into stocks at higher prices just before they’re poised to drop.

These adverse outcomes are real possibilities. But the buy-and-hold, strictly balanced allocation (60% stocks/ 40% bonds) also isn’t easy now for those who (legitimately) fear a 30+ Shiller PE. That’s why it’s arguably reasonable to move some of your stock allocation into cash and/or short-term Treasuries, but not the whole thing. And sitting in cash hasn’t been this easy for a decade or more, now that money markets are yielding over 1% and instruments like PIMCO’s Enhanced Short Maturity Active ETF (MINT) are yielding over 2%. Those yields at least act as a little bit of air conditioning if investment hell persists and prices never correct while you sit in cash with some of your capital.

See A Bubble? Get Out Of The Way.

In early March, we reprinted an article I wrote for Citywire on bubbles. That article focused on an academic paper called “Bubbles for Fama” by Robin Greenwood, Andrei Shleifer, and Yang You on spotting bubbles. It tried to provide a definition that would satisfy proponents of the efficient markets hypothesis who doubt that bubbles exist.. The authors noted that 100% run-ups of asset prices in a two-year period resulted in a heightened probability of a subsequent crash.

Early this week, Research Affiliates weighed in on which assets might be in a bubble today, citing another research paper by Greenwood and Shleifer discussing how investors behave with strong “extrapolative tendencies.” In other words, investors anticipate strong returns after strong return periods, when future returns are likely to be lower, and also anticipate weak returns after weak returns periods, when future returns are likely to be higher.

What’s A Bubble?

But before we get to that argument, Research Affiliates founder, Robert Arnott, and his colleagues, Shane Shepherd and Bradford Cornell try to keep the definition of a bubble simple. They argue a bubble is a “circumstance in which asset prices 1) offer little chance of any positive risk premium relative to bonds or cash, using any reasonable projection of expected cash flows, and 2) are sustained because investors believe they can sell the asset to someone else for a higher price tomorrow, with little regard for the underlying fundamentals.” (Can you say Bitcoin?) There are bubbles now in technology stocks and cryptocurrencies, according to Research Affiliates. Overall, the U.S. stock market is very expensive too.

The authors are aware that modern academic finance would find their definition lacking. Adherents of the efficient markets hypothesis think “[t]he market’s willingness to bear these risks {of high prices relative to reasonable projections of cash flows] varies over time. . . . .high valuation levels don’t represent mispricing; the risk premia just happen to be sufficiently low so as to justify the prices.” Of course, if risk premia or required returns can vary so widely, what’s the difference between and efficient market and an inefficient one?

More realistic observations come from behavioral finance which shows that investors bring their own psychological baggage to markets even when they know and understand formula-based valuation models. Moreover, Greenwood and Shleifer show that investors are so tied to recent price trends that they anticipate higher expected returns after big price runs when valuation models anticipate subpar returns, and lower expected returns when valuation models anticipate robust returns. Moreover, investors bet accordingly, putting more money into stocks after they have gone up, and withholding it after they’ve gone down.

What Can Investors Do?

If you’ve spotted a bubble, the temptation is to short it. But that turns out to be very difficult, despite the success of the hedge funds depicted in Michael Lewis’s The Big Short.  Arnott et. al. recount the story of Zimbabwe at around the time of the financial crisis. At first, when Zimbabwe’s currency crashed, the stock market soared. Then the stock market crashed as the currency continued to crash more. And finally, when the currency collapsed, so did the stock market for good. The problem with having shorted stocks in this case is that their initial run up might have bankrupted you. And even when asset prices don’t react to a currency failure the way Zimbabwe stocks did in 2008 by shooting up initially and then cratering, bubbles can keep getting bigger and bigger. Not everyone facing a bubble has the advantage that the hedge funds doing “the big short” had — knowledge of when most of the adjustable rate mortgages issued would reset at higher rates, causing most borrowers saddled with them to default. A bubble might be easy to spot, but it’s hard to trade.

Instead of shorting, the easiest thing to do when you spot a bubble is to avoid it. Nobody needs to own Bitcoin or cryptocurrency. Also, nobody needs to own any technology stocks right now. Moreover, there are many stock markets around the world cheaper than the U.S. market. The cheapest stock markets around the world are the emerging markets, according to both Research Affiliates and Grantham, Mayo, van Oterloo (GMO) in Boston. It’s true EM stocks often come with an extra dose of volatility, but their valuations are lower than that of the U.S stock market. Also, none of this means those are the only stocks you should own though. There are ways to mitigate overvaluation of U.S. stocks such as with an ETF that owns more of the cheapest ones like the iShares MSCI USA Equal Weighted ETF (EUSA) or the PowerShares FTSE RAFI US 1000 ETF (PRF). But when things are expensive, it’s fine to stay away from them.

Even being relatively conservative by overweighting emerging markets stocks rather than shorting U.S. stocks entails some “maverick risk,” as Research Affiliates calls it. This is sometimes called “career risk,” because clients will fire and advisor or asset manager who deviates too much from a benchmark or his peers for too long a period of time. Investors must be honest with themselves about how much maverick risk they can tolerate, and advisors must be careful not to exceed their clients’ tolerance for maverick risk.

Most of all, when contemplating asset prices and prospective returns, remember that your mind may be playing tricks on you when you expect unusually large or unusually small returns. Don’t extrapolate recent return history into the future. The future might hold the opposite scenario from the recent past.