Just ten weeks ago, investors were coming off one of the best years in a decade for a broad swath of financial assets. The S&P 500 rose by 31.5% and bonds, as measured by the Bloomberg Barclays U.S. Aggregate Index, increased by a dramatic 8.7%. Almost everything good that could happen for investors did happen. What a difference a couple of months makes. With each passing week, markets now seem to be confronted with yet another unexpected piece of news or negative turn of events. The list over the last three weeks alone would be enough to fill an entire year:
- The rapid spread of COVID-19 outside of China not only led to volatility in stock and bond markets, the likes of which we have not seen since the Global Financial Crisis, it has also severely disrupted daily life and travel plans for many around the globe.
- The tenor of the U.S. presidential election shifted substantially as a more moderate candidate emerged to challenge progressive frontrunners at the same time the economic outlook darkens.
- Instead of bolstering confidence, an unexpected emergency interest rate cut from the Federal Reserve confirmed investor concerns of an underlying shift in corporate and economic fundamentals and signaled a potential return to zero interest rate policy.
- Over this past weekend, an alliance of oil producing countries known as OPEC+ fractured, leading oil prices to decline almost 25% in a single day and causing significant declines in the prices of stocks and bonds issued by many well-known energy companies.
Collectively, these events have had a significant impact on the equity positions within investor portfolios and driven long-term interest rates to record lows in the U.S. Uncertainty and worry have turned the market upside down in short order. The speed of the transition suggests the market has gone from pricing assets as if nothing negative would ever happen again to pricing them as if the worst possible outcome is now unavoidable. As risk gets re-priced and sentiment turns negative, government bonds are trading at levels more consistent with a recession environment and stocks are trading slightly above levels that would mark the first official bear market in over 12 years.
It’s important to remember that RGT has been in business for 35 years and has the requisite experience to manage through market disruptions such as this. While each disruption is different, experience is valuable when navigating turbulent market environments.
RGT is preparing for a longer grind than many market pundits are indicating today and one with more frequent bouts of volatility. A technical recession, defined as two quarters of negative GDP growth, or even something more protracted are real possibilities. While we view many of today’s events such as COVID-19 as transitory, economic damage has been inflicted. Corporate investment is slowing, and consumer spending is shifting while risk aversion increases. While the ultimate length of time required for markets to find a bottom, and the ultimate level of that market bottom is unknowable, there are a few silver linings in play.
RGT client portfolios came into this environment balanced and well-positioned. Not only have bonds helped mitigate losses and reduce volatility during this market turmoil, high-quality bonds have performed very well. Our investment philosophy is guided by thoughtful asset allocation and diversification, two pillars that we have stood by when many abandoned them during this period of low interest rates and an uninterrupted bull market. Consequently, we have what we believe is a solid foundation from which we can manage portfolios through this environment as there are no dramatic, rash decisions to be made. Like sailing through choppy waters, marginal adjustments are much better (and easier to make) than wholesale portfolio changes.
We utilize a platform of experienced investment managers continuously focused on improving their portfolio’s risk and return profile. We regularly speak with these managers and are currently deep in the process of speaking to them about the present landscape. These conversations, which are already bearing fruit and informing our views, have reminded us of the value our managers bring in helping us make more informed, marginal changes to portfolios during volatile periods. We believe utilizing managers as a resource to stay current on how the economy and specific companies are performing is an advantage. We loathe the thought of having to look at a portfolio made up entirely of ETFs, quantitative strategies, and index funds that don’t say a word, and make no changes to their portfolios, when times are tough.
Given the significant performance differential over the last month between bonds and stocks, we are now actively looking for rebalancing opportunities between asset classes and other strategies where performance has diverged. We expect a series of smaller changes to be made over the course of months, not days. While this process can be tedious and is often dependent on individual client or family circumstances, it is a disciplined and unemotional act of strategically working to buy low and sell high. Rebalancing also allows us the opportunity to reset portfolio exposures back to longer-term targets.
Finally, it is worth noting that as riskier assets, such as stocks, decline in value they inherently become cheaper. This ultimately improves future returns, perhaps dramatically if the decline is steep or growth ends up surprising to the upside. The ultimate length and depth of economic disruption is anyone’s guess, but stocks have improved return prospects on both an absolute basis and relative to bonds, especially as interest rates plumb record lows. An investor with a long-term time horizon and no need for immediate liquidity will thus be more appropriately compensated for owning risk assets going forward.
As markets continue to fluctuate, sometimes wildly and unpredictably, it is important to remind yourself that these types of environments often give rise to significant opportunities. Current losses aren’t permanent when markets decline despite how uncomfortable it can be along the way. Maintaining a disciplined and deliberate approach centered around a long-term strategic asset allocation increases the probability of participating more fully in higher-returning environments. Responding from a balanced position also makes it easier to identify and invest in compelling opportunities when they arise.
Please let your RGT advisor know if you would like to discuss these ideas.
“We tolerate complexity by failing to understand it. That’s the illusion of understanding.” Steven Sloman and Philip Fernbach, The Knowledge Illusion, 2017.
“But today we have involved ourselves in a colossal muddle, having blundered in the control of a delicate machine, the working of which we do not understand. The result is that our possibilities of wealth may run to waste for a time, perhaps for a long time.” John Maynard Keynes, The Great Slump of 1930, 1930.
If you’ve ever tried to explain something to a small child, then you’re familiar with their constant response of “Why?” to whatever answer you provide. As adults, we seem to believe that this is because children enjoy annoying adults. But maybe it’s because children see the world as a complex place and simple answers just won’t suffice. Eventually we all (or at least almost all of us) succumb to the realization that we are never going to be able to understand this complexity and we learn to rely on mental shortcuts, or heuristics, to give us “good enough” explanations for what’s going on in the world.
For the most part, these heuristics work well enough. But when we try to understand complex systems, like markets, monetary systems, or broad economies, these heuristics often break down. To make matters even worse, our reliance on heuristics to understand causality in complex systems leads us to seek the easy answer, not the complex answer, and feeds into an overconfidence that we understand that which is quite often not understandable.
Performance in the financial markets in the third quarter was a bit of a jumbled mess. The S&P 500 ended the quarter up 1.70% and is up 20.55% for the year. But there was a four-week period running from late July to late August when the S&P 500 lost 5.9% before recovering over the last month of the quarter. Other equity markets, such as U.S. small-cap stocks (Russell 2000), foreign developed markets (MSCI-EAFE), and emerging markets (MSIC EM), were all down for the quarter.
Fixed income markets were no less volatile, with the bellwether 10-year U.S. Treasury yield dropping from 2.00% at the beginning of the quarter to an intra-quarter low of 1.47% on September 3 before rates backed up. The 10-year Treasury ended the quarter at a yield of 1.68%. The falling rate environment was a strong tailwind for bond returns with the Bloomberg Barclays U.S. Aggregate Index up 2.27% for the quarter and up 8.52% for the year.
What led to this intra-quarter volatility? Those seeking the quick answer had a plethora of choices from which to choose – trade wars, slowing economies, tweets, election uncertainty, falling earnings growth, more tweets, and on, and on. It’s tempting to latch on to one or two of these explanations, especially if they conform to our view of the world as we try to seek order in chaos. But the very real danger is that oversimplified explanations can imbue us with a false sense of confidence. Believing that we understand the causal relationships in these complex systems, we in turn are in danger of poor decision making based on our overconfidence. To avoid this trap when we manage portfolios, we try to develop a sound, long-term investment plan, we engage in thoughtful and deliberate decision-making processes, and we seek to build portfolios in such a way as to diversify our risk exposures and our opportunities for return.
“We choose to go to the moon in this decade and do the other things, not because they are easy, but because they are hard, because that goal will serve to organize and measure the best of our energies and skills, because that challenge is one that we are willing to accept, one that we are unwilling to postpone, and one which we intend to win.” John F. Kennedy, September 12, 1962.
If you’re like me, you’ve spent more than a few evenings this summer watching the trove of documentaries that have been airing on PBS and other outlets about the Apollo program in celebration of the fiftieth anniversary of the first lunar landing on July 20, 1969. I find that watching the story of Project Apollo unfold and witnessing the genius, ingenuity, determination, and bravery of the men and women of NASA making the seemingly impossible become a reality to be both fascinating and inspiring.
Revisiting these events has also been an opportunity to see and hear the speech President Kennedy delivered on September 12, 1962 at Rice Stadium in Houston. The quote above, pulled from that speech, has long been one of my favorite presidential quotes. The speech was intended to rally support for the space program, but the rhetoric used to sell the audacious goal of landing astronauts on the moon and bringing them home safely seems to have a much broader application. Just because a task is hard doesn’t mean that it isn’t worth doing. Shirking difficult challenges and opting for the easy way out is not something that can be counted on to produce long-term success.
Our task at hand, managing investments, is certainly a much easier task, by many orders of magnitude, than the challenges faced by NASA and the Apollo program. While the NASA engineers had to solve problems related to the laws of physics and the nature of human biology, the most difficult challenges facing investors are often internal rather external. Being disciplined investors that make good decisions focused on cogent, long-term strategic plans is our ‘hard’ task at hand. The difficulty comes in battling cognitive biases, such as Recency Bias, Hindsight Bias, or Bandwagon Bias (also known as Herding), that are constantly pulling investors in the wrong direction. We are all subject to falling victim to these biases. They are constantly pushing us towards the seemingly easier path and are the most difficult challenges facing most investors.
Recent market performance is providing a plethora of cognitive bias challenges for investors. As has been the case for much of the last 10 years, the S&P 500 was the best performing market index in the second quarter, up 4.30%. This despite some significant intra-quarter volatility. That brought the S&P 500’s year-to-date performance up to 18.54%. This is where our cognitive biases kick in. Recency Bias will lead investors to extrapolate this performance into the future leading them to overweight large-cap US stocks. Hindsight Bias will whisper in the investor’s ear that everyone knew that the S&P 500 was the best place to be – it was obvious. And the Bandwagon Bias will urge investors to jump on board the US large-cap stock train; everyone else has and they are all doing better than you. This is the time that doing the hard thing, maintaining a disciplined long-term approach grounded in fundamental investment principals, becomes most difficult. And it is why investors should be prepared, as Lady Macbeth said, to “screw their courage to the sticking place,” and prepare to do that which is hard, not that which seems easy.
The Tax Cuts and Jobs Act passed in late 2017 provided for tax incentives designed to encourage capital investment in local “zones” in an effort to spur economic development and job creation in distressed areas. The Opportunity Zone, or O-Zone, program encompasses over 8,000 census tracts and more than 30 million residents across the U.S. Texas has approximately 600 Opportunity Zones, with nearly 30 in the DFW area. It is estimated that these new tax incentives will provide over $100 billion of investment in qualifying O-Zones. For investors, income taxes levied on future expected gains can be significantly reduced if the qualifying investment is held for at least 5 years. In addition, if an O-Zone investment is held for longer than 10 years, the gain, which would otherwise be taxable, will be tax-free. Other elements of this new tax law include the chance to reinvest gains incurred from other sales into O-Zone investments and the deferral of any tax that would have been paid for up to seven years. For example, if a business is sold in early 2019 and a taxable gain of $250,000 is recorded, the $250,000 gain can be reinvested in an O-Zone qualified investment fund thereby deferring the taxes due on this $250,000 until a later date. So, there is immediate income tax savings and potential future additional tax savings or elimination of taxable gain, depending on how long the O-Zone investment is held. To provide further guidance, the IRS issued Proposed Regulations in October 2018 as well as April 2019.
Who should consider O-Zone investments? Anyone who has already incurred a taxable gain from sale of any type of investment (no more than 180 days prior to making a qualified Opportunity Zone investment) or who anticipates having a taxable gain in the next 180 days could be a good candidate. Taxpayers can benefit by reinvesting a portion of or the entire gain incurred into a qualified O-Zone fund within the 180-day time requirements. The gain can be from marketable securities, real estate, private investments, sale of a closely held business, gains received through partnership investments, etc. Only the portion of the gain that is reinvested would be eligible for future tax deferral, depending on the holding period of the qualified O-Zone fund investment.
What are the potential rewards? Current year income tax is deferred for any qualified gain invested in an O-Zone fund. For example, if taxes of 20% on $500,000 of gain ($100,000 of income taxes otherwise due) are expected, the taxpayer/investor could choose to invest this $500,000 (or any portion of this gain) in a qualified O-Zone fund. As such, the $100,000 of capital gains taxes would be deferred to a later date and the $500,000 invested would escape taxation if the O-Zone investment is held for a minimum of 10 years. Thus, the tax deferral is immediate as well as the potential savings in the future if the O-Zone requirements are met. Another benefit of the new tax law is the broad range of qualifying O-Zone investment types that qualify (e.g. real estate, equity, loans or other types of legal structures). More IRS guidance is expected to further clarify these criteria.
What are the risks? General investment risk is inherent in any O-Zone fund. While the tax benefits are nice to have, if the O-Zone fund is not successful, any deferral or elimination of taxes would be offset by an unsuccessful investment. It is important to evaluate the investment fund without the tax incentive program benefits being included. If the diligence suggests an investment, the tax savings should be viewed as an added incentive. In addition to general investment risk, there is the risk of a tax law change in the next 10 years that could make this program less beneficial for all taxpayers or select taxpayers above a certain income threshold. Thus, there is the possibility of law revisions which could potentially remove some of the benefits. This needs to be considered before investing.
How do you get more information? Individual circumstances are important to consider when determining whether an Opportunity Zone Investment is appropriate. RGT Wealth Advisors is actively researching the new O-Zone rules and regulations and can provide more analysis and assistance in determining whether these investment funds may be appropriate for an investor. So far, RGT has seen qualifying O-Zone investment funds in NY, CA, TN and AZ. Please contact us for additional discussion on Opportunity Zone investing.
“The investor who says, ‘This time is different,’ when in fact it’s virtually a repeat of an earlier situation, has uttered among the four most costly words in the annals of investing.”
Sir John Templeton, Investment Success, 1933.
Sometimes investment market trends are so strong, and extend over so many years, that even time-tested approaches, such as disciplined, diversified asset allocation strategies, can seem “out of touch”. Oftentimes… Click here to view full article.
“I claim not to have controlled events, but confess plainly that events have controlled me.” Abraham Lincoln in a letter to Albert Hodges, April 4, 1864.
What a difference three months makes. As 2019 began investors were coming to grips with the worst quarterly performance in U.S. equity markets since the third quarter of 2011. Despite the dramatic fourth quarter contraction in equity markets, Fed Chairman Jerome Powell initially indicated that the Fed’s unwinding of its balance sheet would continue on “automatic pilot.” Based on the Chairman Powell’s statement the bond market continued to price in two more rate hikes in 2019.
We noted in our Fourth Quarter 2018 Commentary, however, in contrast to the pessimism dominating market sentiment there were still some fundamentally encouraging factors investors needed to keep in mind, chief among them an economic environment featuring low inflation and low unemployment, and equity markets trading at much more attractive valuations. We also noted in the closing paragraph that investors needed to continue to focus on their long-term investment plan and the “investment plan should include contingencies for changing market conditions.”
It didn’t take very long at all for market conditions to change. Stocks and other risky assets rebounded dramatically in the first quarter. U.S. markets again led the way. U.S. large cap stocks (the S&P 500) and small cap stocks (Russell 2000) were up 13.65% and 14.58% respectively. Broad foreign market indices just missed being up double digits in the first quarter, with the MSCI-EAFE Index posting a return of 9.98% and the MSCI Emerging Markets Index up 9.92%. As has been the case for much of the last decade, growth stocks outperformed value stocks in the first quarter, and the best performing sector in the quarter was Technology, up 19.9%.
While equity markets were rallying, so were bond markets, particularly intermediate- and long-term bonds. The Bloomberg Barclays U.S. Aggregate Bond Index returned 2.94% in the quarter. This bond market rally began in late 2018 when the benchmark 10-Year U.S. Treasury peaked at a yield of 3.24% on November 8. By the end of the first quarter the 10-Year Treasury fell all the way to 2.41%, below the yield of both the 2-Month and the 6-Month Treasury Bills, which both ended the quarter yielding 2.44%. This inversion of the yield curve has added to growing concerns of a slowdown in economic growth. Other indicators seem to add to the growing chorus fears of slowing economic growth, which include fears over the impact of a hard Brexit (the U.K. exit from the European Union), concerns over trade wars, and slowing growth in China. With all of that as a background, in the Fed’s March 20th post-meeting statement, Fed Chairman Jerome Powell said that the Fed was now in a “pause period,” and most observers are pricing in no rate cuts throughout the rest of 2019.
So, in short three months, much has changed. Outside events, or “exogenous shocks” in the language of professional economists, are something for which we should always be prepared. Indeed, as our 16th President noted, we are rarely, if ever, able to control outside events and most often find ourselves controlled by these same events. The key tools that investors have in dealing with unexpected events include a well-thought-out long-term investment plan, a disciplined approach to executing the plan, the fortitude to stick to the plan, and the flexibility to take advantage of opportunities as they arise.
“I have two kinds of problems: the urgent and the important. The urgent are not important, and the important are never urgent.” Dwight D. Eisenhower in a 1954 speech to the World Council of Churches, quoting Dr. J. Roscoe Miller, the President of Northwestern University.
December’s market swoon came as a shock for many investors. After finishing the previous nine years with a positive return, December’s market selloff resulted in the first negative annual total return for the S&P 500 since 2008. The fourth quarter of 2018 also marked the fourth time in the last decade that the S&P 500 declined more than 10% over the course of a quarter. The other three times occurred in Q1 2009 (-10.9%), Q2 2010 (-11.4%), and Q3 2011 (-13.8%). There were numerous factors that seemed to contribute to investors’ fear. Among them were increasing concerns about a slowing global economy, the ongoing trade war between the U.S. and China, the Federal Reserve disappointing markets by raising rates 25 basis points in December and signaling an additional two rate hikes in 2019, uncertainty surrounding the impact of falling oil prices, and fears that corporate earnings may have peaked. Adding “agita” to the markets were comments by current Chair of the Federal Reserve Jerome Powell that the Fed’s ongoing unwinding of its balance sheet would continue on “automatic pilot.” Throw in selling pressure from investors engaged in year-end tax-loss selling and a lack of buyers over the holidays and you have the perfect recipe for a significant market correction. By Christmas Eve, the S&P 500 was less than one-half percentage point from entering a bear market (traditionally defined as a drop of 20% or more). However, equities rallied back following a Christmas break to narrowly avert an official bear market. U.S. small-cap stocks fared the worst of the major equity asset classes, losing 20.2% during the fourth quarter and bringing their year-to-date losses to 11.0%. Losses were wide spread across all equity asset classes and market sectors with virtually all equity asset classes finishing both the quarter and the year in the red.
As investors fled volatility in equity markets, many sought to allocate their capital to the relative safety of bonds. This flight to safety helped push interest rates lower in December, driving the benchmark 10-Year Treasury down to 2.69%, 55 basis points below its peak of 3.24% on November 8, and only 29 basis points above where it ended 2017. Despite interest rates mostly rising throughout the year, the December rate plunge moved broad fixed income indices back to the breakeven point or slightly into positive territory for the year. The Bloomberg Barclays U.S. Aggregate Bond Index, the broad benchmark used by many fixed income investors, finished the year with a return of 0.01%, which would be about as low as you can go and still claim a positive return. Shorter/intermediate-term municipal bonds, measured by the Bloomberg Barclays Municipal Bond 5-Year Index, finished the year up 1.7% after a strong fourth quarter rally.
Despite the pervasive pessimism that seemed to overcome markets in the fourth quarter, there are more than a few bright spots to consider as we look forward to a new year. The U.S. economy grew at an annualized rate of 3.4% in the third quarter of 2018, and growth in China is expected to be in the neighborhood of 6% in 2018. Inflation continues to be benign, with the latest report showing the CPI (Consumer Price Index) rising 2.2% year-over-year through the end of November. The unemployment rate is also low, coming in at 3.9% as of the latest report from the Bureau of Labor Statistics on January 4. Low levels of inflation combined with a strong and apparently stable labor market should continue to provide a counter to some of the worst market fears. And it seems fair to posit that investors are pricing in some fairly negative outcomes related to tariffs, trade wars, and other geopolitical concerns. Given these positive underlying economic indicators, any upward surprise in the areas with which the market has expressed so much concern could significantly improve investor psychology.
As we move into a new year, investors should continue to focus on what is important, their long-term investment plan. The investment plan should include contingencies for changing market conditions, such as portfolio rebalancing, tax-loss selling, and reassessing the asset allocation of the plan as conditions change. But we should all beware of devoting too much time to the tyranny of the urgent, never letting it distract us from that which is truly important.
What just happened?
Since 1990 the S&P 500 has declined more than 10% in a calendar month on five occasions:
- December 2018 -10.1%
- February 2009 -10.6%
- October 2008 -16.8%
- September 2002 -10.9%
- August 1998 -16.8%
U.S. and many foreign stock markets declined over 14% in the 4th quarter – the most in a quarter since the financial crisis of 2008. Because of recent declines, valuations of equity indices are nearing their long-term historic averages. Some sectors of the U.S. stock market, such as technology and financial stocks, traded 25-30% lower at year-end than they did earlier in 2018.
Interest rates increased for most of the quarter. However, over the last few weeks of the year intermediate and long-term interest rates declined as concern mounted over the prospect of slowing U.S. and worldwide economic growth. Despite the volatility surrounding the level of interest rates in 2018, high quality fixed income securities and other capital preservation strategies provided a positive return during the fourth quarter. The 10-Year Treasury yield peaked at 3.2% on November 8th before declining to 2.7% on December 31st. On the other hand, short-term rates continued to rise, due to the Federal Reserve hiking rates another 25 basis points in mid-December. This action reinforces the reality that while the Federal Reserve exerts significant influence on short-term interest rates, it is the market that sets longer term rates.
Markets appear to be going through a transition from an extended period of zero interest rates, low inflation and readily available credit to an environment of higher interest rates and more difficult credit conditions. In addition, there is a growing concern that Federal Reserve policies (raising short-term interest rates and allowing U.S. treasury securities/agencies to mature, thus reversing previous quantitative easing) over the coming year may add to the current volatility and potentially hinder 2019 – 2020 economic growth. While short-term interest rates have risen, and credit conditions are tightening, inflation continues to be benign, with the consumer price index rising at an annual rate of 2.2% as of the end of November. Low levels of inflation, along with low and stable unemployment, registering 3.9% as of January 4th, do not currently support the fears of a weakening economy, nor does the strong December jobs report of over 300,000 new positions created during the month.
Geopolitical tensions and uncertainty continue to be a driver of market volatility. Midterm elections changed the political party in control of the U.S. House of Representatives, increasing policy uncertainty going into 2019. Across the Atlantic, no viable path to ease Great Britain’s exit from the European Union, known as BREXIT, exists despite a deadline in less than three months. Additionally, tariffs and harsh trade rhetoric, specifically between the U.S. and China, escalated late into the end of the year, and are still unresolved. During what is typically a holiday-induced calm, these uncertainties played out in the markets, with significant year-end tax loss selling further pressuring equity prices.
How does the environment of 4th quarter 2018 compare to the environment of previously volatile periods?
The current level of stock market volatility, while difficult to stomach, is not that unusual. The extremely low levels of volatility seen in 2017 and other recent years are more the exception than the norm. The last time the stock market experienced this level of decline in such a short period of time occurred during the financial crisis of 2008 and, prior to that, in 2000 – 2002 following the bursting of the technology bubble market speculation.
While it may be tempting to draw parallels between the recent market sell-off and other prior sharp market declines, there are some significant differences in the circumstances surrounding each of these events:
- In 1999, the technology and internet bubble led to widespread overvaluation of companies with little, or even zero, revenue, much less profits. The entire sector was overvalued and driving the performance of the broader index. Today, the group of stocks driving the market are companies with substantial revenues, significant cash flows, healthy earnings and dominant market shares. While their valuations may be stretched, they are very different from the numerous dot.com companies and failed internet stocks that precipitated the bursting of the technology bubble.
- In 2007-2009, the financial system was extremely fragile which does not appear to be the case today. Banks and other large financial institutions are much better capitalized and the issues that led to the financial crisis do not appear to be as much of a current problem. Most analysts don’t believe a similar crisis is likely now because the financial and banking system appear to be on much firmer footing.
There are a few areas in today’s environment that are worth noting, despite the fact that some conditions that preceded previous bear markets, as mentioned above, do not appear as concerning today:
- High levels of debt on corporate balance sheets, particularly debt used for share buybacks as opposed to debt borrowed for investment and growth, may be a cause for concern in the event of a significant economic slowdown.
- Private market and asset valuations are now stretched as capital has poured into venture capital, real estate, and leveraged buy outs. In addition to elevated valuations, many of these companies/investments also carry significant amounts of debt.
- Debt levels on government balance sheets are higher than ever before. In a rising interest rate environment, this can lead to significant debt servicing costs, hampering government spending and leading to greater geopolitical uncertainty. This problem is not unique to the U.S. and has the potential to be a widespread problem.
Has the recent market volatility created opportunities for long-term investors?
In prior time periods, volatility has often provided opportunity for investors. After December’s selloff equities are trading closer to more normal historical market valuations. Some sectors, such as energy, technology, financials, and consumer staples, are becoming relatively more attractive. For investors adding to their portfolios, the entry point during this period seems to be more attractive from a valuation perspective than it has been in several years. While not all equity sectors are trading at attractive levels, some areas of interest are developing.
Investors not currently adding to or systematically withdrawing from their portfolio can rebalance and effectively take advantage of volatility while maintaining their asset allocation. And as stated, tax loss selling is an important strategy for investors in volatile markets and may contribute to the overall long-term after-tax portfolio return.
A lingering concern in the market revolves around predicting the next recession; however, US economic growth is currently running over 3% with other large economic powers such as China experiencing 6%+ annual growth rates. Given inflation levels are stable in the 2-3% annual range, the need for further interest rate hikes is diminishing.
Unemployment in the U.S. remains under 4%, a level which encourages consumer spending and should support economic growth further into 2019. Finally, U.S. median and average real incomes continue to rise at annual rates above 3%, which is well above historical averages dating back to the late 1960s.
What strategies does RGT recommend given the current environment and how are client portfolios positioned if a significant downturn occurs?
One of the guiding principles of RGT’s approach to portfolio management is that we are long-term and goal-oriented advisors. We are focused on helping our clients achieve their long-term financial goals, not simply on beating a benchmark or unmanaged index. Thus, a cornerstone of the investment process is to develop an investment policy statement and asset allocation for each client that we believe will maximize the probability of the client reaching their financial goals, while doing so in a manner that is aligned with the client’s personal tolerance for risk and ability to make sound decisions during periods of heightened uncertainty. The strategies mentioned below will be implemented in different ways throughout RGT’s client portfolios, depending upon each client’s personal circumstances. And as a result, all client portfolios will not necessarily perform in an identical fashion, particularly during periods of market volatility.
Another guiding principal that RGT utilizes in developing and managing portfolios is related to this long-term strategic approach. To achieve long-term success, we believe investors are best served by developing a broadly diversified asset allocation adjusted to best fit their particular risk tolerance. Well diversified portfolios typically maintain exposures across geographies, industry sectors, market capitalization, and investment styles. Maintaining these exposures over time through disciplined monitoring and rebalancing of the portfolio reduces the risk of portfolios becoming over allocated to any particular sector or investment style. During periods where particular investment styles or market sectors become richly valued relative to history or to other sectors or styles, maintaining this discipline helps limit exposure to these more expensive parts of the market.
Several of the strategies mentioned below are directly taken from the investment principals and long-term approach described in this section. RGT believes it is important to understand that periods of volatility, like the one experienced by investors in December 2018, are part of the normal course of events which we expect portfolios to encounter and are part of the long-term planning and strategy embodied in each client’s investment plan. Should there be any specific risks or opportunities that develop along the way, we still have the flexibility to adjust client portfolios and adapt if we believe other strategies are prudent.
The combined experience of RGT partners and employees includes over 60 previous equity cycles (“bull” & “bear” markets) dating back to the 1970’s and thus, we have experience managing through several previous volatile periods.
Prior to the most recent market decline – RGT purposefully de-emphasized and limited allocations to areas of investment which experience excessive speculation and higher risk. Thus, investment strategies which are perceived to be more “at risk” were naturally limited in portfolios.
During the current market decline – RGT continues to make progress in its due diligence efforts with managers focused on some of the most affected areas of global markets. We are starting to see some outside RGT equity managers find good buying opportunities in the latest period of volatility. Also, RGT portfolios are designed to be under-allocated to areas where valuations are high. Typically, as volatility increases, outside RGT equity managers find it challenging to outperform market indices due to “indiscriminate” selling across the board. Once markets correct for an extended period, RGT believes its managers will seek to take advantage of opportunities that have arisen during this difficult market.
If markets continue to be volatile – RGT consistently reviews areas for opportunistic investment. For example, if interest rates continue to rise, clients are able to earn more income from capital preservation/fixed income strategies given higher expected forward rates of return. Similarly, if stock markets decline further from current levels, more rebalancing opportunities will present themselves. Additionally, for the first time in several years, investors will be presented with the opportunity to consider shifting their overall portfolio allocation to a more aggressive stance at much lower valuations.
In the last 10 years there have been 4 other quarters when equities (both U.S. as measured by the S&P 500 and global equities as measured by the MSCI ACWI index) experienced similar declines as this past quarter – the 1st quarter of 2009, the 2nd quarter of 2010, the 3rd quarter of 2011, and the 3rd quarter of 2015. The recovery in equities after each of these declines was positive in the immediate twelve months following. While there are no assurances that this will occur again, the historical record points out the importance of having the discipline to remain committed to your long-term strategic investment plan.
Thank you for the opportunity to provide this information and analysis. Please contact RGT with additional questions.