The past quarter and first half of the year were characterized by historically low stock market volatility, the strong performance of both stocks and bonds, and the reversal of several market trends. In this quarter’s commentary, we attempt to explain these phenomena, some of which may seem contradictory.
The S&P 500’s actual realized volatility has fallen to among its lowest levels in the past fifty years, according to a recent Goldman Sachs report, while the S&P 500 Index continued to hit all-time highs this year.
The U.S. stock market’s calm ascendance seems to fly in the face of ongoing political uncertainty and geopolitical tumult, including tensions with North Korea, the ongoing crisis in Syria, terrorist attacks in Europe, cyberattacks in the United States, and widening investigations of President Trump as well as members of his administration and election campaign staff. Each day seems to bring a new headline concerning something else to worry about.
Why are the financial markets so calm and why do stocks continue to go up? Do markets reflect a dangerous complacency in the face of so many risks and unknowns? First, yes, U.S. stock investors probably are too complacent now. We see this reflected not just in the extremely low market volatility, but also in high stock market valuations (e.g., price-to-earnings multiples), which implicitly discount a very rosy economic scenario. Based on our analysis of valuations and longer-term earnings fundamentals—even putting aside any near-term political/geopolitical risks—U.S. stocks present unattractive expected returns over our five-year tactical investment horizon, evaluated across the macroeconomic scenarios we think are most likely to play out. In that sense, we think the high level of complacency leaves stocks particularly vulnerable to a negative surprise. Valuation risk is high and offers no margin of safety in the event the optimistic scenario currently baked into valuations doesn’t play out.
That said, maintaining a degree of equanimity is a valuable attribute of successful long-term investors. Global risks always exist and unexpected events inevitably happen, causing markets to fall no matter their valuation. The world and financial markets have faced numerous negative shocks over the decades, but the broad economic impacts have ultimately proved transitory. Over the long term, financial assets are priced and valued based on their underlying economic fundamentals—yields, earnings, growth—not on transitory macro events or who occupies the White House. Therefore, we believe it is beneficial for investors not to react to every domestic political development or geopolitical event with the urge to sell their stocks nor get overly excited and jump into the market on some piece of news they view positively.
We think it is prudent to construct portfolios that are prepared for, and have resilience to, a range of potential outcomes. As a result, in our balanced portfolios, we maintain some exposure to core bonds, despite very low current yields, because of their risk-mitigating properties in the event of a recession or other shock. But given core bonds’ paltry yields and unattractive longer-term (five-year) return prospects, we maintain meaningful exposure to other more flexible and opportunistic fixed-income funds as well as to select alternative strategies. These investments should also provide some protection against rising interest rates and inflation.
On the equity side of the portfolio, we see unattractive valuations and low expected returns for the U.S. market over the next five years. Therefore, we are underweight, but we don’t see any particular near-term trigger for a sharp market decline. Outside of the United States, we see strong potential for both improving earnings growth and higher valuations—leading to relatively attractive longer-term expected returns. We have a moderate overweight to both European and emerging-market stocks.
A final observation: several of the market trends and consensus market views we highlighted in our year-end 2016 commentary have reversed (again) this year. For example,
- European stocks are beating U.S. stocks by a wide margin;
- the U.S. dollar is down (about 6%), Treasury bond prices are up/yields are down, and the yield curve has flattened;
- oil prices have plunged 20% from their recent highs dragging energy stocks with them;
- growth stock indexes are crushing value indexes;
- larger-caps are beating smaller caps; and
- Emerging-market stocks are once again outperforming U.S. stocks after a sharp post-election plunge.
Portfolio Positioning and Outlook
From a big picture perspective, we think the odds favor a continuation of the ongoing mild global economic recovery we’ve witnessed so far this year. That should be broadly supportive of riskier assets, such as stocks and corporate credit. In particular, we believe there is still more room to run regarding the outperformance of foreign stocks given their superior valuations and earnings growth potential versus the U.S market. Even with their strong performance so far this year, our longer-term return expectations still materially favor Europe and emerging markets compared to the United States.
Our positioning is driven by our ongoing assessment of nearer-term (12-month) downside risks, balanced against our longer-term (five-year) expected returns analysis for various asset classes and strategies, evaluated across a range of scenarios and assumptions. Given the lack of market volatility, our portfolio positioning has not changed this year.
Max W. Smith, CFP®, CIMA® | Kent G. Forsey, CFP®