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October 5, 2018


After 9 years of a bull market, media reports of the U.S. stock market’s continuing climb can lead investors to abandon one of the most basic risk mitigating strategies, diversification. It reminds us of the late 1990s, when many investors became convinced that U.S. stocks were not risky. The media fed into that narrative as well. The S&P 500 followed the 1990s with an annualized return of -1% over the next 10 years (1/1/2000-12/31/2009). In addition, this was a decade where the U.S. market plunged on two separate occasions, -49.1% from 3/2000 to 10/2002 and -56.4% from 10/2007 to 3/2009. These were the largest declines since the Great Depression. 

Key highlights:

Ø Stock and bond returns have benefited substantially from 35 years of declining interest rates. Rates have little room to fall further and, as a result, we expect significantly lower returns over the next decade. 

 

Ø Given their high valuations, U.S. stocks should significantly underperform non-U.S. stocks over the next 10 to 15 years.  Also, at high valuations, stocks do not tend to just drop, they tend to drop a lot. This is not a market timing call. No one can predict near-term performance. 

 

Ø Value stocks are stocks that trade at a large discount to fair value (which is derived from future cash flows as well as other fundamental metrics). Growth has significantly outperformed value in recent years. These trends tend to reverse over time.

 

Ø Investors have a lesser chance of meeting their investments goals by limiting their investment allocation to traditional assets. However, alternative assets (Alts), which are those outside of traditional stocks and bonds, can benefit from a rising rate environment and have a strong chance of outperforming. Also, these assets are unlikely to perform in tandem (i.e. low correlation) with traditional assets, which makes them good diversifiers.

Stock and bond returns have benefited significantly from the nearly 4 decades of declining global interest rates. Since the financial crisis, a prolonged period of extraordinary low rates has lifted the price of financial assets considerably. Rates do not just affect the financing costs of corporate and government debt, housing, and commercial real estate, it also becomes the hurdle rate for risk-seeking investors. In other words, in order for an investor to take risk, he or she must get paid a premium over government bonds, whose returns are determined by prevailing interest rates in order to take risk. Given that rates are low, with little room to decline, returns over the next 10 years will be significantly lower in traditional stock/bond assets. One never knows the path the market will take to arrive at these lower returns. However, historically, the markets with higher valuations precede larger market drops than those with lower valuations. We are not making a prediction of a market drop, but sharing what has historically occurred. We believe that investors face a significant risk of failing to meet their goals by limiting their investments to traditional assets. 

 

“The higher the rate, the greater the downward pull. That’s because the rates of return that investors need from any kind of investment are directly tied to the risk-free rate that they can earn from government securities.”

Warren Buffett 1999

 

Global Rates: U.S., U.K., Germany, Canada, and Japan from 1982-2016

Source: OECD.org

The higher the stock market’s valuation, the higher the average decline.

Source: Star Capital


The incremental return of a 60/40 U.S. stock/bond portfolio over T-bills (money market funds) for different interest rate regimes.
 

The U.S. has outperformed the rest of the world substantially since the credit crisis in 2008. Also, growth stocks (especially bio-techs and technology stocks) have outperformed value stocks.  Therefore, a combination of international and value has underperformed substantially.  Our stock mix consists of global equities with an emphasis on value. Despite the recent outperformance by growth stocks, history is on the side of value, but cycles are to be expected. Also, international stocks and U.S stocks change leadership over time.

The next two charts show the performance of value versus growth and U.S. versus international stocks. 

Source: Star Capital
 

As a result of the headwinds facing traditional asset classes, high valuations and rising interest rates, we believe that Alternative assets (Alts) should have a sizeable allocation across client portfolios. These assets have muted sensitivity to global growth or the direction and magnitude of change in long-term interest rates. Our view is simple, if traditional assets perform much better than we expect, investors will be able to reach their goals in spite of an allocation to alts. Otherwise, alts will represent a vital insurance policy against the subpar returns we expect from stocks and bonds. Note: The Stone Ridge Reinsurance Risk Premium Fund, Stone Ridge All Asset Variance Risk Premium Fund and the Stone Ridge Alternative Lending funds represent Alt exposure in client portfolios.

 



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