Daring to Diversify

The S&P 500 (IVV) has made a remarkable recovery in 2023, bouncing back from a challenging year in 2022 when it suffered an -18.16% decline.  As of July 2023, the index has surged by an impressive +20.65%, recouping most of its losses from the previous year.  However, it is essential to recognize that a balanced investment portfolio relies on diversification to achieve a smoother journey toward financial goals. While the S&P 500 comprises 500 stocks, its performance this year has been predominantly influenced by the outstanding gains from a group of high-performing stocks known as the "Magnificent Seven" (Apple, Microsoft, Alphabet, Amazon, Nvidia, Tesla and Meta).

Diversification is a strategy that aims to reduce risk and improve the overall risk/return profile of an investment portfolio. By including assets with lower correlations to each other, the impact of market fluctuations on the portfolio can be mitigated. While the S&P 500 is a prominent option for investing in equities, there are numerous other major equity asset classes and strategies worldwide that offer the potential for good risk/return profiles and diversification.

The performance of various asset classes in July 2023 exemplifies the value of diversification. Per the table below, in contrast to the core S&P 500 index several other diversifying equity asset classes, including small-cap (SCHA), mid-cap (SCHM), and emerging markets (SCHE), outperformed, delivering higher returns. This demonstrates that diversification can yield positive results even when the primary market index lags.

While some diversifying equity asset classes performed well in July, they still trail the S&P 500 on a year-to-date basis by substantial margins. This underscores the importance of long-term perspective and the understanding that different asset classes may perform differently over extended periods.

Also, and perhaps even more interesting, is the benefit of diversification in the fixed income space!  Per the bottom half of that table, please note that ALL diversifying fixed income asset classes have OUTPERFORMED core bonds in July and on a year-to-date basis!  The Bloomberg Aggregate Bond index (SCHZ) was down -0.15% in July and up +2.26% YTD lagging the other major fixed income areas.  This further demonstrates that diversification can be beneficial, even in fixed income investments.

While the S&P 500 has shown impressive recovery in 2023, it should not be the sole focus of investment. Including other major equity asset classes and strategies globally, as well as diversifying within the fixed income space, can provide a more stable and potentially rewarding risk/return profile. Investors should carefully consider their financial goals and risk tolerance when constructing a diversified portfolio to achieve long-term success.

Bond Volatility Chronicles

In June of 2022 I wrote a blog post titled “Smooth or Bumpy?” that dealt with the gyrations in the bond markets.  I summarized that some exposure to the “short” part of the yield curve was prudent given the volatility in rates that we were seeing during the inflation-fighting Fed tightening cycle that started in March of 2022.  Please see the chart below showing the return volatility of longer bonds (LQD, the blue line) compared to shorter bonds (SLQD, the green line) updated to current.

Consequently, around that time all D&A accounts received an increased allocation to shorter bonds to help shorten bond duration and smooth their portfolio return profiles.  Here we are now, 18 months later, and we have started to see some economic and capital market impacts.

The intent of the Fed tightening was to slow economic growth (i.e., reduce aggregate demand) to help curb inflationary pressures without causing a recession – a tall order!  The reported inflation results for June 2023 show material impacts (see chart below).  The monthly Consumer Price index (CPI) for June 2023 was a small +0.18% increase from May and a 12-month increase of +3.09% - certainly good progress, though still above the +2% Fed inflation target.  There has been a dramatic downtrend in the 12-month CPI (the orange line) from when it peaked in June of 2022. 

No one knows for sure, but signs of a “soft landing” are becoming clearer.  With the decline in inflation, we see other supporting indicators showing positive effects including normalization of U.S. industrial production, continued low unemployment and declining inflation expectations.  The higher interest rates we now have may still cause problems, especially in the real estate market, but if we get an easing in rates that should help.

This could translate to more normalcy in the bond market, thus reducing the need for excess diversification to the short end of the yield curve.  D&A will maintain some exposure to the short end of the yield curve for diversification purposes, but we now favor a longer duration target and more focused return to long term strategic targets.

2023 Q2 - Resilient Doldrums

As we leave 2023 Q2, the economic backdrop shows some trouble spots that continue to strain the capital markets.  Inflation is lessening, but still too high and a very low unemployment rate still indicates a good economy that has yet to cool to the Fed’s liking.  Add to those points more potential Fed tightening, the global backdrop and the continuing Russia/Ukraine war and you have a recipe for more market doldrums.

 Despite these points, it is fascinating that the broad capital markets – but certainly NOT all capital markets - have shown so much resilience.  In 2023 Q2, large cap blend stocks represented by the S&P 500 (IVV) (grossly influenced by its 7 largest mega-cap tech stocks) with a 2023 Q2 return of 8.76% once again outperformed the rest of the equity markets (mid- and small-cap equities) by 400 basis points (see table below)!  Yet another recent period where diversification didn’t work; almost every other asset class was a detractor to return!

 But, it wasn’t just small- and mid-cap equities that underperformed core equities.  Diversifying positions in REITs (SCHH), international developed (SCHF) and emerging market equities (SCHE) and high-quality dividend paying stocks (DVY) all have lagged significantly.  It sounds like a broken record, for those who remember what a broken record sounds like, since we have seen this scene repeatedly over the recent past.  We talk a lot about “reversion to the mean” where markets never persistently outperform other sectors because there is a tendency for markets to return to their long-term relationships – we just have not seen it yet!

 My blog post from May 17, 2023 titled Don’t just stand there, Do NOTHING! summarized our philosophy this way:

At D&A we are philosophically inclined to move slowly away from long term strategic positioning unless there is a firm reason to do so.  For example, shortening fixed income duration in 2022 was the correct re-positioning that benefited client portfolios and will be reversed when market conditions indicate.  Alternatively, we are not ready to move away from diversifying positions in U.S. small- and mid-cap equities, emerging market equities, or other “factor” investments that have lagged and we will continue to hold international developed markets that have recovered a bit YTD in 2023. 

Beyond Benchmarks

Clients of Dattilio & Ash Capital Management (D&A) rely on our expertise to manage their investment portfolios and help them achieve their unique investment goals. These goals can vary from preparing for retirement decades down the line to generating current income to support their desired lifestyles. To provide clients with insights into their portfolio's performance, D&A utilizes a selection of risk-targeted iShares exchange-traded funds (ETFs) as benchmarks.

D&A employs Conservative (AOK), Moderately Conservative (AOM), Growth (AOR), and Aggressive (AOA) iShares ETFs as benchmarks for many client portfolios. These ETFs, managed by iShares, reflect base case investment portfolios comprising stocks and bonds. However, it's important to note that the risk profiles defined by these iShares ETFs may not perfectly align with individual client situations.

For instance, the Growth ETF (AOR) generally targets a 60% equity and 40% bond asset allocation, with a substantial allocation to international equities and some international bonds. While this ETF provides a "diversified" portfolio, it fails to capture the nuances and tailored approach that individual clients may require.

One notable limitation is that its U.S. equity allocation only includes a proxy for the S&P 500, neglecting exposure to small- and mid-cap stocks, which can potentially outperform. Additionally, it does not explicitly customize the equity allocation to overweight equities with lower risk profiles for less aggressive investors, nor does it account for thematic equity plays, such as investments in emerging technologies. In the bond space, the sole allocation is to core bonds, overlooking the benefits of a diversified fixed income approach that includes credit and duration risk management.

Therefore, when a client portfolio underperforms its iShares "benchmark," it is important to recognize that the portfolio differs from the benchmark for valid reasons. As readers of this blog are aware, the S&P 500 has outperformed other major asset classes in recent years, albeit with high volatility. However, it is rare for professional investment managers to allocate long-term investment strategies solely to the S&P 500. Instead, they diversify risk by including other equity markets, bonds, and various asset classes.

At D&A, we take a customized approach to each client's portfolio, considering their specific risk tolerance, investment goals, and individual circumstances. Our aim is to optimize the portfolio's performance based on a comprehensive understanding of the client's needs rather than solely relying on generic benchmarks. By tailoring investments to our clients' unique situations and preferences, we strive to achieve long-term success while managing risk effectively.

"You're Fired!" - An NVDA Essay

Most people remember this famous phrase uttered by Donald Trump on Celebrity Apprentice.  If you were a contestant on that TV show, it indicated that you were exiled disgracefully due to a failure in results.  Similarly, investment decisions can either work out fine or, alternatively, either succeed or fail stupendously; in the latter case often leading to the investment manager getting “fired”!

Case in point is the phenomenal stock performance of Nvidia (NVDA)!  This year, NVDA stock has more than “doubled” from a price of $146.12 on December 30, 2022 to $305.38 on May 24, 2023; a +109% increase, not including the 25% intra-day pop on May 25.

Looking through the rearview mirror, it is easy to have “predicted” this performance; the need for advanced computing technology to power artificial intelligence (AI) fits nicely into the NVDA product mix plus the technology is very scalable – something that could lead to increased revenues AND profitability.

But, and there is always a “but”, most observers seem to have forgotten that NVDA stock was DOWN 50% in calendar 2022 and was not the stock “darling” then that it is today.  See the chart below for NVDA price performance starting from January 1, 2022, the blue line, versus the S&P 500, the black line, that it lagged during most of this time horizon!  Granted, this may have been before the impacts of the pending AI revolution was fully understood, but buying NVDA stock last year was a tough call to make in a difficult market.

Which leads me to the Celebrity Apprentice quote that titles this blog post.  D&A Capital Management has a philosophical belief in long term globally-diversified strategic investing tailored to the risk tolerance of its clients to help them achieve their goals.  D&A does not manage portfolios of individual stocks, but instead prefers to invest mainly in portfolios of low-cost passive exchange-traded fund (ETFs) of the major asset classes.  For example, D&A invests in the S&P 500 (IVV) for large cap U.S. stocks, FTSE Developed index (SCHF) for international developed stocks, and Bloomberg U.S. Aggregate Bonds for core bonds (SCHZ) to make up the core investments of many client portfolios.

The net result of this strategy is that D&A investors will hardly ever dramatically outperform (or underperform) the markets; a characteristic that should be highly regarded given the propensity of active managers to underperform their benchmarks over various time horizons (per well-known SPIVA studies).  Certainly, buying NVDA back on January 3, 2022 at $300.88 would have caused many investors to panic as they saw its value plummet to its 2022-low of $112.27 on October 14, 2022, a -63% decline.  In fact, there could have been a few investors who said, “You’re Fired”!  In fact, that weak NVDA performance WAS captured last year in client portfolios, but in a much-diluted state through its inclusion in the S&P 500; as well as its rally so far this year!

Investing is a risky business and needs to be managed prudently to help clients achieve their goals.  Though NVDA has “knocked it out of the park” this year and has helped the broad U.S. equity market perform well as a component of the S&P 500, it didn’t always look that way back in 2022.  D&A strives to gain steady portfolio performance aligned with market benchmarks to counterbalance the risks associated with individual stock investments.

Don't Just Stand There, Do Nothing!

From the most recent all-time high that the S&P 500 (IVV) achieved on January 3, 2022, the markets have struggled to maintain positive momentum.  As I have recounted in my previous blog posts, the tremendous out-sized performance in 2023 of the largest mega-cap tech stocks like Apple, Microsoft, Amazon, Alphabet, and Nvidia have led to large S&P 500 gains in 2023 (see table below), but over the entire time frame the performance of the S&P 500 and these mega cap market leaders is underwhelming.  High quality stocks (QUAL) based on fundamental methods over that time frame have performed a bit worse, whereas high quality stocks that pay high dividends (DVY) have performed a bit better.

Certainly, this has been a difficult time for the markets!  In hindsight, there were a few things that we could have seen and acted on to help ease us through this “rough patch” of weak market performance. For example, the Fed was absolutely clear that it was entering a “tightening” cycle to raise Fed Funds rates to help fight inflation. 

No guarantees, since the Fed does not control the whole yield curve, but reducing interest rate risk seemed like the right thing to do.  Fed tightening has increased short rates by a total of 5 percentage points from where they were prior to the tightening cycle that began in March 2022.  As can be seen by the chart below, shorter duration fixed income investments (the green, blue and gold lines) resulted in better performance than longer duration investments (black and red lines).

Shortest duration fixed income (such as NEAR, SCHO and SLQD) performed best since these investments turned over very quickly to capture the higher rates in the markets whereas longer duration investments (IEF and SCHZ) lagged.  D&A acted quickly in May of last year to increase allocations to the shorter durations resulting in a net positive benefit to portfolios. 

Equities, on the other hand, have been much more problematic! Aside from the partial recoveries of the mega-cap tech leaders, other equities are still struggling with weak returns.  A tactical re-position out of equities into cash could have been a solution, but no one can time the market!

Certainly, a quick look at some of the tactical asset allocators like Cambria, Adaptive Alpha, and Rational Advisors have shown mixed performance; some outperformance in 2022 but varied performance so far in 2023.  For example, the Adaptive Alpha Opportunities fund (AGOX) performed weakly versus the S&P 500 with a total return of -19.22% in 2022 (versus the S&P 500 of -18.16%), but is still lagging YTD in 2023 with a total return of +5.33% (versus the S&P 500 of +7.68%); a cumulative underperformance gap of 3.04%. Some tactical asset allocators have done better, but it impossible to know which ones will outperform ahead of time!

So, where do we go from here?  There is a twist on an old saying that goes, “Don’t just stand there, do Nothing!”  At D&A we are philosophically inclined to move slowly away from long term strategic positioning unless there is a firm reason to do so.  For example, shortening fixed income duration in 2022 was the correct re-positioning that benefited client portfolios and will be reversed when market conditions indicate.  Alternatively, we are not ready to move away from diversifying positions in U.S. small- and mid-cap equities, emerging market equities, or other “factor” investments that have lagged and we will continue to hold international developed markets that have recovered a bit YTD in 2023. 

The Diversification Dilemma

Consider this blog post as “Part 2” to last week’s post, “Tech Titans Take Over!”  All textbooks on portfolio management will trumpet the virtues of diversification.  The idea, of course, is that holding a combination of risky assets will actually result in lesser risk for the portfolio if the holdings have a low level of correlation.  In theory, the diversifying holdings will vary in return compared to the core holdings resulting in a portfolio with lower risk and better returns.  As I have written at length over the recent past, it has been quite a while since we have seen this in practice.

As you can see from the chart below, total returns for the major asset classes on a year-to-date basis have been quite disparate.  Core equities (IVV, 9.16%) have done very well so far this year, beating most other major equity asset categories by a wide margin.  Alternatively, core bonds (SCHZ, 3.89%) have lagged most other fixed income asset categories.  International developed market equities (SCHF, 11.02%) have so far been the big winner this year.

The most effective diversifiers of risk to equities are fixed income investments.  Per the table below, we can see that over the long term, core bonds (SCHZ) have had a correlation coefficient to core equities (IVV) of 0.36; a value considered very low that exhibits low correlation.  However, over the Short Term, that correlation coefficient has actually INCREASED to 0.85 indicating less effective diversification mostly due to the historic negative returns in fixed income returns during 2022 that mimicked equity returns. Moreover, other fixed income diversifiers like investment grade bonds (LQD) and high yield bonds (HYG) have shown a similar increase in correlation, thus reducing their diversification benefits, while short term investment grade bonds (SLQD) have maintained a modest level of correlation from 0.52 to 0.75.

The story for diversifiers within the equity markets is a bit more complicated.  Over the long term, other equity classes like U.S. small- and mid-cap and international developed markets had correlations of about 0.9 and have been modest diversifiers to core equities.  REITs and emerging market equities, however, were more effective diversifiers with long term correlations of about 0.7.

However, over the near term the correlations to core equities have mostly actually DECREASED due to the outperformance of large cap equities in the S&P 500 and the lagging performance of other equity classes.  This is a bad reason for correlations to decrease!

So, I do not believe it is now time to re-write the textbooks and throw diversification out the window, but what do we do?  At D&A we are strong believers in long term strategic investing across a broad range of major asset classes and will continue to seek solutions to diversify client portfolios.  For example, last year we added an allocation of short term investment grade bonds (SLQD) to all client portfolios; we will do more of this kind of rebalancing over the near term.

Tech Titans Take Over!

Diversification has been a bust, once again, so far this year.  All you have to do is look at the following chart below (from Jim Bianco Research) to see the proof!

 As shown, the seven large tech stocks (i.e., Facebook, Apple, Amazon, Netflix, Google, Microsoft and Nvidia) on a cap-weighted basis have accounted for ALL of the positive returns for the S&P 500 so far this year, with the 492 Other stocks actually netting out to a slightly negative return!  Another way of saying this is that the equal-weighted return of the S&P 500 actually has UNDERPERFORMED the cap-weighted return by about 600 basis points!  Moreover, the cap-weighted S&P 500 actually has been a bit less risky on a year-to-date basis.

 So, are we re-writing the book on diversification? Should we all just continue to invest simply in the top S&P 500 stocks and forget about other equity markets and bonds?  Not so fast!

 Traditional long-term strategic investing will always include a component of large cap U.S. equities as a core holding.  Over a longer time horizon we can always expect to see some things go in and out of favor.  For example, though the 2023 YTD experience shown above of the equal- vs. cap-weighted S&P 500 has been extremely weak, if we simply look back to the experience in calendar year 2022 we can see in the chart below that equal-weighted (RSP) actually OUTPERFORMED cap-weighted (IVV) by 660 basis points last year!

 So, please don’t be unduly influenced by the recency effect and think that today’s experience will persist and become the new normal.  No one can outguess the market and pick the winners all the time.  Though we are all happy that Amazon is up +31% this YTD, we should not forget that it was down -49% in 2022!

AI-nvestment Tips!

I asked ChatGPT to “Give me a 4-word funny title for a blog post on AI for Investments” for this blog post, so you have now been exposed to the power (as simple as this request is!) of AI!  I dropped the prefix, “Robots Handling Your Dough:” so there was a bit of human interface and editing!

Everyone seems to be talking about artificial intelligence (AI) these days, whether it is the ChatGPT app for generic queries, robotics, or any of the other customized AI apps for videos, pictures, or business applications.  These applications, though not perfected, are amazing and capturing the imaginations of all of us.  Using AI to help with stock selection to help “beat the market” is, likewise, out there and trying to make an impact.

Way back in 2017, an investment firm named EquBot started a new ETF that was a collaboration between themselves and the IBM Global Entrepreneur Program and IBM Watson to explore ways to integrate AI with investment solutions.  EquBot launched the AI Powered Equity ETF (AIEQ) on October 17, 2017 to analyze millions of news, social media, and financial statement data points to strive to beat the broad U.S. equity market.

At D&A, we favor broadly diversified asset allocation to help minimize portfolio risk.  The new AIEQ ETF seemed to fill a niche to possibly help diversify exposure to the broad U.S. equity market reflected by the S&P 500 (IVV).   We felt that the AI model driving AIEQ would be neutral to behavioral bias and naïve capital market weighting and could serve as a good diversifier.  Let’s see how it has done so far!

As seen from the chart below, through the end of 2021 the AIEQ ETF (the blue line) performed fairly well and even beat the S&P 500 (IVV, the green line) by a good margin (+7.00%!) in 2020.  However, since the beginning of 2022, AIEQ has lagged significantly and ended up lagging the S&P 500 since its inception by a 6.00% annual deficit.

One of the criticisms of AI is that it is somewhat of a “black box” meaning we are not really sure how it works and the answers that come out of it may not be explainable.  That is certainly the case here!  I can hypothesize that since the AI model is neutral to behavioral bias, then perhaps it has underperformed recently since it needs a robust “fear or greed” behavioral component to help anticipate the market.  Also, as we all know, the existence of unpredictable “external“ factors like the Russia/Ukraine war, a hawkish Fed, and domestic and global politics certainly impact the market in mysterious ways.  

The one truism relating to AI is that they tend to get better over time as the models have more situations from which to learn.  So, being patient is a virtue in this case and may be worth the wait.

2023 Q1 Relief

2022 certainly showed no mercy as global capital markets, both stocks and bonds, struggled to pull themselves out of negative territory.  The perfect trifecta of rising interest rates, high inflation and the Russia/Ukraine war persisted into 2023 Q1 putting a cap on any sustained positive momentum.  In fact, Fed tightening to fight inflation helped cause a minor banking crisis headlined by Silicon Valley Bank (SVB) in early March that seemed to ease as we closed out the quarter on a high note.

 Perhaps surprisingly, we did see some positive returns during Q1 out of some of the broad capital market indices like the S&P 500 (IVV) and international developed markets (SCHF).  But, those returns were certainly not broad-based and merely recovered with outsized Q1 returns some of the excess losses experienced during 2022 from the largest S&P component stocks like Apple, NVIDIA, Amazon, and Microsoft.  In fact, almost all of the gains in Q1 from the S&P 500 came from the 15 largest component stocks.

 As seen from the table below, the S&P 500 (IVV) index of large cap stocks, benefited mightily by the recovery in the large cap tech names highlighted above, generated a +7.44% total return during 2023 Q1.  But, other diversifying equity sectors like small cap (SCHA, +3.86%), mid cap (SCHM, +3.79%) and REITs (SCHH, +1.76%) lagged, mostly due to the drawdown that resulted from the mini banking crisis that was thought to impact the financing needs of companies in those sectors.  Even high-quality dividend-paying stocks (DVY, -1.95%) suffered since there was fear of a contagion into the high-quality banking/financial and recession-fearing energy sector.  

To celebrate my 200th blog post back in February, I re-posted a blog about risk.  In it, I said,

 “I have written a lot about the importance of long term strategic investing, diversification, and risk management.  I almost always close my blog posts with the caveat that market timing is impossible, except by luck, and it is always best to invest for the long term with a strategy that is consistent with your goals.”

One Man's Treasure

ESG (Environmental, Social and Governance) investing has been in the news a LOT lately!  A huge cynic would say ESG investing is just another money-making scheme made up by Wall Street to sell something “New & Improved” to an unsuspecting public.  A die-hard “tree-hugger” would say it is about time that we “vote with our dollars” on companies that “Do Good”.  Or, as reported in a recent article quoting Larry Fink, CEO of Blackrock, anything related to climate change or other ESG-issues is simply an investment risk that needs to be part of the investment analysis equation.   As is almost always the case, the real truth lies somewhere in the middle of this discussion.

ESG investing strives to limit investing in companies that do not follow a collection of current views on such topics as global warming, pollution, equal rights, board composition, and other things.  The idea is that if investors stay away from those companies, then their share price will fall and their corporate debt will be more expensive to issue and they will thus be forced to change their corporate behavior to a more ESG-friendly approach.

Most of the large investment firms manage mutual funds or ETFs that tilt their style to accommodate ESG considerations.  For example, Blackrock manages an ESG-Screened ETF (XVV) that filters out companies viewed as not ESG-friendly.  Out of the top 25 holdings, the major exclusions are the oil companies Exxon and Chevron due to climate change concerns.  See the chart below that shows the S&P 500 (IVV, the blue line on top) performance from September 30, 2020 (its inception date) compared to the S&P 500 ESG-Screened ETF (XVV).  They both tracked together fairly closely over time, but the cumulative total return of the S&P 500 (IVV) was +22.19% beating the +18.69% for the ESG-filtered (XVV).

The trouble with this analysis, however is that there is no  hard and fast rule on what qualifies as “ESG”. If you do a Google search on ESG investing, you will find a multitude of ESG “scores”; each claiming to be the definitive measure of ESG strength.  For example, Tesla, the electric car company, has an ESG rating of “Medium” from Morningstar, but was recently excluded from the S&P ESG index due to S&P’s proprietary measure of Tesla’s weakness on social and governance issues.  So, one man’s treasure is another man’s trash. 

At D&A, we agree with Larry Fink’s view that all investment risks need to be considered within the context of creating and managing an investment strategy.  D&A’s focus on a portfolio of high quality investments managed to an appropriate overall risk target, implicitly reflecting any ESG risks, is designed to help you achieve your goals.

Wash, Rinse, Repeat!

I wrote blog posts back in 2019, 2020, and 2021 with a different focus but the same theme:  we can talk all day about the state of the economy and the capital markets, but when asked what will the markets do, the answer invariably should be “Beats Me!”  Similarly, back in February of 2022, when all seemed lost with heightened inflation, rising interest rates, falling stock prices, and the escalation of the Russia/Ukraine war, I revisited an old insurance slogan proclaiming, “It’s Always Something!”  Certainly, now feels the same way with the Silicon Valley Bank (SVB) failure adding to the mix of a difficult time in the markets.

No one knows if the SVB failure is systemic or just a very isolated “idiosyncratic” event unique to that bank.  Certainly, the higher interest rates targeted by the Fed to fight inflation affects all banks and contributed to the SVB failure, but aspects of SVB make it a bit unique since it was primarily a “tech” and business lender with about 90% of its deposits “uninsured” and “smart money” venture capital firms familiar with SVB prompted the “run on the bank”.

Meanwhile, higher interest rates continue to be on the docket (though may be off the table for a bit post-SVB?), inflation is still troublingly high, and the Russia/Ukraine war continues with a troubling persistence.  What is an investor to do?

As I have always said, as long as your investment strategy is tailored to your risk tolerance/profile and managed to achieve your goals, it is best to stay the course.  For example, I did some work for a potential “high net worth” retired client and showed them that they could keep all their liquid assets in “cash” and be pretty well assured that they would not run out of money and live the life through retirement that they wanted.  They were happy to hear that (and did NOT become clients!), but the message was clear; a lowest risk strategy worked for them!  Alternatively, younger investors with a longer time frame and higher risk tolerance can afford to take some risk and reap the benefits of potential higher returns.

Bonds are Risky

When the Fed started its tightening cycle back on March 17, 2022 to help quell inflation, the target rates for Fed Funds were 0.25%-0.50% and they now sit at 4.50%-4.75%.  Today, you can easily find 1-year bank CDs paying just about 5.0%!  As expected, the increase of rates at the short end of the curve caused the yield curve to invert, i.e., higher rates at the short end compared to the longer end, but also increased up and down volatility in all interest rates and bond values.

As seen from the chart below, core bond (AGG, the blue line) returns have been on a roller coaster ride similar to stocks (IVV, the green line); stocks showing lots of zigging and zagging, but bonds did too, though not as much!  The only respite from volatility has been from shorter duration bond exposures, like the iShares 0-5 Year Investment Grade Corp ETF (SLQD, the gold line) that shows a “smoothish” path and only a modest annualized loss over this time horizon of -1.4%.

The idea that bonds are “less risky” than stocks is well documented, but depending upon their characteristics, they can still be “risky” investments.  As we at D&A have communicated consistently, we believe that diversification is key to aid in the success of long term investing; and that diversification includes management of the bond sector allocations.  We believe that a well-managed bond allocation needs exposures to all parts of the yield curve and, during a Fed tightening cycle, a shorter overall bond duration exposure.

The modified duration of “core” bonds (AGG) recently has been about 6.3 years; modified duration being a proxy for risk over a time horizon.  No one knows the path that interest rates will take, but the Fed has communicated a clear focus to increase rates until inflation appears quelled.  Therefore, a shorter bond modified duration than the core bond proxy is warranted.  Most all D&A client accounts have an exposure to “core” bonds, but also to very short bonds (NEAR and BKLN) and short bonds (SLQD) to account for an overall bond modified duration in the range of 4.0 years; shorter than the core bond proxy of 6.3 years.

My "200th" Blog Post!

This is my 200th blog post!  Hard to believe!  I started writing these back around early 2019 and have tried to keep them informative and entertaining!  Hope you all have enjoyed them!

I have written a lot about the importance of long term strategic investing, diversification, and risk management.  I almost always close my blog posts with the caveat that market timing is impossible, except by luck, and it is always best to invest for the long term with a strategy that is consistent with your goals.

In order to celebrate, I am re-posting one of my favorite blog posts titled, “Beats Me! (Again!)”. Though I have many “favorite” posts, I highlight this one because it focuses on risk and the impact of “uncertainty” on the markets and our difficulty dealing with it.  In fact, when I wrote this way back in 2021, covid and its growing impact on inflation was the story of the day and there was no Russia/Ukraine war to create geopolitical turmoil in the markets.   

Here is my post from way back on November 30, 2021 (before the rapid acceleration of inflation, the Russia/Ukraine war and the weak market performance of 2022 ):

“Beats Me! (Again!)”

On the surface, there are plenty of positive signs about the current economic situation.  For example, in the post-pandemic environment the unemployment rate has fallen from 14.8% in April 2020 to 4.6% in October 2021, a recent low but still much higher than the recent pre-pandemic low of about 3.5%.  Economic growth has picked up, too, with real GDP recovering nicely from the pandemic lows with quarterly growth rates of +6.7%, +6.3% and +2.1% over the past three quarters in 2021.  So why are we all worried about the future?

Though we live in an uncertain world, the capital markets don’t like uncertainty!  The largest uncertainty we all face is the potential for a re-emergence of covid-19 in a potentially more-onerous mutated form.  That is still to be seen, but the omicron variant announced last week is certainly causing a stir in the capital markets.

Aside from the externalities like covid impacting the markets, the potential for rampant inflation seems to be on everyone’s mind as they leave the gas station and grocery stores seeing much higher prices!  Certainly, inflation has picked up with the Consumer Price Index showing a +6.1% increase from prices a year ago.  Even excluding the more volatile prices from food and energy, inflation still shows a spike of +4.1%.  As seen from the chart below, after the drop in prices during the pandemic, we have seen a marked increase in prices from the beginning of the year, “transitory” or not!

Just like trying to predict the capital markets, no one knows if rampant inflation is on the horizon.  The period after the Credit Crisis back in 2008/09 likewise saw many thought leaders postulate much higher inflation due to extreme Fed easing and fiscal stimulus, which, of course, we never saw!  This time there are supply chain issues and other factors that very likely will be solved by market forces and time so there is good reason to be bullish on the inflation front.

This situation reminds me of insights from my favorite Chief Investment Officer at a former employer.  At every quarterly investment review meeting he would lead off the discussion with a lengthy discussion about the current economic situation and capital markets telling a good story about where we are.  He would close by saying, “So, what is the market going to do? Beats Me!”

Finally, from my blog post, Beats Me!, from way back in August 2019:

As I am wont to say, plenty of reasons to be cautious, but no reason (yet!) to run for the hills.  New money should go into the market slowly, since that is ALWAYS the low risk approach to get market exposure.  Investors with a long term strategic approach properly diversified and positioned in the risk profile appropriate for their situation should stay the course.

The "X" Factor

The world of investments is constantly evolving.  The latest investing trend is “ESG” (Environmental, Social and Governance); investing in companies that reflect characteristics considered positive for society.  Another recent trend supported by much academic research is “factor” investing; investing in companies that show a clear statistical bias to outperform broad indices over a long period of time based on their underlying characteristics.

The four major characteristics that show the best statistical outperformance are momentum (positive trending performance, MTUM), minimum volatility (relatively less risky, USMV), size (small company, SIZE), and quality (good financial condition, QUAL).  In theory, adding an overweight to positions in these kind of stocks will add incremental return to beat the broad benchmark.  Let’s see how these have done over the recent past and longer term.

The recent history has been kind to factor investing, but not so good over the past 3- or 5-year history.  As seen from the table below as of January 31, 2023, both the size and value factors have shown recent consistently good relative outperformance (green text highlighted) and added value to a portfolio, but over longer time frames none of the factors have outperformed the broad S&P 500 (IVV) benchmark.

Granted, the past 5 years have been extraordinarily unusual with the global pandemic and historically low interest rates followed by an interest rate tightening cycle, so perhaps the time horizon has not been long enough for the statistical bias to emerge.  Or, perhaps the underlying portfolio rebalancing of the factor ETFs has not matched with the shifts in the market so as to miss the inflection points where cycles may have started to shift. 

Regardless of the reason for the longer term underperformance, placing positions in any of these factor investments, in addition to the broad indices, adds to the overall diversification of a portfolio and we expect that will lead to outperformance over time.

Perfect Foresight?

This is the time of year when Callan LLC publishes their annual “Periodic Table of Investment Returns” (see chart below).  It is a colorful mosaic quilt of annual investment returns for the major asset classes arrayed by year by return.  It is most instructive to show the variability of returns for each asset class in comparison to the others.  For example, you can observe from the medium blue box labelled Large Cap Equity (S&P 500) that annual returns over the last 20 years have varied from -37.00% in 2008 to +32.39% in 2013.

Given all this great data, there are a few other observations and calculations I like to highlight:

1. The variability of return of Large Cap Equity calculates to an average annualized return of +9.80% over the last 20 years.  But, that comes with a large annual standard deviation (risk) of return of 16.75%; meaning there is a high probability of returns varying around the average easily dipping into the negative return region - something we can easily observe from the chart and have seen in 2022!

2. Cash Equivalent (the light blue box), as the least risky asset class, fulfills its role as a stable floor of returns with average annualized returns of +1.27% over the past 20 years.  Cash Equivalent was the best performing asset class in 2022, but if an investor can tolerate some risk over a long time horizon, there are other places to earn more return.

3. As reported almost everywhere in the financial press, U.S. Fixed Income (the teal box) had a historically weak return in 2022 of -13.01% compared to its average annual return +3.10%.  Not surprisingly, from the chart you can see that this asset class actually was the best performing asset class in 2008, a very bad year for equities!

4. Finally, if we had perfect foresight and were able to pick the best performing asset class each year, the calculated average annual return would have been an amazing +26.26% over 20 years!  Of course, no one can do this, but it is certainly fun to think about!

As the chart shows, asset class returns are variable and switch places on an almost random way.  It is always best to have a well-diversified portfolio of investments that are managed to a risk target that is designed to help you achieve your goals.

Is THIS the year for Emerging Market Equities?

I knew a very sharp portfolio manager who used to say, “I re-buy my portfolio every day”!  By that, he meant that he regularly checked all the holdings in his portfolio to evaluate what he liked and what he didn’t like.  If something had changed, he would evaluate if the portfolio needed a change.

This is a complicated problem at the portfolio level.  It is not just ONE holding, but a group of holdings that are all positioned to inter-relate with each other.  Ideally, some will zig when others zag, and vice versa.  In fact, if we are properly diversified, it is almost a certainty that there will be SOMETHING that has shown disappointing performance, but still serves a place in a portfolio as a diversifier over a longer time frame.

For example, emerging market equities have been on everyone’s list the past few years as an asset class that is “cheap” and ready for a “pop”.  As we know, per the chart below, that has not been the case as annualized returns of emerging market equities (SCHE, -0.3%) have struggled and underperformed the U.S. markets (IVV, +8.5%) by a wide margin over the three years since January 2020.  However, if you go back a few years to 2017, emerging markets were a legitimate darling that year with a total return of +37.3% besting the U.S. markets return of +21.8%.   And also, on a year-to-date basis this year, emerging market equities (SCHE) are up +8.7% beating U.S. large cap (IVV) of +4.2%.

We hold asset classes like emerging market equities because we believe they have a low correlation with core holdings like large cap U.S. equities (IVV) and “will zig when others zag”.  In fact, long term correlations of emerging market equities do exhibit that quality with a long term correlation coefficient to U.S. equities of 0.74 over the past 20 years.  This is not as low a correlation as core U.S. bonds (AGG) of 0.16, but is still relatively low for the equity space.

As always, we believe that patience will serve long term investors well.

A Disappointing 2022

The 4th quarter of 2022 offered a bit of respite to weary investors in 2022 due to positive pops in October and November, but December quickly showed no mercy as negative momentum kicked in and tempered any optimism of ending the year on an upbeat.  The themes of 2022 continued during Q4 as volatility reared its ugly head with market interest rates moving up, from down, and equities moving down, from up.

We have become accustomed to the usual suspects of inflation fears, a hawkish Fed, rising market interest rates and the global geopolitical and economic consequences from the Russia/Ukraine war playing havoc with capital markets.

 Though 2022 Q4 shows some “positive” quarterly total returns for the major asset classes, the results are far from inspiring and not necessarily indicative of an inflection point.  Per the table below, the major asset classes showed Q4 returns that were “in-the-black”, but not by a wide margin and certainly not enough to compensate for the overall weakness we had seen over the entirety of 2022.  For example, during Q4 the S&P 500 (IVV) was up +7.59% and core bonds (SCHZ) was up +1.68% but those asset classes were both down a LOT over all of 2022 at -18.16% and -13.17%, respectively!  The weakness in bonds is historic; worst annual return ever!

My blog post on November 28 posited the thought, “Is the Bottom In?”  In it, I showed three separate market bounces that naively foretold more market gains, but resulted in losses!  Forecasting market returns is really HARD, but practically speaking is mostly a “conditional” game; if this, then that.  If you luckily guess the conditions correctly, then maybe you will be lucky guessing market outcomes. 

Per that blog post, themes that could change that could impact markets include:  hawkish centrals banks fighting inflation, higher rates, tighter liquidity, weaker financial conditions suggesting downside risk to earnings and potential for severe recession, unattractive credit spreads, currency-induced sovereign crisis and escalation in Russia/Ukraine war. So, stay tuned!

"Play the Hand That You're Dealt"

No one likes to lose money but, as they say, you must “play the hand that you’re dealt”.  If you are a long term investor, it is likely you have some built up unrealized gains over the years.  For example, despite the S&P 500 being down -16.3% so far this year, it is still up +31.2% cumulatively over the last three years.  Conversely, unfortunately, some diversifying positions have not done so well!  This includes emerging market high dividend equities (DVYE) that are down -20.9% cumulatively over the past three years, while being down -31.0% this year alone.

The tax codes do allow some respite for taxpayers with investments in taxable accounts through the deduction of up to $3,000 of net realized losses against ordinary income.  In this current year, it certainly makes economic sense to take this tax loss selling to save a bit in taxes.

Another, less utilized, tax loss selling strategy is to realize GAINS on long term holdings and immediately buy them back at the higher cost basis while offsetting the gains with tax loss selling.  The net result of this kind of transaction is to raise the cost basis so that taxes will NEVER be paid on those realized gains.  Let’s run through the rationale for this kind of transaction.

If a taxable investor has a taxable account with $100,000 in unrealized gains, he could realize the gains and have a net after-tax gain of $80,000 (assuming a 20% tax rate).  But, if there are $100,000 of other realized losses in the portfolio he could offset the gains completely and NOT pay the $20,000 tax in the current year.  Going forward, the $100,000 of realized gains are completely sheltered from taxes and the $20,000 in realized gain tax will NEVER be paid on that $100,000.  Of course, the investor would much prefer there being NO offsetting losses against the $100,000 unrealized gains, but at least this is a way to make the best of other losses existing in the portfolio.

This is NOT tax advice since there are many other investor-specific issues to consider, including wash sale rules, taxable situation, overall portfolio management and risk preferences.  I do not recommend this as a DIY transaction since there are many pitfalls.  D&A manages all client taxable accounts with a “tax-aware” strategy.

Is the Bottom In?

In the face of this horrible year with the S&P 500 (IVV) currently down -14.30%, we have had some decent mini-rallies.  For example, from March 14 through March 29 we saw the S&P 500 go up +11% and from June 16 through August 18 it went up +17% (see chart below).  We are seeing another mini-rally now with the S&P 500 currently up +13% from a recent low on October 12.  So, is the bottom IN and will this rally take us to new highs or is this another rally to be short-circuited by any of the troubles facing the markets?

I read an interesting article this weekend published by Wellington Management, a multi-billion dollar global investment manager based in Boston, titled Inflation, rates, and volatility: The best defense is a good offense.  Aside from the title, the gist of the article deals with the large number of binary events we are facing that will dictate the course of the global economy.  Several of them are summarized below:

• Hawkish centrals banks fighting inflation

• Higher rates, tighter liquidity, and weaker financial conditions suggesting downside risk to earnings and potential for severe recession

• Unattractive credit spreads

• Currency-induced sovereign crisis

• Escalation in Russia/Ukraine conflict

All we need to do is switch the “negative” tone to a “positive” tone in a few of those bullets to see a turnaround in the market outlooks.  The article implies that the potential for market dislocations from these major items could cause a need to act swiftly with some tactical repositioning.

Though D&A has a strong philosophical bias to focus on long term strategic positioning, there are opportunities to act tactically. For example, earlier this year, D&A made a commitment to shorten bond duration for all client accounts given the risk/return profile displayed by the flat yield curve (long bonds compared to shorter bonds) (see recent blog posts, including It’s Complicated, and others). In other ways, for taxable accounts, given the large market drawdown this year, there is a potential for advantageous tax loss selling. We will continue to monitor market dynamics and adjust portfolio positions to advantage all client accounts.