October has proven to be a rocky, volatile period for markets, with a broad correction sending the Dow Jones Industrial Average, S&P 500 index, and NASDAQ composite below their 200-day moving averages1 – a presumably bearish signal – spurred by a feared slowdown in earnings growth. Interest rates, driven in part by short-term rate hikes by the Fed and in part by expectations for corporate earnings, economic growth, and expanding debt levels, have continued to rise. The political environment, both domestically and globally, remains tense as the tariff war escalates. Despite these movements, investors have found room for continued optimism given the current strong US economic fundamentals. Taken in context, over the past twelve months the Dow Jones Industrial Average is up over 9%, the S&P 500 over 7%, the NASDAQ composite over 9%.2
The above chart illustrates the volatility index (a widely used measure of investors’ near-term risk expectation) vs. the level of the S&P 500 index. Despite spikes in volatility (see January and October 2018), the S&P 500 has still generated positive returns over the past twelve months.
In this environment, we are cautious of near-term valuation movements. Put simply, one can view market valuation as being a function of equity earnings and underlying interest rates - as rates rise, valuations should decline in kind. As Warren Buffett has stated: "The most important item over time in valuation is obviously interest rates. If interest rates are destined to be at low levels. . . It makes any stream of earnings from investments worth more money.” (CNBC interview, May 8, 2017)
We have built our strategies and portfolios for durability throughout the market cycle. Our advanced portfolios seek to benefit from diversification by allocating to asset classes with low-to-negative correlations (the relationship between the performance of each asset class).
In times of market turbulence or decline, we expect alternative investments to provide portfolio ballast. Our alternative asset allocation includes Managed Futures, Style Premia, and commodities. Historically, these asset classes have been effective portfolio hedges and have performed well when equities have declined.
The above chart illustrates the relative valuation of commodities (the GSCI index) vs. the S&P 500. In periods of market stress (1973, 1990, 2008), commodities have seen their value appreciate substantially in relation to stocks. This inverse relationship provides downside relief to portfolios with commodity exposure.
A particular alternative asset class that has proven to provide portfolio ballast in 2018 has been our exposure to commodities. We have seen our allocation gain upwards of 5.0% in 2018 largely on the strength of underlying energy positions. We would expect continued growth in commodities as rates rise and investors show greater interest in gold and crude oil, in particular.
As rates continue to rise and the business cycle matures, we continue to evaluate our overall equity, fixed-income and alternative asset weightings to better allocate from a risk-reward perspective. Each client has a portfolio designed with their specific risk tolerance and objectives in mind. This forms the basis of our long-term investment strategy. Different types of assets perform well at different points in the business cycle; as a result, we will make shifts within asset classes when appropriate.
Of late, reward has begun to look meager in high yield corporate bonds, so we’ve started increasing the quality of our fixed income with a move toward short term U.S. Treasuries. Large growth companies in the U.S. have also begun to look pricey and we’re beginning to shift our weighting toward less expensive large companies as represented in the value and blend styles. These two shifts, while minor in size, position accounts modestly more defensively which we believe is prudent this late in the cycle.
As always, we continue to stay vigilant and monitor market conditions with the explicit goal of protecting our clients’ assets.
1S&P 500 (SPY) (graph)
Dow Jones Industrial Average (DIA) (graph)
Nasdaq (FNCMX) (graph)
2http://news.morningstar.com/index/indexreturn.html#