Third Quarter 2018 Commentary – A Picture Within a Picture

When it comes to investing, it’s best served to check your biases at the door and simply follow the facts.  Contrary to conventional belief, U.S. equities have been historically calm over the past few months while other global equity markets have been extremely volatile.  For U.S. equities, the summer months were sleepy as stocks grinded higher with little resistance.  You would have to return to late June to find the last time the S&P 500 moved 1% in either direction on a single trading day.  Using the most common measure of market volatility, the Chicago Options Exchange Volatility Index (VIX) retreated back to 2017 levels, which was one of the least volatile years in market history.  After the VIX climbed to 36 (about twice the historical average) in tandem with January’s market selloff, the VIX sank like a dumbbell back to 12, well below a normal level.  To the contrary, international developed and emerging market equities both hover in correction territory, (down as much as 10% and 20% from their January highs) as of mid-September with daily gyrations of 1% being par for the course.

However, U.S. equities only comprise roughly half of the global equity universe and unlike 2017, global equity markets are not being conducted in symphony. Barring a huge reversal, 2018 will not be remembered as the year of a “rising tide” as non-U.S. equities have been unable to float with their U.S. counterparts.  This is not abnormal – developed and emerging markets both outpaced U.S. equities last year.  Markets move in cycles and mean reversion dictates that non-U.S. equities will eventually play catch up or U.S. equities will lose some steam.  The U.S. is currently the premier equity market in the world, but it won’t be forever.  While owning part of each of the world’s equity markets may be out of style, it remains a sensible approach even though it won’t feel like it at times.  If you only gave credence to the mainstream news flow and neglected the price action, it would be easy to misdiagnose the reality of this market.

U.S. equities have continued to flirt with all-time highs as U.S. stocks have remained insulated from stagnation in international equities and an ugly spectacle in emerging markets. The S&P 500 finished the quarter up nearly 8%, its best quarter since 2013. U.S. small caps had another strong quarter, up 5%, and continue to stand taller than any other major asset class this year. In the equity world outside of the U.S., things have chilled this year relative to last. International and emerging market equities have been hamstrung by a proverbial “murderers’ row” of items related to tariffs, trade, a stronger dollar and higher interest rates. From a certain vantage point, it feels like the volatility that has seeped out of the U.S. equity market has transferred into foreign equity markets.

Furthermore, equity markets are often cited as having one god and it goes by the name of earnings growth. Currently, the U.S. has that in spades relative to the rest of the world. The U.S. tax bill that was passed into law late last year was based on a simple theory – if you lower tax rates for large and small businesses while making it easier to bring back profit dollars sitting idle in overseas banks, it will create a blueprint for growth, and more importantly, incentivize it. To that effect, it has created a tremendous tailwind for U.S. equity markets. Earnings growth among U.S. companies has been trending in the range of 20-25% relative to last year, putting earnings at nearly 10-year highs. This has played a big role in making non-U.S. equities less attractive as investors, in effect, “go where the earnings go.” But as we approach 2019 and U.S. companies start lapping these large earnings next year, the numbers will likely cool off, potentially leading to rosier investor outlooks for non-U.S. equities.

In fixed income, all major bond indexes finished the quarter flat to slightly down, leaving everything but international bonds negative for the year. Interest rates moved up during the quarter as the 10-year Treasury finished at 3.10%, peaking back above 3% for the first time since mid-May. For bond investors, the saving grace of higher rates is the higher coupon payments that will eventually come due. The path of least resistance for interest rates appears to be higher as the Federal Reserve continues its course of lifting interest rates. In the short term, this leads to periods of discomfort as bond values decline. But receiving 2% or thereabout on high-quality fixed income investments forever would arguably be more uncomfortable.

As we enter the final three months of the year, U.S. equities lead the pack and nothing else is really close. International stocks, emerging market stocks, and most bonds have posted negative returns to date. If you were a genius investor, your portfolio would be entirely comprised of US equities, both large and small. That type of portfolio would be served well this year but it would not have served quite as well last year. Therein lies a worthwhile distinction – you don’t have to be a genius investor. By owning a collection of different assets that do different things, a more reasonable range of outcomes can be expected given a long enough runway. There is a point in time where U.S. equities will be dealt a fate similar to the one emerging market equities are facing at this moment. Holding a portfolio entirely comprised of U.S. equities when that comes to fruition will feel unpleasant. But if you do something reasonable and stick with it through tough times, the results will eventually come due. While keeping the faith is hard, doing the “right” thing can feel wrong for a long time. Owning anything other than U.S. equities has made it difficult to stay in your seat during 2018. But that will not be the case forever.


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