History only gets written after the fact, but at this moment, it feels like the bear market of 2022 will be one that is remembered and studied for many years to come. The abysmal performance of bonds was most noteworthy with the primary U.S. bond benchmark index posting its worst decline since inception, falling 13% for the year. To pile on, global stocks were down 18%, marking the first time in 50 years that both bonds and stocks have fallen in a calendar year.
Only time will also tell us whether 2022 will mark the beginning of a decadal change from an era of falling rates and rock bottom interest rates when growth stocks and long-term bonds seemed to go in only one direction. But in the short term, investors who seemingly ignored the ever-growing interest rate risk for fear of missing out were dealt a serious blow with long-term government bonds down 31% and U.S. growth stocks falling 29%. With minimal exposure to these assets, many of our portfolios were able to deliver better returns than their benchmarks.
There is much uncertainty going into the year ahead, and that likely means continued volatility. 2022 reminded us that volatility can take many forms, not just wild swings day to day, but months of up followed by months of down. But we do know that with each passing month of down markets, investor expectations become more pessimistic, and it becomes easier to exceed expectations and for a rebound to be sustained over the long term. Our goal is to be positioned to capture that growth when it happens.
Disclosure: All opinions expressed in this article are for general informational purposes and constitute the judgment of the author(s) as of the date of the report. These opinions are subject to change without notice and are not intended to provide specific advice or recommendations for any individual or on any specific security. The material has been gathered from sources believed to be reliable, however Merriman cannot guarantee the accuracy or completeness of such information, and certain information presented here may have been condensed or summarized from its original source. Merriman does not provide tax, legal or accounting advice, and nothing contained in these materials should be taken as such. To determine which investments may be appropriate for you, consult your financial advisor prior to investing. As always please remember investing involves risk and possible loss of principal capital and past performance does not guarantee future returns; please seek advice from a licensed professional.
Russia’s threats and invasion of Ukraine have upset global markets and driven them lower to start the year. Losses and volatility are typical when the future course of events is highly uncertain. However, as shown in the graphic below, what happens in the short term usually has little bearing on future market returns.1
Intra-year market declines are much more common than one might realize. Every year since 1979, the U.S. market (represented by the Russell 3000 Index) has experienced an intra-year decline of at least 2.7%. In 1987, the market experienced an intra-year decline of 33.1% but still finished the year with a positive return.2
We are biologically hard-wired to respond to uncertainty with action. When we were hunter-gatherers, uncertainty looked like a lion waiting in ambush and action was a beneficial response. When it comes to markets, the opposite is usually true. Time after time, we have seen that sticking with a carefully designed, diversified allocation through ups and downs yields a better outcome compared to selling out and trying to guess when to buy back in.
As we saw in March 2020, early in the pandemic, what feels like the worst of times can, in hindsight, be a market bottom followed by a strong rally. It is also very possible we will see further declines from here. There are many players whose decisions will influence the trajectory of events as well as new paradigms at play, like economic sanctions of unprecedented size and speed of application, and cyberoperations assisted by commercial companies. Given the complexity of the conflict, it is impossible for anyone to predict the outcome or its effects on the global economy.
What we do know is that diversified portfolios are designed to weather uncertainty, and that human ingenuity, perseverance, and adaptability have enabled businesses and their investors to prevail even through difficult times, especially when they are on the side of democracy and freedom. The Ukrainian businesses switching from making farm combines to tank-stopping hedgehogs and metal road spikes, and turning malls into logistics warehouses are great examples.
While our portfolios are diversified, the emerging market funds we recommend have less than 1% of their assets currently in Russian companies and as of March 4, our largest emerging market fund provider, Dimensional, has announced they will be divesting from all Russian assets. We anticipate the others will follow shortly. The markets are signaling that the biggest fear right now is inflation, especially if Western nations choose to cut off the flow of Russian energy. Historically, value stocks have done better in inflationary periods than other areas of the market and we are seeing this with our value positions outperforming the growth segments of the market. With their heavier exposure to natural resource companies, we anticipate this trend could continue if commodity prices and inflation continue to rise.
Hopefully you can find peace of mind knowing that your Merriman portfolio will weather the current storm. If you want to act, you can feel confident in your ability to donate in support of humanitarian aid or the valiant fight of the Ukrainian people, or take action to help reduce dependence on Russian energy.
Sources: 1 Vanguard
2 Dimensional Fund Advisors.
Disclosure: The material is presented solely for information purposes and has been gathered from sources believed to be reliable; however, Merriman cannot guarantee the accuracy or completeness of such information, and certain information presented here may have been condensed or summarized from its original source. Merriman does not provide tax, legal, or accounting advice, and noting contained in these materials should be relied upon as such. Past Performance is no indication of future results. The Russell 3000 Index is a market-capitalization-weighted equity index maintained by FTSE Russell that provides exposure to the entire U.S. stock market. The index tracks the performance of the 3,000 largest U.S.-traded stocks, which represent about 97% of all U.S.-incorporated equity securities. Any reference to an index is included for illustrative purposes only, as an index is not a security in which an investment can be made. Indices are unmanaged vehicles that serve as market indicators and do not account for the deduction of management fees and/or transaction costs generally associated with investable products.
One of the most noted and real impacts of the coronavirus is that employees are working from home. While it has been a huge shift, four plus months in, the results have been positive for many, and headlines in business publications are examining whether a substantial fraction of these employees may never return to the office. There is solid debate about how big the impact will ultimately be, but there is no doubt that companies will be revisiting their spaces.
This trend might lead one to worry that real estate values will plummet as demand falls and supply stays constant. To this I would offer two counter points. First and foremost, commercial real estate encompasses a wide range of investments. The pie chart below shows the sub-sector breakdown of the holdings of our most widely recommended real estate investment, the Dimensional Global Real Estate Fund (DFGEX).
REITs that focus on office properties as of June 30th, 2020, made up just 12% of the fund’s allocation. Office REITs do not just own high-rise commercial office buildings in downtown cores. Much of the space they own is in suburban office parks and includes space leased by dentists, hairstylists, lawyers, and small research and engineering firms. While many more things can be done virtually, there are still many businesses, such as orthodontists and spas, that will always require an in-person experience.
While demand for some types of office space may be dropping, demand for other types of real estate in the fund is growing. As of June 30th, the top three holdings in the Dimensional fund were American Tower Corporation, Crown Castle International Corporation, and Prologis Inc. American Tower and Crown Castle are owners and providers of infrastructure for wireless communication and fall into the Specialized category. Prologis is in the logistics real estate business, leasing distribution facilities to support direct fulfillment to customers. All three of the companies are poised to see substantial growth from increasing demand. The fund owns many other businesses, from cold storage warehouses to multi-family apartments to medical facilities, where demand remains high.
The second point is that changes always follow any societal upheaval. There is no doubt that COVID will have an impact on our world. However, it is unclear that the shifts will be as radical as some are predicting or that COVID alone will cause the demise of industries or institutions. Large scale change rarely happens that quickly or dramatically.
For example, the idea that demand for office real estate will suddenly drop 60–70% seems overblown. IBM was an early proponent of telecommuting. In a 2009 report, they boasted that “40 percent of IBM’s some 386,000 employees in 173 countries have no office at all.” According to an Atlantic article from 2017, they unloaded 58 million square feet of office space at a gain of nearly $2 billion. By all accounts, it sounded like a winning strategy. Only, it did not work out, and in March of 2017, IBM decided to move thousands of its workers back to physical company offices.
The problem was likely a drop in what the Atlantic terms “collaborative efficiency”—or the speed at which a group successfully solves a problem. Physical distance still mattered when it came to team creativity, and remaining competitive in a rapidly changing landscape more and more requires novel solutions to complex problems. Offices may look different, but I believe that more than ever people and employees will need places to gather and connect.
The future trajectory is never clear even to the greatest minds. What is clear is that people will always need spaces to live, work, and conduct business. What those spaces look like will evolve, but companies are motivated to adapt. And historically, they have changed industrial warehouses and former malls into Amazon fulfillment centers and multi-family apartment complexes. Despite the recent drawdowns and changing landscape, we believe that investing in a diversified real estate portfolio continues to offer the potential for equity-like returns, current income, and solid inflation protection, all important elements of a well-balanced portfolio.
With coronavirus cases rising, unemployment at historic levels, and ongoing protests across America, the strong market rebound feels like it could be driven by irrational hope. Are the markets assuming there is an effective vaccine by the fall? Are they ignoring the effects of a worldwide 100-year pandemic that has killed over 650,000 people as of July 30th?
While there are certainly times when markets can behave irrationally, such times are few and far between and usually concentrated in a certain asset class or sector. At this point, with the exception of the FAANG stocks (Facebook, Apple, Amazon, Netflix, and Google), we do not see signs that the global equity markets are acting irrationally. It is important to distinguish that this belief does not mean that the market might not experience another significant downturn.
Market prices represent the aggregate predictions of thousands of professional and individual investors regarding the value of the company’s future earnings plus the book value of its assets. The operative words here are prediction and future. The stock markets typically bottom when investors have the most fear and have the bleakest outlook on the future. Historically, bottoms have typically coincided with the point of peak unemployment. A rise in the stock market does not mean that the recession is over or that it might not continue for several more years. It simply means that investors are anticipating a better future down the road.
For example, according to Charles Schwab’s analysis of data from Refinitiv, the market consensus estimates for S&P 500 companies for Q3 2020 is a -23.5% drop from the previous year. That does not seem very optimistic to me. Ned Davis and Charles Schwab recently showed that historically the S&P 500 has performed best when year-over-year earnings growth was between -20% and 5%. It seems very counterintuitive that stocks would be rising when earnings growth is negative, but again, markets are predicting the future, not what is happening at present.
Many of you are probably still wondering or worried about the market going down from here. As the future is uncertain, the answer is, unfortunately, yes, the market could go down from here. But that does not mean you should pull all your money out.
Ironically, your risk of losing money in the markets today is less than it was in January. Markets account for uncertainty by keeping prices below fair value. The difference between true fair value and the market price is the compensation investors receive for taking risk. In times of perceived low uncertainty, market prices are close to fair value and investors get little compensation for taking risk. As the pandemic has taught us, risk is always with us whether we see it coming or not. Currently, because of the high degree of uncertainty, market prices incorporate more downside risk, and investors who stay in the market are getting higher compensation for taking that risk. Taking risk is a necessary part of investing, but as investors, one of the most important things we can do for long-term success is to ensure that we are being appropriately compensated for those risks. Staying in markets when we receive high compensation for taking risk is a key part.
I would love to have a crystal ball that could tell you how the market is going to move tomorrow or next month or next year. It seems very possible that the economic recovery could slow, and the market could go sideways or take another dip. It also seems very possible that through a combination of growing knowledge, human adaptation, and government stimulus, the economic impact will not be as severe as some fear, and the market will continue its steady climb. A wide variety of data suggests that current market valuations are not irrational and that markets are appropriately accounting for the high degree of uncertainty surrounding the trajectory of the economic recovery that will ultimately occur. There are plenty of investors who are pulling money out or who are continuing to sit on the sidelines as well as plenty of buyers. Our recommendation is to continue with your target equity allocation. This approach allows you to benefit from the relatively high compensation you are getting for taking on risk right now while providing sufficient downside protection that your financial well-being is not at risk.
Disclosure: Past performance is no guarantee of future results. No client should assume that future performance of any securities, asset classes, or strategy will be profitable, or equal to the previous described performance. The S&P 500 is a market capitalization-weighted index of 500 widely held stocks often used as a proxy for the U.S stock market.
“Past performance is no guarantee of future results” is a required compliance disclosure used by money managers when reporting performance. Unfortunately, it is truer in the world of investments than almost anywhere else. When you find a 4.5-star restaurant on Yelp, there is a high probability that you will have a positive experience. Statistically, funds that had the best performance over the past three years (or one year) are no more likely to outperform the following three years than any other fund.
The same is true at the portfolio level. In the late 1990s, U.S. growth stocks were the best performing asset class and investors flocked to the S&P 500. We introduced the Merriman MarketWise All-Equity Portfolio in 1995 in the middle of this period. After the first five years, the cumulative return of the Vanguard 500 Index Fund was more than 2.5 times that of MarketWise, as Figure 1 shows. What happened over the next decade from 2000 through 2009? The exact opposite.
Over the tumultuous decade from 2000 to 2009, the MarketWise All-Equity Portfolio (after fees) was up 70% compared to the Vanguard 500 Index fund which had lost -10%, as Figure 2 shows. That 10-year period during which the S&P 500, cumulatively lost money is commonly referred to as the lost decade. It was a painful period for many investors. Their faith in the S&P 500 had been strengthened by nine straight years of positive returns (six years exceeded 20%) and by watching it outperform major indices around the globe.
While it was a difficult period, the investors who suffered most were those who switched investments based on past performance. Figure 3 starkly illustrates the effect of “chasing” good recent performance. The blue and orange lines show the cumulative returns of the MarketWise All Equity Portfolio and the Vanguard 500 Fund. The gray line shows the cumulative growth of funds invested in the MarketWise All-Equity Portfolio from the 1995 inception through 1999 and then in the Vanguard 500 fund from 2000 through 2009. While after fees, the MarketWise All-Equity Portfolio slightly outperformed the Vanguard 500 Fund, investing in either approach yielded solid growth. The investor who switched from MarketWise to the Vanguard 500 Fund at the top of 1999 ended up with less investment growth than the investor who stuck with either strategy throughout the whole period.
2009 to 2017 the S&P 500 again delivered nine straight years of positive returns and outperformed most major world indices. In 2018, the index was down -6.6% but has quickly rebounded in 2019. No one knows what the next ten years will bring. History suggests that past performance is no guarantee of future results and that tides turn, but when that will happen is anybody’s guess.
IMPORTANT DISCLOSURES: The performance results shown are for the Merriman-managed MarketWise All Equity (100%) Portfolio and the nonmanaged Vanguard 500 Fund, during the corresponding time periods. The performance results for the MarketWise All Equity Portfolio do not reflect the reinvestment of dividends or other earnings, but are net of applicable transaction and custodial charges, investment management fees and the separate fees assessed directly by each unaffiliated mutual fund holding in the portfolios. The performance results do not reflect the impact of taxes. Past performance is not indicative of future results. No investor should assume that future performance will be profitable, or equal either the previous reflected Merriman performance or the Vanguard 500 Fund’s performance displayed. The S&P 500 is a market capitalization-weighted index of 500 widely held stocks often used as a proxy for the U.S. stock market. The Vanguard 500 Fund is a core equity index fund that offers investment exposure to the companies represented by the S&P 500 index. Source of VFINX data is Morningstar.
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