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Third Quarter 2018 Newsletter

posted on

Happiness is a warm puppy  

Many people would agree with the above statement.  A little, fuzzy, snuggly puppy keeping your lap warm would indeed make most people happy.  But what if the warmth was coming from the puppy urinating on you?  Would you feel the same?  Would your feelings about  a “warm puppy” be different in that scenario?  We have purposely used this tasteless example to underline the fact that a person’s expectation has a lot to do with their feelings.  If someone’s expectations are met, or exceeded, then most people are happy about that occurrence.  If something doesn’t meet expectations, then typically there is an unhappy or disappointed result.

You may be asking what any of this have to do with your investment portfolio?  Quite a lot. With financial markets, there are known expectations.  Some basic, some more complex.  An example of a basic financial expectation is that stocks should have a higher long term return than short term bonds or Treasury Bills.  That higher return pays investors to hold a riskier, more volatile asset class.  (All charts below courtesy of DFA Inc.)

This higher expected return for stocks is called the equity premium.

But all asset classes do not have the same expected returns.  You may remember when we first built your portfolio, we attempted to increase its long term performance by overweighting asset classes that have a history of superior returns compared to the basic long term equity premium.  By increasing a portfolio’s ownership of certain asset classes focusing on size (Small beats Large), relative price (Value beats Growth) and profitability (High beats Low), our expectations are for superior long term performance compared to simply owning an equity portfolio that mirrors the US or Global equity market. See the premiums that some of these asset classes have provided. 

However, these expected premiums do not happen like clockwork.  They do not give the same premium every year, and some years they give no premium and actually underperform.  For instance, even though we know the stock market out performs Treasury Bills over the long term by a generous amount, we know that there are years when stocks lose money and underperform T-Bills.  Likewise, each of the premiums mentioned above, in any given year, is not guaranteed to produce its premium.  However, the longer the time frame used, the more likely it will be for that premium to occur. 

As you can see in Exhibit 1 above, even during periods of 10 years there is not a 100% guarantee that these premiums will be experienced.  However, we can gain perspective by viewing many 10 year periods in a row.  Each bar on the below charts represents a 10 year period ending on that year. 

As you can see in Exhibit 2 above, each red bar represents a 10 year rolling period where an expected premium did not occur.  These periods of underperformance occur in cycles that cannot be predicted.  Currently, an underperformance is being experienced with the Value premium.  We think you would agree that the worst possible time to turn away from owning Value would be now, after this premium has underperformed for several 10 year rolling periods.

So what does all this have to do with a warm puppy?

All investors have certain expectations about their portfolio’s performance.  During certain periods of time, even for periods of 10 years and longer, expectations we have about certain asset classes and the premiums we should be earning will undoubtedly not be met.  This is simply the nature of equity markets.  If expectations are not properly based on valid perceptions of what is and is not possible during market cycles, there is a risk that we react in a way which is contrary to our goal of growing our portfolios in a highly efficient manner.  Becoming impatient reacting by changing your portfolio merely because of faulty perceptions has the potential of defeating a very sound long term investment plan. 

The goal is to fully realize that there will be times when proven equity premiums do not meet our expectations, and understanding that these periods are certain to occur over time and are part of the long term investor’s journey.  When that is accomplished, we will be able to have those warm and fuzzy feelings for all the right reasons, and not end up behaving in a way that will potentially dampen our long term goals and objectives. 

Third Quarter 2018 Asset Class Returns

The third quarter had the strongest equity returns of the year.  Both US Large and Small Caps have experienced double digit returns year-to-date, with Value lagging behind Core/Growth.  Real Estate and Income asset classes, except for long term maturities, eked out fractionally positive return for the quarter.  However, all Income asset classes had negative YTD returns.  International equities had either low single digit positive or negative returns for the quarter, and all have experienced negative YTD returns. 

Strong economic growth and new highs for US Large Cap indexes contrast with what is happening in most other foreign markets.  The quarter marks 9 ½ years of the current US bull market, the longest on record.  In addition to strong economic growth and continuing low unemployment, corporate earnings have been assisted by the Trump corporate tax reduction, as discussed in the last newsletter.  But with this continuing growth, there has been a gradual increasing of interest rates.  The Federal Reserve increased the discount rate in late September, and has signaled the probability of another in December.

As can be seen in the comparison of yield curves above, current interest rates (top curve) are showing a dramatic flattening compared to the steep curve seen a few years ago.  As the Fed continues to increase the discount rate, many market observers are expecting a complete flattening of the curve, with some even guessing an inverted curve could occur.  This means short term yields could reach higher levels than mid and longer term rates.  An inverted yield curve has been deemed by some to be a precursor to a recession.  However, it is far too early to make those types of guesses, especially when economic growth is at its current high level.

While Mexico and Canada have come to terms with the Trump Administration’s demand for changes in the North American Free Trade Agreement, China is showing no such action in its trade discussions with the US.  More than $200 Billion in trade is currently effected, with potentially much more.  This continues to be one of the question marks and major bricks in the wall of worry that investors must scale in order to remain confident about the potential for further economic expansion. 

Lastly, much importance is being made about the midterm US Senate and House elections to be held in November.  It appears as though Democrats have a good chance of controlling the House, while Republicans will remain in control of the Senate.  Whether this will have any effect on the stock market is questionable.  All of this information is known by market participants, and it does not seem to be of major importance at this time. 

No doubt, by year end we will have greater visibility regarding interest rates and   midterm election results.  The financial markets will have already reacted to these events and given further evidence of the issues it deems to be important for 2019.  In the meantime, all of us at DHG Wealth Advisors hope you and your family get to celebrate and enjoy the upcoming holidays together!

Sincerely,

Frederick F. Kramer IV, JD
Co-Chief Investment Office

Attachments

  1. 3Q18InvestmentNewsletter.pdf 10/11/2018 10:26:41 AM