Over the last few months, the financial sector has experienced prosperity, decline and only one thing has been constant — that nothing seems to be constant. We all experience the anxiety that comes with not knowing what comes next. Our clients have been asking great questions lately, running the gamut in topics from the current geo-political climate to economic conditions to investing fundamentals. Trust Company’s CIO, Dan Tolomay, has compiled some of our most frequently asked questions and responses for you below.
The COVID-19 cases keep rising. What does this mean for the economy and the markets?
Different states took different approaches to shutting down and re-opening. Those that rushed to re-open learned the hard way that they should have listened to the medical experts. Increasingly, the policy response has fallen on state and local leaders. Hopefully, they will learn from areas that have had success containing the virus.
There is a risk of more shutdowns, which would be effective at slowing the virus but would harm the economy. It is interesting to see capitalism at work. In a relatively short-time frame, we’ve learned to conduct virtual business and education, shop at (without entering) brick-and-mortar stores, and interact when necessary with the help of masks, shields, and sanitizer. The transition isn’t easy; but, over time, companies innovate and adapt, and conditions improve. The incentive to provide solutions and make profits drives these companies. These same reasons drive the continued search for a vaccine.
Many have been confounded by the rise in the markets at a time of increased Coronavirus cases. There are two things to remember with markets: (1) they are efficient at processing new information and adjusting prices accordingly and (2) they are forward looking. The news seems bad, yes. But, if it’s not as bad as macro expectations, that’s a positive. Also, the focus is not on the economic damage done or cases reported but future prospects and containment. The markets were blindsided with COVID but now deal with a known enemy. Each day we learn more and are closer to its exhaustion.
What’s the latest on value vs. growth stocks? Has TCTS made any changes?
A component of our investment philosophy is that we expect stocks trading at lower relative prices to have higher returns than names where valuations are higher. This is not a guarantee, though. We have been in a period of growth out-performance. While we believe in value long-term, we also have tactical reasons to be optimistic.
At the end of 2019, growth stocks were trading at 8.17x book value (vs. 5.10x average) while value traded at 2.14x book value (vs. 2.06x average). As there is a tight relationship between valuations and subsequent return, value had the better outlook.
The market sold off from 2/19/20 to 3/23/20. At the end of March, growth had fallen to 7.12x while value dropped to 1.60x. After the selloff, growth was cheaper but still expensive. Value became even more attractive. Fast forward to June 30th and growth and value were at 10.98x and 2.05x, respectively. The continued value lag has been frustrating, but we are more ardent than before.
With the headlines reminding us of value’s under-performance, it helps to put a value tilt in perspective. For example, for the 12 months ended June 30, 2020, the Russell 3000 Growth Index returned 22% while the Russell 3000 Value index delivered -9%, a variance of 31%. This gap is eye-opening but was not likely realized by many.
The market is roughly split between value and growth, so the return would have been 6.5%. An all value portfolio would have lagged by -15.5%. Not good, but not as bad as -31%. Compare that to a value tilt of say, 60% value and 40% growth. The return on that portfolio would be 3.4% and lagged the market by only 3.1%.
Why should I hold international stocks?
International stocks, represented by the MSCI All Country World Index (ACWI) ex US, have underperformed U.S. stocks in 8 of the last 10 years. But, how many of those years was the United States the top performer? Zero. Its best showing was 2013 when it placed 3rd (behind Finland and Ireland). Better returns will likely come from a country outside the U.S., but we don’t know which one(s).
So, what do we do? Own them all. As Jack Bogle, the founder of Vanguard said, “rather than look for the needle in the haystack, buy the haystack”. If we can’t identify the winners in advance, owning all the options gives us at least some exposure to the winners. Unfortunately, we also get some exposure to the losers. But research can help us optimize.
About half of the global investable stock market is international, which is a big opportunity set. Historically, investors have reduced their volatility the most by holding 30-35% of their equities abroad. Doing so ensures exposure to the best performer and should make an all domestic stock portfolio’s ride less bumpy.
Over the past 21 years, the US has won 11 times and foreign shares have been on top 10 times. At the beginning of 2008, when international triumphed six years in a row, one might have asked “why own US stocks?”. While it’s not known when the tide will turn, we know it will at some point. As valuations are more attractive beyond our shores, it’s a good time to buy low and sell high.
What moves should I be making ahead of the election?
As is the case with every election, anxiety rises. And, whether the worry is four more years or a change in control, the answer is the same – accept it is out of your control. There are reasons to feel reassured: checks and balances and mid-term elections.
In our current situation, one party controls the White House and Senate while another party controls the House. This can lead to frustrating gridlock, but it also prevents major policy changes. Should one party gain control of all three chambers, there are still items that prevent upheaval. One is the presence of the other party and moderates. The fringe elements garner the headlines, but there has to be consensus buy-in to implement changes. Lastly, even if one party begins radical changes, mid-term elections are only two years away.
It is not recommended that portfolio changes be made in anticipation of the election. First, what seems certain may not materialize (ex. 2016 presidential election, Brexit, etc.). Second, markets efficiently process new situations such that trying to outsmart global investors’ collective wisdom is futile. Lastly, much like the COVID situation, companies adapt to profit. In the face of tax changes, regulation revamps, tariffs, etc., firms modify their actions for survival and success.
If the government’s actions cause the dollar to weaken, what does that mean for my portfolio?
If government spending and monetary stimulus from the Federal Reserve increases inflation and the Fed holds down interest rates, there could be downward pressure on the U.S. dollar. There are multiple ways that this could impact one’s investments.
U.S. multinationals would benefit as American goods would become less expensive overseas. Also, when foreign sales are repatriated back to the States, there would be a benefit as the foreign currency would buy more dollars. International stocks would face the reverse situation. But, a U.S. investor would benefit as shares of foreign companies, which are denominated in other currency, could appreciate as the dollar declines.
A weak dollar is inflationary to Americans. Foreign goods become more expensive as the dollar falls. Higher inflation expectations tend to push up interest rates as bondholders seek to earn a positive return after inflation. Higher yields would push down bond prices. Inflation would force the Fed to take a more restrictive posture, which would likely mean higher short-term rates and better yields on money market vehicles.
How can the U.S. remain stable if it keeps running deficits?
The government spending more than it takes in is nothing new. However, a renewed focus has been placed on its finances in the wake of the COVID-19 response. Tax revenues are down and spending is up due to stimulus (and potentially more to come). What’s more, many states and cities are also experiencing financial strain, which has been exacerbated by the pandemic.
States are not able to routinely issue debt; so, they cannot finance ongoing deficits. If the books need to be balanced, revenues must rise and/or expenditures must fall. Such moves would be restrictive, not stimulative, at a time when economies are shaky. As such, the Federal government may have to step in.
Additional spending would need to be financed. Thankfully, rates are currently very low, which will ease the burden. Also in the government’s favor is the fact that American rates are higher than many other nations. As a result, finding buyers of our debt should be easier.
Eventually, the bill will come due. Taxes will need to rise and/or spending will need to fall. If steps are not taken, we’d expect to see buyers of Treasury debt perceive the U.S. as less creditworthy. This would take the form of a higher required return. So far, we have not seen that dynamic play out.
Why would I want to hold bonds at today’s low interest rates?
There is a great visual from Vanguard that shows the close relationship between the current 10-year U.S. Treasury yield and the subsequent decade’s return for high quality fixed income. That number is below 0.75% today. Does it make sense to hold bonds?
The two main roles that bonds play are to generate income and dampen equity volatility. There’s not much income to speak of today. Rather than chase yield in lower quality or longer maturity bonds, more equity might be the answer. The dividend yield on stocks is close to 2% today. So, an investor could collect the higher yield, have exposure to potentially rising dividends, and have the possibility of capital appreciation as well.
This move is not without risk, though. Dividends can be cut and share prices can fall. So, increasing equity exposure should not exceed one’s ability or willingness to bear risk. If volatility reduction is sought, equities and riskier bonds are not the answer. High quality bonds provide stability and a better yield than cash (0.08% currently). Further, the Fed has been clear that short-term rates (which drive money market yields) are to remain low for some time.
Being smart about a bond allocation can improve results. For example, risk should be sought when compensation for bearing that risk is offered. For example, if bonds, which have greater risk, yielded the same as cash, why would you own bonds? Alternatively, if a lower quality bond doesn’t pay more than a high quality issue, why take the risk? Diversifying across maturities and geographies can lower volatility and improve returns by expanding the opportunity set.
We’ve had quite a run from 2009, aren’t we due for a downturn? Should I reduce risk?
Making investment decisions based on past performance or hunches is not wise. Rather, the questions to ask pertain primarily to: required return, risk tolerance, and time horizon. If your portfolio has performed better than hoped, you may be able to de-risk as you don’t need to target the same level of return. Similarly, if your personal situation has changed that you are not willing or able to tolerate as much risk, a change may be in order. Last, as the time until your goal nears, it can make sense to lower your risk and return profile as there’s less time to recover from a market dip.
If no changes are necessary, stick to the controllable and fundamental: diversify, target areas of the market where valuations are more attractive and risk is being compensated, and minimize costs.
As Chief Investment Officer, Dan is responsible for developing Trust Company’s investment strategy and managing client portfolios.