Executive Summary
Global portfolios had a poor showing this quarter and year to date, although through the 3rd quarter of 2018 U.S. Large Cap Growth stocks have been a bright spot. However, U.S. Large Cap Growth has experienced a weak October so far. Even though the S&P 500 has done much better than a global equity portfolio since the great financial crisis of 2009, over longer periods of time a globally diversified portfolio performs better (higher return with less volatility). This is obviously important because your time horizon of a lifetime is a (hopefully) long period that spans multiple business and market cycles. We have three important illustrations to emphasize the long term power of global portfolios with a value factor tilt.
Illustration 1
Illustration 2
In addition to poor global returns, the value factor premium, which historically offers more than 3% per year over growth is now negative for the past 10 years (growth stocks have outperformed value stocks over the past 10 years). The value premium was first identified by Graham and Dodd in 1934 and is based on the discovery that companies with low price to book ratios (value) historically provide a higher long term rate of return than companies with high price to book ratios (growth). The value factor has been well researched and there is strong consensus of its validity. Is this recent time period different? Is something new taking place where the value premium is no longer relevant? We don’t believe so. The timing of when value or growth stock will do “best” cannot be predicted. We recently sent a note to everyone on how strong portfolio discipline is needed to capture the long-term premium associated with the value factor: https://www.laketahoewealthmanagement.org/news-notes/2018/8/20/the-importance-of-portfolio-management-discipline
Illustration 3
Concerns from business leaders regarding international trade disputes have been ever present in the news. While we are seeing some progress on trade deals with Mexico and Canada, which still must get through congress, the focus is on trade with China. Discussions between the United States and China have yielded little in positive results and have even become acrimonious. We are not likely going to see a jump in international developed and emerging market stocks until a trade deal is reached with China, or the impacts are fully understood. This also cannot be timed.
The current U.S. economic expansion is the second longest in U.S. history. It started in June 2009 and if the expansion continues until next summer, at 121 months (through July), it will break the record that was set during the 1990s tech boom. U.S. unemployment, wages and GDP growth all look very positive. While a new record expansion does look likely, the threat of inflation could cause the Fed to raise rates faster than anticipated. In October, the 10-year and 30-year treasury yield has pushed through strong resistance levels to new highs, which has steepened the yield curve. If long term interest rates don’t rise too quickly, a steeper yield curve is positive for the economy.
Given this backdrop, along with the recent (as of 10/11/2018) U.S. stock market volatility, we would like to share the following words of wisdom with you:
Beware of Behavioral Finance errors. Avoid “herding” (the fear of missing out that drives us to do what others around us are doing with their investments) and “loss aversion” (the fear of loss because an investment loss provides more emotional anguish than the emotional elation provided by investment gains….in other words, you don’t sell during market declines!). Avoid the “swing for the fence” mentality of attempting to outguess the markets with active stocks, especially concentrated positions. Do not attempt market timing or chasing the best past performing asset class, as these actions are proven through research to lead to significant underperformance relative to the benchmark. Here is a recent analysis of active vs. passive funds, which concludes the odds of finding a consistently strong active mutual fund are so low, it is a loser’s game to pursue that strategy: https://www.etf.com/sections/index-investor-corner/swedroe-persistence-hard-come
Hold a globally diversified portfolio. Global diversification broadens the investment universe, allowing you to capture returns wherever they occur in the world. Holding just the S&P 500 may not be enough to manage overall risk (remember the S&P 500 was down 52% through the Great Recession); and the popular index suffered a “lost decade” from 2000-2009 (average annual return during the decade of -0.95%, including dividends). International equities did much better during the S&P 500 lost decade, as seen in Illustration 2 above. Notice the cyclical nature of U.S. to international stock relative performance and how long we have been in the latest trend of U.S. stock out performance. That trend is highly likely to reverse at some point and, given relative valuations, it appears it could happen very soon.
Use “Factor Tilts” in your portfolio. You must stay disciplined and maintain the portfolio factor tilts over time in order to capture the factor related excess returns. The factor tilts have been researched extensively and the evidence shows that these tilts have worked well over many business cycles. The primary factors we use include Value, Size, and Profitability. These factors have proven to be persistent in all climates over time and pervasive in all equity asset classes over time. A visual example of excess returns from a factor tilt (in this case the Value factor) is located above in Illustration 3.
Take advantage of proven strategies to increase returns. These include active rebalancing and portfolio asset location. The rebalancing process helps you avoid emotional decisions during times of volatility. Instead of reacting to news or market swings, you already have your strategy in place no matter what the markets do. Portfolio asset location adds value by placing tax efficient assets in taxable accounts, tax inefficient assets in tax deferred accounts, and more aggressive asset classes in tax free accounts, leading to reduced tax costs over time.
Focus on what you can control. This includes having a comprehensive financial plan tied to goals and sticking to that plan by maintaining spending and savings discipline.
We help you do all the above through our financial planning process, portfolio management discipline, and behavioral finance coaching. If you have any questions regarding your financial plan or portfolio, or if you feel any anxiety based on the news or market activity, please contact your LTWM Financial Planner.
For those who want to dive deeper into our market and economic commentary:
World Asset Class 3rd Quarter 2018 Index Returns
Third quarter index returns were very strong for U.S. stocks (although that trend has reversed thus far in October); and index returns were below average for global real estate, U.S. and global bonds, and international developed and emerging market stocks. It is important to note that “market” encompasses many asset classes, not just the U.S. Large Cap stocks we see reported in the nightly news. Emerging market stocks remain challenged as a result of the trade tariffs implemented, since emerging economies are much more reliant on export trade. The current trade tariff actions are affecting capital flows in multiple asset classes due to the uncertainty around how the current tariffs, and potential additional tariffs, will affect corporate profits.
A larger sample of world asset class returns shows the strength of U.S. large cap and small cap stocks; and large cap stocks were stronger than small cap stocks (Russell 1000 LC index up 7.42%, Russell 2000 SC index up 3.58%). U.S. stocks out-performed international developed and emerging market stocks during the third quarter. REITs under-performed stocks.
Here are additional details for the U.S. stock market, which had the highest returns for the quarter. Large growth was ahead of large value and small growth was ahead of small value.
If we look back over the past 10 years, the value premium has been negative as large and small growth have outperformed large and small value. This is unusual, and the trend has extended for a very long time, which is a sound reason to maintain portfolio discipline as the trend is likely to reverse.
Bond market values around the world were mixed due to a parallel shift up in the yield curve. Notice how similar the increase in rates is across all bond maturities.
During the third quarter, the yield on the 5-year Treasury note rose 21 basis points (bps), ending at 2.94%. The yield on the 10-year Treasury note increased 20 bps to 3.05%. The 30-year Treasury bond yield rose 21 bps to finish at 3.19%. The Fed has raised the overnight lending rate another 0.25% this past quarter, from 2% to 2.25%, and the Fed is expected to raise the rate another quarter point before year end.
Here is a look at fixed income returns:
Notice the high yield bond sector is still performing well over the past quarter and the past year, a sign of economic strength. As rates rise at the short end, it helps savers earn a higher return, providing confidence and more purchasing power.
Unemployment is at a new low of 3.8%, last seen in 1969. This is positive for consumer spending and its impact on higher GDP growth. The housing market is showing signs of slowing down with price declines in the most expensive locations and sizeable declines in home building stock values. (The chart below is from Bureau of Labor Statistics):
One cannot time markets and the short-term news cycle is just noise. Our advice is not to react emotionally to markets and the news cycle. Maintaining a long-term focus is critical for your success as an investor. Here is a sample of how the global stock market responded to headlines news during the third quarter (notice the insert of the second graph that compares the last 12 months to the long term):
CONCLUSION
The third quarter jump in U.S. large cap stocks valuations was impressive; but concerns regarding high valuations for growth stocks seem to be coming to the forefront in October. We view any pullback in U.S. stock valuations as healthy given the current lofty valuations. International and emerging market stocks have improved valuations. We are closely watching bond markets for any increase in credit spreads, increasing short term rates that may attract capital flows out of stocks and into bonds, and/or a yield curve inversion or spike in interest rates that could cause a deeper stock correction. So far in October, the fixed income markets are behaving well, but the S&P 500 volatility index, known as the VIX has spiked (showcasing the importance of a diversified portfolio that tempers volatility).
We recommend adhering to our five points outlined above and to the investment strategy that has always been in place as this strategy is not reactionary and has been built on a foundation of empirical evidence from rigorous research instead of the shaky foundation of emotional reactions and crystal ball prognostications. In other words, be proactive with a plan in place as opposed to emotionally reactive.
Standardized Performance Data and Disclosures
Russell data © Russell Investment Group 1995-2017, all rights reserved. Dow Jones data provided by Dow Jones Indexes. MSCI data copyright MSCI 2017, all rights reserved. S&P data provided by Standard & Poor’s Index Services Group. The BofA Merrill Lynch Indices are used with permission; © 2017 Merrill Lynch, Pierce, Fenner & Smith Inc.; all rights reserved. Citigroup bond indices copyright 2017 by Citigroup. Barclays data provided by Barclays Bank PLC. Indices are not available for direct investment; their performance does not reflect the expenses associated with the management of an actual portfolio.
Past performance is no guarantee of future results. This information is provided for educational purposes only and should not be considered investment advice or a solicitation to buy or sell securities. Diversification does not guarantee investment returns and does not eliminate the risk of loss.
Investing risks include loss of principal and fluctuating value. Small cap securities are subject to greater volatility than those in other asset categories. International investing involves special risks such as currency fluctuation and political instability. Investing in emerging markets may accentuate these risks. Sector-specific investments can also increase these risks.
Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, liquidity, prepayments, and other factors. REIT risks include changes in real estate values and property taxes, interest rates, cash flow of underlying real estate assets, supply and demand, and the management skill and creditworthiness of the issuer.
Principal Risks:
The principal risks of investing may include one or more of the following: market risk, small companies risk, risk of concentrating in the real estate industry, foreign securities risk and currencies risk, emerging markets risk, banking concentration risk, foreign government debt risk, interest rate risk, risk of investing for inflation protection, credit risk, risk of municipal securities, derivatives risk, securities lending risk, call risk, liquidity risk, income risk. Value investment risk. Investing strategy risk. To more fully understand the risks related to investment in the funds, investors should read each fund’s prospectus.
Investments in foreign issuers are subject to certain considerations that are not associated with investment in US public companies. Investment in the International Equity, Emerging Markets Equity and the Global Fixed Income Portfolios and Indices will be denominated in foreign currencies. Changes in the relative value of these foreign currencies and the US dollar, therefore, will affect the value of investments in the Portfolios. However, the Global Fixed Income Portfolios and Indices may utilize forward currency contracts to attempt to protect against uncertainty in the level of future currency rates (if applicable), to hedge against fluctuations in currency exchange rates or to transfer balances from one currency to another. Foreign Securities prices may decline or fluctuate because of (a) economic or political actions of foreign governments, and/or (b) less regulated or liquid securities markets.
The Real Estate Indices are each concentrated in the real estate industry. The exclusive focus by Real Estate Securities Portfolios on the real estate industry will cause the Real Estate Securities Portfolios to be exposed to the general risks of direct real estate ownership. The value of securities in the real estate industry can be affected by changes in real estate values and rental income, property taxes, and tax and regulatory requirements. Also, the value of securities in the real estate industry may decline with changes in interest rate. Investing in REITS and REIT-like entities involves certain unique risks in addition to those risks associated with investing in the real estate industry in general. REITS and REIT-like entities are dependent upon management skill, may not be diversified, and are subject to heavy cash flow dependency and self-liquidations. REITS and REIT-like entities also are subject to the possibility of failing to qualify for tax free pass through of income. Also, many foreign REIT-like entities are deemed for tax purposes as passive foreign investment companies (PFICs), which could result in the receipt of taxable dividends to shareholders at an unfavorable tax rate. Also, because REITS and REIT-like entities typically are invested in a limited number of projects or in a particular market segment, these entities are more susceptible to adverse developments affecting a single project or market segment than more broadly diversified investments. The performance of Real Estate Securities Portfolios may be materially different from the broad equity market.
Fixed Income Portfolios:
The net asset value of a fund that invests in fixed income securities will fluctuate when interest rates rise. An investor can lose principal value investing in a fixed income fund during a rising interest rate environment. The Portfolio may also be affected by: call risk, which is the risk that during periods of falling interest rates, a bond issuer will call or repay a higher-yielding bond before its maturity date; credit risk, which is the risk that a bond issuer will fail to pay interest and principal in a timely manner.
Risk of Banking Concentration:
Focus on the banking industry would link the performance of the short term fixed income indices to changes in performance of the banking industry generally. For example, a change in the market’s perception of the riskiness of banks compared to non-banks would cause the Portfolio’s values to fluctuate.
The material is solely for informational purposes and shall not constitute an offer to sell or the solicitation to buy securities. The opinions expressed herein represent the current, good faith views of Lake Tahoe Wealth Management, Inc. (LTWM) as of the date indicated and are provided for limited purposes, are not definitive investment advice, and should not be relied on as such. The information presented in this presentation has been developed internally and/or obtained from sources believed to be reliable; however, LTWM does not guarantee the accuracy, adequacy or completeness of such information.
Predictions, opinions, and other information contained in this presentation are subject to change continually and without notice of any kind and may no longer be true after the date indicated. Any forward-looking statements speak only as of the date they are made, and LTWM assumes no duty to and does not undertake to update forward-looking statements. Forward-looking statements are subject to numerous assumptions, risks and uncertainties, which change over time. Actual results could differ materially from those anticipated in forward looking statements. No investment strategy can guarantee performance results. All investments are subject to investment risk, including loss of principal invested.
Dimensional Equity Balance Strategy Index Description
Rebalanced monthly. The Dimensional Equity Balanced Strategy Index is comprised of commercial and Dimensional indices, 70% US equity indices, and 30% non-US indices. US: S&P 500, large cap value, small cap, small cap value, Dow Jones REIT; non-US: international value, international small cap and small cap value, emerging markets, and emerging markets value and small cap. Additional index information is available upon request.
Real Estate Strategy weighting allocated evenly between US Small Cap and US Small Cap Value prior to January 1978 data inception.
International Value weighting allocated to Fama/French International Value Index prior to January 1994 data inception, and evenly between International Small Cap and MSCI EAFE Index (net dividends) prior to January 1975 data inception. International Small Cap Value weighting allocated to International Small Cap prior to July 1981 data inception.
Emerging Markets weighting allocated to MSCI Emerging Markets Index (gross dividends) prior to January 1994 data inception, and evenly between International Small Cap and International Value prior to January 1988 data inception.
Emerging Markets Value and Small Cap weighting allocated evenly between International Small Cap and International Value prior to January 1989 data inception. Two-Year Global weighting allocated to One-Year prior to January 1985 data inception.
For illustrative purposes only. The balanced strategies are not recommendations for an actual allocation.
Indices are not available for direct investment; their performance does not reflect the expenses associated with the management of an actual portfolio.
Rebalanced monthly. All performance results of the balanced strategies are based on performance of indices with model/back-tested asset allocations; the performance was achieved with the benefit of hindsight; it does not represent actual investment strategies. The model’s performance does not reflect advisory fees or other expenses associated with the management of an actual portfolio. There are limitations inherent in model allocations. In particular, model performance may not reflect the impact that economic and market factors may have had on the advisor’s decision making if the advisor were actually managing client money.
Past performance is no guarantee of future results.
Description of Dimensional Indices:
Dimensional US Large Cap Value Index is compiled by Dimensional from CRSP and Compustat data. Targets securities of US companies traded on the NYSE, NYSE MKT (formerly AMEX), and Nasdaq Global Market with market capitalizations above the 1,000th-largest company whose relative price is in the bottom 30% of the Dimensional US Large Cap Index after the exclusion of utilities, companies lacking financial data, and companies with negative relative price. The index emphasizes securities with higher profitability, lower relative price, and lower market capitalization. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. Exclusions: non-US companies, REITs, UITs, and investment companies. The index has been retroactively calculated by Dimensional and did not exist prior to March 2007. The calculation methodology for the Dimensional US Large Cap Value Index was amended in January 2014 to include direct profitability as a factor in selecting securities for inclusion in the index. Prior to January 1975: Targets securities of US companies traded on the NYSE, NYSE MKT (formerly AMEX), and Nasdaq Global Market with market capitalizations above the 1,000th-largest company whose relative price is in the bottom 20% of the Dimensional US Large Cap Index after the exclusion of utilities, companies lacking financial data, and companies with negative relative price.
Dimensional US Small Cap Index was created by Dimensional in March 2007 and is compiled by Dimensional. It represents a market-capitalization-weighted index of securities of the smallest US companies whose market capitalization falls in the lowest 8% of the total market capitalization of the Eligible Market. The Eligible Market is composed of securities of US companies traded on the NYSE, NYSE MKT (formerly AMEX), and Nasdaq Global Market. Exclusions: Non-US companies, REITs, UITs, and investment companies. From January 1975 to the present, the index also excludes companies with the lowest profitability and highest relative price within the small cap universe. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. Source: CRSP and Compustat. The index monthly returns are computed as the simple average of the monthly returns of 12 sub-indices, each one reconstituted once a year at the end of a different month of the year. The calculation methodology for the Dimensional US Small Cap Index was amended on January 1, 2014, to include profitability as a factor in selecting securities for inclusion in the index.
Dimensional US Small Cap Value Index is compiled by Dimensional from CRSP and Compustat data. Targets securities of US companies traded on the NYSE, NYSE MKT (formerly AMEX), and Nasdaq Global Market whose relative price is in the bottom 35% of the Dimensional US Small Cap Index after the exclusion of utilities, companies lacking financial data, and companies with negative relative price. The index emphasizes securities with higher profitability, lower relative price, and lower market capitalization. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. Exclusions: non-US companies, REITs, UITs, and investment companies. The index has been retroactively calculated by Dimensional and did not exist prior to March 2007. The calculation methodology for the Dimensional US Small Cap Value Index was amended in January 2014 to include direct profitability as a factor in selecting securities for inclusion in the index. Prior to January 1975: Targets securities of US companies traded on the NYSE, NYSE MKT (formerly AMEX), and Nasdaq Global Market whose relative price is in the bottom 25% of the Dimensional US Small Cap Index after the exclusion of utilities, companies lacking financial data, and companies with negative relative price.
Dimensional International Marketwide Value Index is compiled by Dimensional from Bloomberg securities data. The index consists of companies whose relative price is in the bottom 33% of their country’s companies after the exclusion of utilities and companies with either negative or missing relative price data. The index emphasizes companies with smaller capitalization, lower relative price, and higher profitability. The index also excludes those companies with the lowest profitability and highest relative price within their country’s value universe. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. Exclusions: REITs and investment companies. The index has been retroactively calculated by Dimensional and did not exist prior to April 2008. The calculation methodology for the Dimensional International Marketwide Value Index was amended in January 2014 to include direct profitability as a factor in selecting securities for inclusion in the index.
Dimensional International Small Cap Index was created by Dimensional in April 2008 and is compiled by Dimensional. July 1981–December 1993: It Includes non-US developed securities in the bottom 10% of market capitalization in each eligible country. All securities are market capitalization weighted. Each country is capped at 50%. Rebalanced semiannually. January 1994–Present: Market-capitalization-weighted index of small company securities in the eligible markets excluding those with the lowest profitability and highest relative price within the small cap universe. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. The index monthly returns are computed as the simple average of the monthly returns of four sub-indices, each one reconstituted once a year at the end of a different quarter of the year. Prior to July 1981, the index is 50% UK and 50% Japan. The calculation methodology for the Dimensional International Small Cap Index was amended on January 1, 2014, to include profitability as a factor in selecting securities for inclusion in the index.
Dimensional International Small Cap Value Index is defined as companies whose relative price is in the bottom 35% of their country’s respective constituents in the Dimensional International Small Cap Index after the exclusion of utilities and companies with either negative or missing relative price data. The index also excludes those companies with the lowest profitability within their country’s small value universe. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. Exclusions: REITs and investment companies. The index has been retroactively calculated by Dimensional and did not exist prior to April 2008. The calculation methodology for the Dimensional International Small Cap Value Index was amended in January 2014 to include direct profitability as a factor in selecting securities for inclusion in the index. Prior to January 1994: Created by Dimensional; includes securities of MSCI EAFE countries in the top 30% of book-to-market by market capitalization conditional on the securities being in the bottom 10% of market capitalization, excluding the bottom 1%. All securities are market-capitalization weighted. Each country is capped at 50%; rebalanced semiannually.
Dimensional Emerging Markets Index is compiled by Dimensional from Bloomberg securities data. Market-capitalization-weighted index of all securities in the eligible markets. The index has been retroactively calculated by Dimensional and did not exist prior to April 2008.
Dimensional Emerging Markets Value Index is compiled by Dimensional from Bloomberg securities data. The index consists of companies whose relative price is in the bottom 33% of their country’s companies after the exclusion of utilities and companies with either negative or missing relative price data. The index emphasizes companies with smaller capitalization, lower relative price, and higher profitability. The index also excludes those companies with the lowest profitability and highest relative price within their country’s value universe. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. Exclusions: REITs and investment companies. The index has been retroactively calculated by Dimensional and did not exist prior to April 2008. The calculation methodology for the Dimensional Emerging Markets Value Index was amended in January 2014 to include profitability as a factor in selecting securities for inclusion in the index. Prior to January 1994: Fama/French Emerging Markets Value Index.
Dimensional Emerging Markets Small Cap Index was created by Dimensional in April 2008 and is compiled by Dimensional. January 1989–December 1993: Fama/French Emerging Markets Small Cap Index. January 1994–Present: Dimensional Emerging Markets Small Index Composition: Market-capitalization-weighted index of small company securities in the eligible markets excluding those with the lowest profitability and highest relative price within the small cap universe. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. The index monthly returns are computed as the simple average of the monthly returns of four sub-indices, each one reconstituted once a year at the end of a different quarter of the year.
Source: Bloomberg. The calculation methodology for the Dimensional Emerging Markets Small Cap Index was amended on January 1, 2014, to include profitability as a factor in selecting securities for inclusion in the index.
Lake Tahoe Wealth Management, Inc.is a Registered Investment Advisory Firm with the Securities Exchange Commission.
