by Brad M. Weafer, CFA | Chief Investment Officer
Click Video Below for Quarterly Update
Key Points
- Both bonds and stocks posted negative returns in Q3, but balanced portfolios have delivered solid returns year-to-date
- Cyclical investment risk rises during late-cycle environments like we are experiencing today
- We currently have lower exposure to equities than normal and see increased value in our focus on owning high-quality companies given the economic backdrop
Third Quarter Results
Though both stocks and bonds experienced negative performance in Q3, the resilience of the global economy has supported financial markets and delivered positive returns for the first nine months of 2023 (see graphic below). Even with a decline of 3.3% in the third quarter, U.S. large stocks (as measured by the S&P 500 index) have still returned over 13% for the year. The index continues to be led by the very largest companies, predominantly technology related. Small cap stocks lagged their larger peers again, finishing September up only 2.5% for the year. International stocks also fell this quarter, now up 7.6% for the year. In fixed income, rising interest rates continue to weigh on bond prices. The primary bond benchmark (the Bloomberg U.S. Aggregate) declined 3.2% in the quarter, with a negative 1.2% return for the year. Fortunately, equities have performed strongly enough to deliver attractive returns for balanced portfolios this year. A portfolio of 60% global stocks and 40% bonds has appreciated almost 6% thus far in 2023.
Performance for select asset classes as of 9/30/2023
Data Source: Bloomberg. U.S. Large Cap represented by the S&P 500 TR Index, U.S. Small Cap by the Russell 2000 TR Index, International Developed by the MSCI EAFE TR Index, International Emerging by the MSCI EM TR Index, U.S. Agg Bond by the Bloomberg U.S. Aggregate Bond TR Index, Global 60/40 by 60% MSCI ACWI and 40% Bloomberg U.S. Treasury Index.
The Cycles of Investing
Investment performance varies across asset class categories (like stocks and bonds) over time, and is correlated with the different phases of the business cycle. We attempt to capitalize on these ups and downs by managing our portfolio exposures to different asset classes based on where we are in that cycle. Without attempting to time the tops and bottoms of highly volatile markets, a business cycle approach to asset allocation can add value to balanced portfolio returns. Business cycles are never the same, but often they follow similar paths and exhibit comparable characteristics that we can draw historical inferences from.
Consider the traditional path in its most basic form. As economic growth increases, the environment for corporate profit growth improves, supporting positive outcomes for risk assets like equities. Investor sentiment follows a similar path, increasing as investors expect the good times to continue well into the future. At some point, higher expectations become harder to match and stock strength becomes harder to achieve. Growth too, eventually, reaches a peak as the business cycle matures, often consistent with inflationary pressures. Traditionally, at this point in the cycle monetary policymakers try to slow the economy, keeping price pressures in check. Ultimately, that helps slow the growth rate of the economy, profits come under pressure, and stock prices follow the direction of that lower rate of profit advance. When that slowing growth turns to outright declines in a recession, corporate profits are diminished and stocks typically experience their worst drawdowns. At the depth of these recessions, investors lose hope, valuations are low, and expectations for profit growth are non-existent. At these nadirs, even nascent signs things are less bad begin to support improvement in prices and the cycle starts anew. Monetary policy moves to spur growth at these points as central banks loosen financial conditions, supporting markets. Coming off lower levels of profitability, earnings growth is often strongest in this earliest part of the economic expansion and stocks earn their highest returns.
Asset Class Performance by Market Cycle Phase
Fidelity Institutional Insights, “The Business Cycle Approach to Asset Allocation”. Past performance is no guarantee of future results. Asset class total returns represented by indexes from Fidelity Investments, GFD, and Bloomberg Barclays. Fidelity Investments proprietary analysis of historical asset class performance is not indicative of future performance. Source: Bloomberg Barclays, Fidelity Investments (AART), as of March 31, 2021.
Hopefully this approach makes intuitive sense, but a review of historical returns drives the point home even further. Fidelity recently performed an analysis evaluating the annual performance of U.S. stocks, bonds, and cash from 1950 to 2020. As you can see in the figure below, the dispersion of returns between the different economic phases highlights the value created by shifting weights to different asset classes through the cycle. In general, growth-oriented and more volatile asset classes like stocks do best when the economy is accelerating, and lower risk assets like bonds and cash perform better following the peak of growth as the economy moves toward contraction.
Phases of the Market Cycle
Defense Wins Championships
The renowned college football coach Paul ‘Bear’ Bryant was quoted as saying, “Offense sells tickets, defense wins championships”. This axiom holds just as true in investing as it does in football. In our business cycle framework, we play defense by lowering our exposure to more economically sensitive asset classes (like equities) and increasing our exposure to less risky asset classes (like government bonds). Though the Fidelity study above is instructive, we believe it understates the importance of such an approach, as peak-to-trough declines associated with recessionary environments have been even more severe. This not only impacts investment performance but also leaves emotional scars on investors, often making it difficult to remain rational and objective when trying to stick to long-term investing plans.
Consider the results in the post-World war era, during which time there have been 12 U.S. recessions. According to a study done by T. Rowe Price, the median peak-to-trough decline in the S&P 500 was 24%, with the average decline at around 30% (see figure below).
S&P 500 Declines During Economic Recessions
Data Source: T. Rowe Price
Why is protecting the downside REALLY important?
At a recent BFM event, an astute client asked a very important question. This client wondered if our investment proclivity to focus on defense, and choose to avoid risk first, was too conservative. Would our apparent conservatism save returns in bad markets, but ultimately lead to lower returns over time? Consider the graphic above, illustrating that the U.S. was in recession in only 12 of 75 years, or approximately 16% of the time. This stands in stark contrast to the historical track record where the S&P 500 registered positive returns in 75% of all years since 1948! The lopsided nature of that fact begs the question, shouldn’t we be more optimistic considering how often stocks rise and the fact that recessions are rare? This simple rubric fails to recognize how devastating drawdowns can be. Large percentage capital losses require an even larger subsequent gain for portfolios to recover fully. An easy math example: after a 50% loss, you would need a 100% gain just to break even. This recovery can take some time, meaning portfolios can remain underwater for several years following these negative phases. The great financial crisis presents a poignant example in the not-so-distant past. The S&P 500 Index fell 57% from the highs in late 2007 to the market trough in March 2009. It took until the middle of 2013, over 4 years later, and a cumulative return of nearly 132% to fully recoup these losses. The large gains and significant amount of time needed for a portfolio to recover after a significant setback may not be feasible for every investor. What can be even more devastating, is that investors often make their worst decisions under times of market stress. Rising fear creates emotional pressure to sell risk assets such as stocks at the worst time. By managing exposures through time, we hope to ensure investors realize less portfolio pain, ultimately raising the chances they will stick to their plan during the most scary environments.
Portfolio Positioning
As we review the current economic environment, we see a long list of signs that indicate we may be towards the latter end of the business cycle. We have referenced many of these signs in previous commentaries, including contractionary monetary policy, slowing housing and manufacturing activity, and tighter bank lending standards. This supports maintaining lower exposure to cyclically sensitive asset classes, and our portfolios currently have lower equity exposure relative to long-term investment plan targets, and higher exposure to lower risk asset classes including U.S. Treasury and high-quality corporate bonds. We also continue to see value in the absolute returns and diversification benefits provided by non-traditional alternatives such as private credit and managed futures.
Simple, but not easy
The business cycle framework is simple, but not easy. Often, different economic data can seem contradictory. Timeframes also matter, as the lengths of the different phases of cycles have varied significantly throughout history. The best hedge against this challenge is owning select groups of asset classes that can deliver profits without the cyclical backing of the economy. We seek companies that are “all-weather”, with the ability to withstand the ultimate pressures tougher economic environments foist on businesses broadly. High-quality companies of this nature can be identified by their high profitability, low leverage, and durable growth in cash flow and dividends. Portfolios constructed with these types of companies
If you have questions about the capital markets, your portfolio, or how your assets are invested, please reach out to your wealth manager. We are always happy to take your calls and questions.
Market Commentary Disclaimer
This publication is for informational purposes only and should not be considered investment advice or a recommendation of any particular security, strategy or investment product. The information contained herein is the opinion of Boston Financial Management and is subject to change at any time based upon unforeseen events or market conditions.
Professional Designation Minimum Requirements Disclosure
CFA® – Chartered Financial Analyst. Minimum requirements for the CFA® designation include an undergraduate degree and four years of professional experience involving investment decision-making, in addition to successful completion of each of the three CFA® level exams.