Normally when I write my quarterly market update, I don’t begin until a few days after the quarter’s ended. This gives me time to digest the data from the previous three months, and synthesize it into (hopefully useful) thoughts about what’s going on in the markets and in the world, and how that might impact your portfolio.
I also get some help with the research. You’ll notice many of the charts I use come from Dimensional Fund Advisors, and I leverage economic & financial data from periodicals I read, including Barron’s, The Wall St. Journal, and Financial Times.
I’m starting with this background because U.S. stock markets had a very strong third quarter, with the S&P 500 up 7.71%. But in the first few days of the fourth quarter, the story has been starkly different. The Dow Jones fell about 800 points on Wednesday, another 500 yesterday, and the financial media would have you believe the world is about to end.
To put some context to Wednesday’s drop, the S&P 500 fell 97 points. This represents about 3.4% of its total value. Since the bear market in 2009 ended, Wednesday and Thursday mark the S&P’s 20th and 21st days losing 3% or greater.
But as painful as it is to see the value of your portfolio fall, we really haven’t lost that much ground. As I write this, the index is trading at about 2770, which is a low we haven’t seen since….June.
So before we dive into what happened in the third quarter, don’t be alarmed if the current sell off continues. It was bound to happen at some point. My guess is that it’s only a short term “pressure release valve”. But even if it’s not, your strategy shouldn’t change because the market lost a few points. Your portfolio should be built with this expectation in the first place.
As I mentioned above, and as you can see from the charts, the third quarter was generally very good for stocks. FAANG stocks (Facebook, Apple, Amazon, Netflix, and Google) continued to pace the leaders, but have fallen hard in the last few days:
It’s important here to point out the disparity between the performance of growth stocks and value stocks. Over the last ten years, large cap growth shares have outperformed value 14.31% per year vs. 9.79% per year, on average. And just over the last 12 months, growth has outperformed 26.3% to 9.45%.
Do not expect this trend to continue. This phenomenon is pretty typical during the latter stages of bull markets. And given that we’ve been in a bull market for about 10 years, it’s no surprise that growth shares have done so well.
Over longer periods of time, value shares tend to do a little better. According to Fidelity, the S&P 500 large cap growth index has grown an average of 8.6% per year since 1990, while the S&P 500 large cap value has grown 9.03%. This trend only grows stronger the farther back into history you go.
This may sound like a broken record if you read last quarter’s commentary. But I’m repeating myself because it’s important: don’t get rid of your value shares. Value will rise again! It’s only a matter of time.
Stocks in developed economies outside the U.S. gained ground on the quarter, but as a group under performed American shares by over 5%.
Growth is outperforming value in this asset class as well. Over the last ten years growth has returned 5.78% on average, compared to 4.51% for value shares. And looking at just the last 12 months, growth has gained 5.47% while value has actually fallen 0.13%.
Looking at individual performers, Israel’s markets had an excellent quarter, growing 8.53%. Israel is in the midst of an economic boom, with it's GDP is growing at around 3.5% per year. Money from international investors is flowing into the country in droves, which is helping to prop up returns.
Additionally, all this activity has caught the attention of index fund managers. Funds like EIS, ITEQ, and IZRL were recently brought to market based on investor demand, and allow broad diversification and access to Israel’s local companies.
Going forward, just like here in the U.S., I do not expect growth to outperform value forever in the international markets. The long term data suggests very strongly that value stocks tend to outperform growth stocks abroad. The disparity is actually stronger internationally than it is here in America.
Index Fund Advisors recently interviewed one of Dimensional Fund Advisor’s head researchers, who confirmed this with their data. Here’s a summary of IFA’s findings:
You can see how prominent the value premium is here. Over the last 20 years, growth shares averaged 3.92% per year outside the U.S. Value averaged 6.15%.
Yes, I may be a broken record here, but this is another good reason to stay consistent with your allocations to value shares, both here in the U.S. and in international and emerging markets stocks.
Emerging Markets Stocks
If you glance at the “Select Country Performance” chart above, you’ll notice that Turkey is a negative outlier in the emerging markets. Actually, you probably could have surmised this without looking at the chart if you’ve been following the news. Turkey is going through a currency crisis, as it battles severe inflation.
The data released in September (covering August prices) showed 17.9% year over year inflation. You don’t need to be an economist to realize that this is a big problem. As prices rise, the value of the Turkish lira falls. And for international investors, there’s a great deal of risk of holding Turkish lira or assets based on the Turkish lira. If inflation continues to go unchecked, it will become difficult for Turkey to trade with the rest of the world (who wants to buy Turkish lira when the value is falling so fast?). That would be bad for Turkey’s economy and citizens. And certainly Turkish stock returns.
You’ll notice in the chart above that the emerging markets were the one sector where value outperformed growth. This has been the case both year to date and over the last 12 months. Growth has performed better over the 3, 5 and 10 year cycles. But longer term (as referenced above) the value premium tends to be significant in the emerging markets, just like here in the U.S., and just like all other developed countries. Value just tends to do better in the long term.
In the fixed income world, interest rates continue to rise across the board. The 10-year US treasury yield now exceeds 3%. On the short end of the curve the 1-month US bill yields 2.12%.
This is a pretty rapid jump from where we were just two years ago. And the trend looks to continue into the foreseeable future. The Federal Reserve has raised short term rates three times already this year, and is largely expected to do so again before the year is out.
If you’re been watching the news at all, you may have caught a sound byte from President Trump signaling his displeasure with the rate hikes: “I think the Fed is making a mistake. They are so tight. I think the Fed has gone crazy.”
From my seat, the Fed’s actions are totally prudent. We’re exiting a period of unprecedented accommodative policy, with interest rates at, near, or below zero for an extremely long time. Returning to a normal policy regime should be handled very cautiously, because things (aka value of the dollar) could spin out of control quickly.
President Trump’s criticism is that the economy will be harmed by the Fed raising rates too fast. Higher rates mean that money is more expensive for individuals and businesses to borrow, which he apparently thinks will lead to an economic slow down.
No, we don’t want economic growth to decelerate. But more importantly, we don’t want to lose price stability either. The risk involved in raising rates too slowly is far greater than the risk involved in raising rates too fast. Those of you old enough to remember 20% interest rates back in the late ‘70s and ‘80s know what I mean. If we’re too slow to the party, prices can spin out of control and our economy could begin to resemble Turkey’s. Or even worse, Venezuela’s.