"Until I know this sure uncertainty,
I'll entertain the offered fallacy.”
- William Shakespeare, The Comedy of Errors (Act 2, scene 2)
Near-term: Uncertainty
As we enter this holiday season weary of the virus, its spread surges again with record numbers of new cases in recent weeks, very high levels of deaths, and strained hospitals. Yet we’re grateful for extraordinarily good news about vaccine development, for continued economic recovery, and for an apparent election outcome that while not pleasing everyone in all ways, at least seems to have taken the market’s worst fears off the table regarding feared increases in corporate, income, capital gain, and estate taxes. Looking ahead, as they do, markets cheered those developments plus the prospect of Janet Yellen as Treasury Secretary and stocks soared, with the Dow piercing 30,000 for the first time. The MSCI ACWI index of global stocks posted its best November ever and US stocks had their best November since early 1987. As December opens, we would prefer to proffer as much holiday cheer as markets, but we’re reminded this is still 2020 so must naturally wonder if this unusual year may not have yet another unpleasant surprise or two held in reserve.
The near-term looks like a knife-edge balancing act between this third wave virus surge (and economic headwinds that may follow more restrictions it could engender) versus the prospect that the virus may soon dissipate thanks to vaccines. With such strong, conflicting forces, heightened volatility is always a possibility, particularly after a nice market run-up.
Over the past 75 years, seasonality has been positive for stocks in election year Decembers: the average gain has been 1.4% and the S&P 500 has been positive a remarkable 84% of the time. Yet again we note: this is still 2020!
Long-term: Uncompensated Risk
Patterns aside, these considerations are short-term in nature, and for markets, the short-term is essentially unknowable. We’re much more comfortable with the long-term which, counterintuitively, is more predictable. The most significant determinate of long-term return is beginning valuation, which is both available and observable. An accommodative Federal Reserve, low inflation, and strong momentum in economic recovery notwithstanding, most investments look expensive these days, and that implies the strong likelihood of sub-par returns over the next 10 years and more.
While that is true of most investments today, it is especially true of high-quality bonds where the yield on the benchmark 10-year US Treasury notes is now a paltry 0.93%. That this yield is up substantially from 0.54% in late July gives little comfort: What do you think the odds are that inflation will average as little as 0.93% per year over the next 10 years? If you are thinking, “not great”, we agree. In fact, the “market’s” implied inflation rate (per the US TIPs market) over the next 10 years is 1.8% per year. If that proves to be remotely right, 10-year US Treasury notes held to maturity would offer negative yields after accounting for inflation. That’s not very appealing.
In addition to yield, however, US Treasury bonds also offer risk mitigation benefits to portfolios since historically they have gone up in value when stocks have fallen the most. We were happy, for example, to have held a significant amount of Treasuries (mostly in IRAs) from late February through early March as stocks tanked and Treasury bond prices jumped. But at current levels of yield, some question how much crisis diversification benefit such bonds may offer now.
Perhaps the most basic principle of finance is that risk and return should be roughly proportional – that higher prospects of return necessarily involve higher risk, at least in the form of higher volatility, and vice versa. When bonds yield less than likely inflation, all the usual risk remains but is paired with much less than normal return. That unhappy combination may be easiest to see with the Treasury bond example, but it is pervasive across many investment categories.
Fortunately, there exist important exceptions. We’ve written often about the extreme underperformance of Value stocks relative to so-called Growth stocks for a few years, but especially so this year through August. That pattern seems to have started to turn in recent months, with the Russell 3000 Value index outperforming the Russell 3000 Growth index by 7.44% since 8/31. That may look like a big move, and it is. But it’s a relative drop in the bucket compared to Value’s cumulative underperformance over the past several years. Because of this, one area of markets that still offers decent long-term expected returns from current levels is Value stocks, that is, stocks selling at lower multiples of earnings and cash flow as well as offering better dividend yields than the market. Value stocks also stand to gain the most from the ebbing of the pandemic as they are concentrated in areas more sensitive to the economy than Growth stocks. Similarly, small stocks, which have historically produced above average long-term gains, have underperformed large stocks for a few years and now are much cheaper, also offering the prospect of better long-term returns. Finally, US stocks have produced much greater returns than non-US stocks for some time, and especially through much of this year. As a result, non-US stocks are generally cheaper now than US stocks, so they generally offer better long-term return expectations from here. In short, while the overall stock market looks expensive, that is mostly because of how very expensive certain large stocks are that dominate the large cap US stock indices, and virtually all other areas of the stock market offer better long-term opportunities today. Diversification in stocks is generally considered a risk management tool. But over the longer-term from here, diversification among stocks likely offers better returns as well.
Likewise within bond portfolios, there will likely always be reasons to hold some US Treasury notes, but very low yields make this a time in which it is particularly important to diversify within bonds by identifying attractive risk/reward opportunities in niches such as alternative lending, emerging market bonds, and certain high yield bonds. And beyond stocks and bonds, other diversifiers such as market risk hedges and inflation hedges such as TIPs, real estate, and infrastructure like pipelines look appealing from a long-term perspective given low yields and low expected long-term returns in most traditional asset categories.
Today, the near-term is exceptionally uncertain with the virus raging while tremendous help in the form of vaccines seems to be just around the corner. Long-term, very low interest rates mean most traditional asset classes offer paltry returns. But just as vaccines offer hope in the near-term, the bright spot in the long-term investment picture is that there are parts of the stock market that have become cheap enough to reasonably offer long-run expectations of better-than market returns.