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Weekly Market Analysis - Staying the Course and Allocating Portfolios for the Long-Term
Posted on3 Things to Know
Don’t Ignore Structural Balance in an Investment Portfolio
The bulk of our investor questions have tended to focus on short-term factors – election outcomes, geopolitical risks – and whether the stock market is too high for a particular moment in time. What so often gets neglected is the structural balance in a portfolio. A misaligned portfolio for the long run can potentially accumulate either excessive idiosyncratic risk or lost opportunities akin to enduring a bear market, albeit hidden beneath the surface over time.
The Leaders of Today May be the Laggards of Tomorrow
The US has led global equity returns for an unusually long streak of roughly 15 years. It’s been concentrated in a small number of US tech-related shares. There’s no good reason to doubt the immediate fundamental strength of potential innovations such as AI. We also can’t tell how far the bull market in these shares has already progressed. History shows the S&P 500’s top ten constituents by capitalization each year underperformed the broader market in subsequent years (data from 1991-2023).
Small, not Seismic, Shifts
Rather than calling for a wholesale shift from US equities to cheaper markets, our approach calls for considering appropriately sized exposure to both. The relative sizes of our long-term allocations will reflect the divergence in valuations, allocating somewhat less to expensive markets and somewhat more to cheaper ones.
Summary
US large-cap equities have been on quite the winning streak. From the depths of the Global Financial Crisis at the end of 2008 to the end of 2023, this sub-asset class – as represented by the S&P 500 Index – has registered an annualized total return of 14.3%.
This performance has prompted some investors to ask a searching question: has portfolio diversification had its day? After all, anyone who put their entire equity allocation or even their entire investment wealth in US large cap equities would have enjoyed strong returns. The US’s unique combination of global economic and technological leadership, strong institutions, and its status as the largest and most liquid market may continue to make US large cap equities an enticing investment. However attractive it may sound, an equity allocation to just one geography – or a handful of large, top performing stocks from that geography – is significantly risky.
Portfolio considerations
With many investors holding disproportionately large positions in a single equity market – often their home market – broadening equity exposure to a globally diversified portfolio, including fixed income, is likely a prudent first step to consider. For investors over-allocated to the world’s winning equity market (US large caps), the deep underperformance of emerging markets in the past decade makes a broadening core allocation more appealing for suitable investors, not less.
Source: OCIS (Office of the Chief Investment Strategist) Strategic Asset Allocation and Quantitative Research, and FactSet. Analysis from December 1990 to December 2023. Chart shows the cumulative total returns of the top ten S&P 500 firms by market capitalization at the end of each year over the following 12 months alongside the cumulative total return of the S&P 500. Each point on the chart shows the cumulative return between that point and one year later. Indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment. Index returns do not include any expenses, fees, or sales charges, which would lower performance. Past performance is no guarantee of future results. Real results may vary.
Don’t Ignore Structural Balance in an Investment Portfolio
Many investors are fixated with timing markets, typically shifting between cash and equities. Their aspiration is to ride the uptrends while sidestepping downtrends. While avoiding market drawdowns has obvious appeal, both financially and psychologically, experience shows it is very hard to accomplish. Typically, market timers end up missing out on valuable stretches of equity gains and earning much lower returns on cash instead (please see our May 18th CIO Bulletin for more).
Staying fully invested and broadly diversified, by contrast, enables investors to seek compound returns over time. High quality bonds may help offset some of the effects of holding equities during bear markets.
The bulk of our investor questions have tended to focus on short-term factors – election outcomes, geopolitical risks – and whether the stock market is too high for a particular moment in time. What so often gets neglected is the structural balance in a portfolio. A misaligned portfolio for the long run can potentially accumulate either excessive idiosyncratic risk or lost opportunities akin to enduring a bear market, if hidden beneath the surface over time.
The Leaders of Today May be the Laggards of Tomorrow
Thanks to their strong collective performance, US large cap equities now represent 62% of the MSCI ACWI IMI Index, a broad global benchmark spanning developed and emerging markets. However, history cautions against extrapolating today’s dominance into the long-term.
The outperformance of certain markets tends to wax and wane over time. Between 1990 and 2000, for example, US equities also beat other leading equity markets across the world. From 2000 to 2010, however, the situation was reversed, with emerging market equities outperforming. Likewise, Japanese outperformance in the 1980s took its stock market to a 30% share of global capitalization. A multi-year bear market ensued, and even today, Japan accounts for only 6% of world equities.
To be clear, this is not to say the US is doomed to poor performance over the next decade. However, valuations for the US – as measured by the cyclical-adjusted price to earnings ratio or "CAPE" – are currently high. Over time, high CAPE readings for equity markets have historically given way to low returns over the subsequent decade. At the same time, some markets elsewhere – and particularly in emerging countries – have lower valuations, which suggests the potential for higher returns over the next ten years.
Small, not Seismic, Shifts
Rather than calling for a wholesale shift from US equities to cheaper markets, our approach calls for considering appropriately sized exposure to both. The relative sizes of our long-term allocations will reflect the divergence in valuations, allocating somewhat less to expensive markets and somewhat more to cheaper ones.
During various bouts of market stress over the past quarter century, some asset classes have delivered positive returns even as equity markets have fallen. In February 2003, for example, while US equities were down 23.6% year-on-year, commodities were up 57.8%. And in December 2008, when US real estate was down by just over half, US bonds were up 5.2% over the previous year. We believe such dispersion in asset class performance makes a case for allocating across many geographies and asset classes rather than trying to pick winners among them.
