Diversification: The Only “Free Lunch” Doesn’t Feel So Free Right Now
The best performing strategy year-to-date has been to own the few high-flying stocks that are responsible for the majority of U.S. stock market returns. Against this backdrop, we feel it is an appropriate time to review Daintree’s investment strategy and why we think it has a higher probability of long-term success.
Things rarely play out the way people foresee them. Take the FIFA World Cup for example, which recently concluded its 21st installment. The tournament began with 32 national teams vying for soccer’s ultimate prize, with tournament stalwarts Germany, Brazil, or Argentina favored to lift the trophy again. Against all odds though, each of these favorites crashed out, eliminated by seemingly lesser teams. No one could have predicted this result or that the tiny nation of Croatia would make the final. However, that is the nature of a contest with numerous potential outcomes; it is unpredictable and full of surprises.
A historic era is over. For 18 months prior to January of this year, the S&P 500 experienced zero pullbacks of 5% or more. This might not sound impressive in and of itself, but put in historical perspective, this was a period of extremely low volatility. In a normal calendar year, the S&P 500 typically experiences five pullbacks of 5% or greater and one pullback of 10% or greater. However, for an extended period markets confounded this norm as asset prices experienced unabated appreciation. At the beginning of this 18-month period, a reasonable investor would assume seven or eight sizable equity market pullbacks, yet equity markets experienced none.
Are you unfazed by the markets’ lofty valuations? Equity markets do not seem too fazed by much of anything. No matter what disaster or uncertainty came our way during 2017, global equity markets (MSCI ACWI) were up in each month of the year. That is a remarkable result and a measure of calm in the face of extreme political drama, international terror, policy changes, North Korea’s nuclear threat, cyberattacks, hurricanes, wildfires, etc.
This year’s story has been the strength of global stock markets. Equities have moved higher based on better than expected fundamentals including synchronized growth across most economies. Other factors—such as central banks, North Korea, hurricanes, and politics—have not been enough to disrupt an economic environment that could easily be characterized as “good but not great.” The strength of equities outside the U.S. is not surprising given the more attractive valuations in foreign markets. Other themes this year include the strength of high yield bonds, non-U.S. REITs, and gold.
“Steady as she goes” is a common nautical phrase used when maintaining current course. The command says nothing about a ship’s current surroundings; it can be issued in the calmest of seas or in the most brutal of storms. While the command means to maintain the status quo, it does not mean to drop guard and settle into careless complacency. Vigilance is always paramount while at the helm, as identifying hazardous developments is of the utmost importance. Foresight is equally crucial, as a prompt, and more importantly, proper response to any perilous changes could mean the difference between foundering and continuing forward.
Since the election, a tightly wound balance between investor hope and fear has driven markets. Market valuations are influenced by a combination of fundamentals and investor sentiment. When emotions overshoot fundamentals, that’s when opportunity, or risk, can emerge. The first quarter opened with post-election momentum continuing to propel US markets to new highs, but the pace tempered late in the quarter with the realization that implementing President Trump’s pro-growth agenda would face potentially significant obstacles. The release of less-robust-than-expected economic data compounded this slowdown. Nonetheless, positive investor sentiment, the so-called “soft data,” continued to buoy the market overall.
When heading to a destination, many turn to Google Maps or other GPS apps for turn-by-turn directions. You have advance notice of turns, left-hand exits, and even accidents or road construction. Should you miss a turn, they recalculate your journey without judgment. No such reliable guide exists for investors, as the future of markets is impossible to map. Prudent investing therefore becomes an exercise in “recalculating” without a map, and building portfolios must take this reality into account. Confounding expectations are a regular feature of the markets and the fourth quarter was no exception. Clearly, the most surprising event was the election of Donald Trump, defying most experts’ predictions. This surprise poses many implications going forward, but the biggest impact on markets to date has been the rapid rise in interest rates. The move actually began before the election, as the 10-year Treasury moved from 1.6% on September 30 to 1.9% on Election Day. To be sure, the subsequent move to 2.5% by year-end was more impressive as investors fully embraced an expected pick-up in growth and inflation (see chart below). This recognition coincided with the increased likelihood of a Fed rate hike, which happened in December.
