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Expert Perspective

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Investment e.Perspective

Current Issue | October 29, 2018

Second Quarter Review: The Trend is a Fickle Friend

By: Cam Johnson, MBA, CFA, Senior Investment Strategist & Oxford Investment Fellow


In the second quarter, equity markets resumed a pattern which has become familiar throughout most of the nearly decade-long bull market. US Stocks, and growth stocks in particular, led the market while non-US Stocks and US bonds lagged behind. The 10-Year column in the chart below highlights the degree to which US equity has outperformed all other major asset classes in the current bull market. It’s natural for investors to question the merits of broader diversification after an extended period of underperformance. This is particularly true given the strong fundamentals currently driving domestic stocks. Recency bias is a cognitive bias which describes the tendency of people to assume recent trends will continue into the future. In investing, this can be dangerous, causing investors to buy high and sell low. Given such biases, we felt it appropriate to review the strategic case for diversification in fixed income and international equity...it remains strong.

Strong Earnings Growth Drives Domestic Equity
The domestic economy is firing on all cylinders. In the second quarter, sales and earnings per share for S&P 500 companies are poised to grow at nearly 9% and 20% respectively. The following factors are contributing to that growth:

  • The Tax Cuts and Jobs Act signed in late 2017 is providing a significant boost to corporate earnings.
  • Consumer spending is robust, fueled by an unemployment rate near 49-year lows and accelerating wage gains. Consumer confidence is at its highest level since the early 2000’s.
  • Corporations have increasingly utilized easy credit markets to expand their balance sheets and increase share buybacks.
  • The energy sector is experiencing a significant rebound in earnings, with the sector’s earnings expected to grow 145% in the second quarter.

There are, however, a number of risk factors for investors to consider when assessing the sustainability of domestic equity returns looking forward.

  • Slowing growth/recession: The US in the midst of its second longest expansion ever. The slope of the yield curve has historically been a good leading indicator of economic growth. An inverted yield curve has frequently preceded recessions. The yield curve is currently as flat as it’s been since 2007, suggesting caution is warranted.
  • Interest rates: Monetary policy is tightening. The Federal Reserve increased rates twice this year and reiterated its plans for two additional increases in 2018.
  • Leverage: Corporate leverage has reached record highs while the budget deficit is projected to approach 6% next year. In a rising interest rate environment, the debt service associated with increased leverage will weigh on growth.
  • Trade tensions: We continue to see escalating rhetoric around protectionist trade policy. A global trade war would have negative implications for growth. There are indications that corporate and consumer confidence have already been negatively impacted.

Fixed Income: Stability in Challenging Markets
The Bloomberg Barclay’s Aggregate Bond Index earned a negative return year-to-date as interest rates rose across the yield curve. The 10-year Treasury increased from 2.40% to 2.85%. With yields still depressed by historical standards and interest rates likely to rise, expected returns for fixed income remain modest.

That said, it’s important to remember the role of fixed income in a portfolio. Investors accept the lower long-term returns in fixed income for their volatility-reducing benefits. The chart below highlights the importance of an allocation to fixed income. In times of financial distress, risk assets tend to decline together. In each of the last three equity market corrections of 10% or more, fixed income has increased, mitigating overall portfolio volatility. An allocation to high quality bonds allows investors to rebalance and purchase risk assets at depressed levels.

International Equity: Stay the Course
International and emerging market countries account for nearly half of the global equity market cap and are projected to contribute 80% of global economic growth. As growth rates are a key component to our capital market assumptions, we do have higher return expectations for non-US markets.

Domestic equity returns have benefitted to a far greater degree from valuation expansion in recent years. Using the Shiller P/E ratio, the multiple on the S&P 500 has expanded from 13.3x at its trough in 2009 to 32.1x today. As the chart below highlights, US large cap and small cap stocks trade at well above average valuations.

Meanwhile, developed international stocks and emerging markets stocks trade at below average valuations. Valuations are not a good predictor of short-term market movements, but are a very strong indicator of long-term returns. Current valuation disparities suggest International diversification will be much more beneficial to portfolios looking forward.

Conclusion
Timing recessions or market corrections is nearly impossible. Remembering that market cycles exist is critical. With domestic equity valuations near peak levels and the duration of the economic expansion approaching the longest in history, it is prudent for investors to confirm that their mix of safety and growth assets is consistent with their time horizon and risk tolerance.

A decade ago, many US investors, drawn to the strong trailing outperformance of emerging and international equities over domestic equities, increased their strategic allocation to foreign stocks. As tempting as it may be to do the opposite today, rebalancing to strategic targets will likely prove more rewarding.

The above commentary represent the opinions of the author as of 7.26.18 and are subject to change at any time due to market or economic conditions or other factors.