From a return perspective, 2018 could largely be considered the year that wasn’t. Despite a few half-hearted rallies leading into the closing day, global financial markets ended December with the worst annual returns since the financial crisis. Larger-cap U.S. stocks fell nearly 14% in the fourth quarter, wiping out year-to-date gains and ending down 4.5%. Smaller-cap stocks fared worse, falling 20% in the quarter and 11% for the year. Foreign stocks suffered through most of the year, with mid-double-digit year-end losses for both developed and emerging-market stocks (despite their relative outperformance versus U.S. stocks in the fourth quarter).
In addition to the equity market declines, what stands out about 2018 is the breadth of negative returns across almost every type of asset class and financial market, whether bonds, equities, or commodities. Even core investment-grade bonds were in the red. It was extremely difficult to make money in the financial markets last year.
The lackluster performance of so many asset classes, culminating with the fourth quarter’s dramatic U.S. equity decline, is largely due to the uncertainty that prevailed throughout much of 2018. As the year wore on, early positive market indicators such as still-solid U.S. economic growth and declining unemployment numbers were swamped by investors’ fears surrounding ongoing U.S.-China trade tensions, political uncertainties in Europe, and continued Fed tightening, among others.
It was a challenging year for our portfolios, driven by sharp declines in international and emerging stock markets. In absolute terms, most investments were negative for the year. However, several of our actively managed bond funds and floating-rate loan funds posted positive returns. Our fourth quarter portfolio performance also demonstrated the risk-management and diversification benefits of our lower-risk alternative strategies as they outperformed U.S. stocks.
Keeping Consistent Focus
Throughout the history of our firm, we’ve succeeded on behalf of our clients by emphasizing the importance of creating a financial plan with a long-term perspective. With a long-term perspective comes the necessity of discipline and patience in sticking to your investment process and executing it consistently over time rather than being subject to swings in investor sentiment and market consensus, which more often than not detracts from returns versus enhancing them.
While today’s headlines may be filled with distress signals and warnings of market weakness, it’s worth remembering that just one year ago those headlines boasted 20%-plus global equity gains and historically low market volatility. In fact, most investment strategists expected 2018 would bring a continuation of the synchronized global economic recovery. The sharp market pullbacks witnessed this past year only reinforce our view that no one can consistently predict short-term market moves.
Over the next year, the range of potential equity market outcomes is just as wide as it was going into 2018. Our approach and preparation remain the same. We construct and manage portfolios to meet our clients’ longer-term return goals based on their specific financial plans, which means successfully investing through multiple market cycles, not just the next 12 months. Given our current investments, we are confident our portfolios are positioned to perform well over the medium to long term and to be resilient across a range of potential shorter-term scenarios.
If the current recession fears are overdone, we expect to generate strong overall returns with outperformance from our foreign equity positions, tactical overweights, and flexible bond funds. On the other hand, if U.S. stocks slide into a full-fledged bear market, our portfolios have “dry powder” in the form of lower-risk fixed-income and alternative strategies that should hold up much better than stocks. We’d then expect to put this capital to work more aggressively; for example, by increasing our exposure to U.S. stocks at lower prices and valuations implying much higher expected returns over our medium-term horizon.
U.S. Stocks Still Expensive
In the period since the financial crisis, there has seemingly been little need to own anything other than U.S. stocks. But it should be particularly clear after this year (and this past quarter) that isn’t a sound long-term approach. The multiyear period of U.S. stock market outperformance versus the rest of world is reaching an extreme relative to history. The results of the past 10 years are not sustainable, and they won’t be repeated over the next 10 or 20 years.
Even after their fourth quarter declines, U.S. stocks are still expensive. However, many markets elsewhere are oversold, strengthening their appeal for long-term, value-seeking investors like ourselves. Europe is historically cheap, with a lot of the worries (e.g., Brexit, Italy’s political and debt concerns) likely already priced in.
The selloff in Asia has been particularly severe. Here again the market seems to be overreacting to potential risks (e.g., a slowdown in China) rather than reflecting the true value of emerging markets—a vast investment opportunity set that continues to expand at a faster rate compared to developed markets. Despite the risks we see over the short term, we have high conviction that our investments in European and emerging-market stocks will earn significantly higher returns than U.S. stocks over the next five to 10 years.
Our allocations to foreign stocks also provide our portfolios with diversification away from the U.S. dollar. After the dollar’s strong performance the past several years, a U.S. budget deficit not seen outside of recessions or war, and the overvaluation we see in U.S. stocks, we believe the U.S. dollar is a risk factor that investors would be prudent to diversify away from.
Successful investing is a process of consistently making sound, well-reasoned decisions over time, and across market and economic cycles. Our goal is never to track or beat a particular benchmark from one year to the next, but rather to provide our clients with the optimal return for the environment we’re given and the risk profile of their particular strategy.
Given this approach, it is normal, not unusual, for us to go through periods where we will look out of sorts with the broader market. As we continue to execute our approach with discipline and patience during the inevitable periods when it is out of favor, we will continue to achieve successful and rewarding long-term results for our clients, as we have over the life of our firm.
As with all other periods of extreme volatility, many investors are considering “getting out” of the market (or significantly reducing their risk exposure). This classic behavioral mistake should be avoided and replaced with a focus on things you can control. Specifically referring back to your financial plan to determine if you are saving and/or spending properly and if you are still on track to meet your goals.
As always, we appreciate your trust in us and welcome questions.