Robert Ryan

November 8, 2022

Investment Committee

Rockbridge Institutional – October 2022 Market Review

MARKET COMMENTARY

Stocks

Except for emerging markets, stocks were up in October. Domestic markets led the way – large cap (S&P 500) up 9%; small cap (Russell 2000) up 11%. International developed markets (EAFE Index) were up 5%, while emerging markets (MSCI Index) were off 3% due to sharply negative results in China. While uncertainty remains, October is a welcome change.

Bonds

Bond yields were up, especially at the short end. Yields at 1-year maturity are 4.5%, up 0.4%; 1- month and 3-month yields are up 1.0% and 0.8%, respectively. Yields on the 10-year are up just 0.2%-4.0%. Returns move inversely with yield changes, which explains losses in October. The Yield curve stayed inverted (1-year yields exceeding 10-year yields by 0.5%), which is often associated with a recession down the road. The spread between nominal and real yields (inflation adjusted) – a reasonable measure of the market’s expectation for future inflation – remains at 2.5% for 5-year maturities.

WHY INTERNATIONAL MARKETS?

Over the last 10 years the largest companies traded in international stock markets (EAFE) earned a real return (inflation adjusted) of just 3%, while domestic stocks (S&P 500) earned 11%. An international allocation has been a drag and raises the question of the title. Yet, if the goal is to build an efficient global portfolio – one with the best expected long-term trade-off of risk and expected return – then international stocks belong.

To begin to look at international stocks, we need measures of how markets are expected to behave. Unfortunately, neither we nor anyone else can reliably predict future markets – the best we can do is come up with a reasonable description that includes not only an expected payoff, but also a range of possible outcomes. Past market behavior provides a clue. Over the past 42 years there are 168 rolling 10-year periods. While I think recent periods distort the picture, and making no adjustments, the average 10-year returns are 7%; the standard deviation is 3%. This picture provides context for the most recent 10 years in international markets. If these statistics describe what we can expect from international markets, then the most recent 10 years is rare (5% probability).

Individual markets don’t all act together – when one is up, the other is apt to be down, and vice versa (e.g., over the same period domestic market returns were well above long-term averages). Because of this lack of perfect correlation, combining market results in the same expected return but with less volatility, the optimum portfolio will include an allocation to international markets, the recent past notwithstanding.

Unfortunately, the benefits of diversification are not always apparent. However, some comfort can be found in the idea of “regression to the mean.” This idea suggests that after a below-average period, to realize the average, future returns must be above the average and justifies sticking to an established strategy in the face of below-average results.

Investing risky assets is hard. It is a long-term process throughout which there will be a lot of short-term volatility. Success requires commitment and patience.

WHO WE ARE

Rockbridge Institutional serves the unique needs of institutions, foundations, and endowments by applying a disciplined, proven and responsible investment philosophy. We are intimately familiar with challenges boards face as we serve on boards and finance committees ourselves.

We are committed to investment ideas that are grounded in academic research. The essence of our investment philosophy is that capital markets work in the long run; a portfolio’s risk is defined by its allocation among asset classes; and that security selection is a matter of constructing portfolios with specific expected return/risk characteristics at the lowest cost.

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