June 6, 2023
ROCKBRIDGE INSTITUTIONAL – May Market Review
Stock markets are volatile waiting for some resolution of today’s uncertainties, which include not only the Debt Ceiling, but also the banking system, the trajectory of interest rates and the Fed’s perseverance, inflation expectations and the prospect for a recession. Monthly stock returns are mixed – Domestic stocks are little changed; international stocks are down. The year-to-date numbers look better driven by the largest US Tech Companies and developed international markets. The EAFE is up 7% and the S&P 500 is up nearly 10%, almost all of which is explained by Apple, Microsoft, Google, Amazon and Facebook.
Over the past thirty days yields for shorter-term bonds were up, especially for one-month maturities. Yields for bonds that mature beyond two years were little changed. The shorter-term yields shot up due to the uncertainty in the resolution of the US debt ceiling negotiations.
The yield curve continues to slope downward – usually a sign of lower interest rates ahead, which is consistent with expectations for a more accommodative monetary policy to combat a recession and reduced inflation. The spread between 5 and 10-year nominal and inflation-adjusted yields, a reasonable measure of market expectations for inflation over these periods, remains just above the Fed’s 2% objective.
The year-to-date stock market numbers show us some of the short-term costs of maintaining a well-diversified portfolio. Recently large company stocks traded in both domestic (S&P 500) and international (EAFE) markets, earned returns well above those of other markets making it uncomfortable to remain committed to a diversification strategy. Yet, it is well known that diversification increases a portfolio’s expected return without assuming more risk – a “free lunch.”
Allocations to value stocks (value effect) and stocks of small companies (size effect) have been shown to produce diversification benefits. It is reasonable to expect premiums of 1% to 1.5% but with considerable short-term variability. This variability is especially evident in recent periods. While over the previous three years a portfolio geared to take advantage of this value and size effect has matched the returns of broad market indices, recently it has lagged by an uncomfortable 3% margin. However, because shortfalls will not last forever and turnarounds can happen quickly, it is important to remain committed to these markets.
Monitoring results is an important role of fiduciaries. While at first glance this process seems straightforward, it is not. Two problems loom – (1) using short-term results to monitor long-term expectations, and (2) random noise in the data. To deal with the first problem fiduciaries construct and maintain benchmarks that reflect appropriate risk profiles. Periodic results are measured against these benchmarks and nothing else.
The second problem means that periodic results will not always match even a well-constructed benchmark – sometimes they will be above, other times below (tracking error). Regardless of whether positive or negative, tracking errors must be investigated, and explanations understood.
Monitoring periodic results and maintaining diversification strategies can be hard, yet is key to investment success.