Despite some choppiness in September, the S&P 500 Index rose 8.9% in the quarter, recovering its previous losses for the year. Underneath the surface, mega-cap growth names continue to lead the U.S. market and they now dominate the index. But their outsized past returns have come from their ascension to the top, not from owning them once they were already there. Over time, owning the largest stocks has badly lagged owning the diversified index.
The U.S. mega-cap growth effect has driven the relative returns of U.S. versus foreign stocks this year. Developed international stocks gained 6.0% this quarter, almost three percentage points behind U.S. stocks, though, emerging-market stocks outperformed U.S. stocks with a return of 10.2%. Both groups still trail U.S. stocks year to date.
Bond markets were calm throughout the summer, thanks in large part to the Federal Reserve’s extremely accommodative monetary policy. With Treasury yields unchanged, core investment-grade bonds gained 0.6% in the third quarter.
Going into the final quarter of 2020, multiple crosscurrents and uncertainties are presenting both investment risks and opportunities. There are reasons for caution:
Election uncertainty can cause financial market volatility. This election is unique in many ways. A disputed result or ballot-counting delays could mean greater volatility than usual.
The pandemic remains a significant societal, economic, and financial market risk. Additional fiscal stimulus is likely needed, but time is running out for a political agreement in 2020.
U.S. stocks are expensive relative to history. Forward and median price-to-earnings ratios are nearing dot-com-bubble highs. In our base-case economic scenario, our five-year expected returns for U.S. stocks are very low.
There is always the potential for a geopolitical or other unknown shock. It’s impossible to consistently predict when such drops will happen, how deep they will go, or how long they will last. But these events can sometimes provide excellent buying opportunities.
Despite the risks and uncertainties, there are also reasons to be cautiously optimistic about the prospects for global stocks and corporate bonds:
An economic recovery is underway. Economic data and forecasts continue to improve. But how much of this recovery is priced into markets already? The stock market may be susceptible to disappointment.
A vaccine is likely in 2021. The consensus is that we will have an effective and widely distributed vaccine in the next six to 12 months. No matter the exact timing, it makes sense to be optimistic the pandemic will end in the not too distant future. In the meantime, the world is learning to adapt to living with the virus without total economic shutdowns.
Monetary policy is extremely supportive. Central banks have cut interest rates to zero and have engaged in massive “quantitative easing” asset purchases ($7 trillion since the pandemic) to support financial markets and the economy.
U.S. stocks are cheap relative to bonds. Given very low bond yields, our expectations for stocks is better than bonds. Investors must put their capital somewhere, so this relative valuation advantage supports stocks (for now) even though they are expensive compared to history.
Our watchwords for portfolio construction and positioning remain balance and resilience. Our portfolios are balanced and diversified across multiple dimensions. And we believe they can provide strong returns in our base-case and more optimistic economic scenarios, while still maintaining resilience should a more challenging scenario play out.
Investing in a way that accounts for the wide range of plausible outcomes requires discipline, patience, and a willingness to stand away from the herd at times. It can feel uncomfortable to stay the course, or add to equities, when markets are plunging or to care about valuation and not chase markets higher when they are soaring. But in the end, this is the best approach we’ve found to achieving one’s long-term investment goals.
Actions to Take in Uncertain Times
In a volatile environment like the one we find ourselves in today, and experienced just two years ago in 2020, we recognize that some investors feel as though they should make changes in their portfolios—even if just to take action.
Research Update on Market Volatility
Given the renewed market downturn, fed by high uncertainty around inflation and the war in Ukraine, we want to share our most-current views and portfolio positioning with clients and followers of our research.
Commentary from Our CIO—First Quarter 2022
In this commentary, we highlight key developments in the global economy and financial markets. The biggest macro event was Russia’s brutal invasion of Ukraine. As is our job, our focus is on the economic and financial market impact of this event. Clearly, the human impact has been devastating and tragic, and our hearts and support are with the Ukrainian people.