Our 2024 Q1 Investment Update

By Brian Tall | Apr 09, 2024 |

In our first-quarter investment update, we’ve put together a collection of charts that offer a snapshot of how investments have fared, tackle the questions our clients ask most often, and delve into the major themes currently dominating the news.

Expansions and Contractions: 60% Equity Portfolio

expansions and contradictions Q1 2024

About this slide: This chart shows the growth of a moderate risk portfolio—with a 60% weighting to stocks—since the peak of the market before the 2008 global financial crisis.  The bottom half of the page shows the length and magnitude of expansionary and contractionary periods during the [approximate] sixteen years shown. While it is typical for investment returns to be presented using standardized date periods, such as calendar year or annualized trailing periods, analyzing historical performance via expansionary and contractionary runs offers a more complete picture of market behavior and the investment experience.  This is because intra-year volatility is often hidden within calendar year periods and trailing periods are heavily influenced by moving start and end dates.  As one example, consider that the market contraction at the onset of the COVID-19 pandemic is not observable in calendar year returns since markets had fully recovered to provide a positive return by the end of the year.

Key takeaway: 

For the past two years our commentary in relation to this chart has focused on the quantitative similarities between the 2022 decline and the average of the previous five declines dating back to the global financial crisis.  Our message was that the catalyst behind the 2022 decline was unique but the investment experience—in terms of the magnitude and length of the decline—was about equal to the average of the previous five episodes. Understanding the normal behavior of asset classes and portfolios—in up and down markets—is a key ingredient to remaining objective and non-emotional in our decision-making.

From a qualitative standpoint, there were also important parallels to the past: the recovery period started without a concrete catalyst, skeptics believed the initial recovery would not hold, and prognosticators had negative outlooks for the US and global economy for a myriad and ever-evolving list of reasons.  Like many times before, however, the global economy and financial markets proved more resilient than most anticipated, and investors who stayed the course have been duly rewarded with strong returns.  As diversified portfolios are back to making new highs, the past few years serve another reminder that capital markets will never send an “all clear” signal for us to invest near the bottom, and if we wait for one to appear, chances are markets will climb higher as we keep waiting.

Data disclosures: Moderate Risk Portfolio: 10% Short-Term Bonds, 10% Intermediate-Term Bonds, 4% Inflation-Protected Bonds, 4% Multisector Bonds, 4% Floating Rate Bonds, 4% High Yield Bonds, 4% Preferred Securities, 34.5% US Stocks, 18% International Stocks, 4.5% Global Real Estate, 3% Master Limited Partnerships. The foregoing information is provided for discussion purposes only and should not be relied upon as indicating any expected or projected returns. Hypothetical back-tested performance does not represent actual performance, trading costs or the impact of taxes and should not be interpreted as an indication of such performance.  Data source: Morningstar Direct.

Component Performance: Back to New Highs

About this slide: This chart shows performance of the core market segments within our portfolios since September 30, 2022—the low point for a diversified portfolio in the current market cycle.

Key Takeaway(s):

  • Every asset class ended the recent quarter at a high point for the current expansionary market cycle.
  • After a three-month consolidation period during the late summer months of 2023, the rate of appreciation across market segments accelerated starting last October and continued throughout the first quarter of 2024.
  • The surprising aspect about the continued strength of market performance since last October is that the renewed upward trajectory formed around expectations that the Federal Reserve would be in a position to cut interest rates early this year.
  • In our Q4-2023 investment update we noted that treasury futures markets were pricing in expectations for 6 interest rate cuts this year, with the first one expected to take place as early as March.
  • Yet, markets continued to push higher, even as incoming inflation data was firmer than expected in the first quarter, resulting in material revisions to interest rate expectations. As of quarter-end, expectations for the first interest rate cut have been pushed out to June (60% chance) or July (75% chance), and the total number of expected interest rate cuts for 2024 has declined from six to three.
  • Had a time traveler from the future told you inflation data would come in firmer than desired and expectations for interest rate cuts would be tempered as a result, you probably wouldn’t have guessed that the US stock market would be up more than 10%…in an election year to boot. But that’s why it’s so important to approach investing with a heavy dose of humility. While headlines seem to focus primarily on the risks we ought to prepare for, it’s just as important to be prepared for positive surprises too.

Data Disclosures: Taxable Bond Portfolio: 50% Vanguard Short-Term Bond Index + 50% Vanguard Total Bond Market. Tax-Exempt Bond Portfolio: 50% Vanguard Limited-Term Tax-Exempt + 50% Vanguard Intermediate-Term Tax Exempt. Inflation-Protected Bonds: Vanguard Inflation-Protected Securities. Multisector Bond Strategy: PIMCO Income. Floating Rate Bonds: Fidelity Floating Rate. High Yield Bonds: PIMCO High Yield. Preferred Securities: Nuveen Preferred Securities. US Equity: DFA US Core Equity I. International Equity: DFA World ex US Core Equity. Global Real Estate: DFA Global Real Estate. Data source: Morningstar Direct.

Lightning Strikes

About this slide: This chart shows performance of the core market segments within our portfolios since their respective lows last October.

Key Takeaway(s):

  • The speed and magnitude of the recent “everything rally” underlies the age-old investor saying that “you have to be there when lightning strikes.”
  • The reason disciplined investing is so important is that much of the returns earned by investors over time can come in short and powerful runs like the one we’ve seen over the past 5 months.

Data Disclosures: Taxable Bond Portfolio: 50% Vanguard Short-Term Bond Index + 50% Vanguard Total Bond Market. Tax-Exempt Bond Portfolio: 50% Vanguard Limited-Term Tax-Exempt + 50% Vanguard Intermediate-Term Tax Exempt. Inflation-Protected Bonds: Vanguard Inflation-Protected Securities. Multisector Bond Strategy: PIMCO Income. Floating Rate Bonds: Fidelity Floating Rate. High Yield Bonds: PIMCO High Yield. Preferred Securities: Nuveen Preferred Securities. US Equity: DFA US Core Equity I. International Equity: DFA World ex US Core Equity. Global Real Estate: DFA Global Real Estate. Data source: Morningstar Direct, Brighton Jones.

Returns by Presidential Terms

About this slide: This chart shows performance of the US Stock Market, 5-Year Treasury Bonds, and a portfolio consisting of 40% bonds and 60% stocks by presidential term.  Performance is measured as of the inauguration date (we separately looked at returns from election dates, but differences were immaterial).

Key Takeaway(s):

  • Presidential election years tend to cause anxiety for investors, but markets have performed well under a variety of leadership configurations throughout the post-war era.
  • Whether the stock market has historically performed better under one party, or the other, is highly sensitive to a small number of data points.
  • George W. Bush became president as the US stock market had already started its decline from peak valuations during the tech bubble. He later exited office near the bottom of the market during the global financial crisis. The performance of the stock market during his term in office explains most of the difference in equity returns between the two parties.
  • The 2024 election is unique in that both nominees of the primary parties have served as president, and the stock market performed well under both (to date).
  • Political elections are important for many reasons. But history does not suggest investors should alter their investment strategy based on which party wins the White House.

Data Source: Returns 2.0, Brighton Jones

How It Started; How It Went

About this slide: Every time there is a crisis, certain investment companies rush new products to market that (1) would have potentially protected investors from the recent crisis, and (2) sell the need for ongoing insurance against a reoccurrence of a similar crisis.  More often than not, investment products that are created in the aftermath of a large-scale event have a short life.  The Simplify Tail Risk Strategy ETF, with the ticker “CYA,” was no exception.  Launched in the later stages of the pandemic, and “designed to handle multiple types of market dislocations” while being “robust to path dependency,” the fund has liquidated after losing 99% in about 2 ½ years.

Key Takeaway(s):

  • Investors can take two approaches to managing portfolio risk and volatility. One alternative is to remain fully invested in stocks but use option strategies to dampen downside price movements. The other alternative, and in our view the preferable choice, is to take less risk by diversifying across a wide range of asset classes, including fixed income.
  • Using option strategies to hedge a fully invested equity portfolio can sound alluring, but the strategy is sure to test one’s patience. Strategies that claim to hedge tail risks should be expected to lose money most years (because markets trend upward over time). That means you have to add money to the hedging strategies in all those years it doesn’t pay off to maintain a specified target weight.  If you don’t re-up your insurance, the eventual payoff won’t be material because your initial contribution will trend towards zero over time (just like the ETF).  So, the rebalancing function is crucial.
  • Perhaps more challenging is the fact that the underlying strategy is a black box—many hedging products won’t tell you exactly what they are doing. After several years of re-upping your hedges to maintain the target allocation, you might start to question whether you really need a tail risk hedge and/or whether this particular strategy will actually work when needed (those are two different considerations). You can never be sure because you might not know what the fund is actually doing.
  • More challenging still is that even if you believe this is an important piece of your portfolio and that this particular strategy will work when the right fact pattern presents itself, if other investors lose their resolve along the way, the manager might decide to close due to insufficient assets and just manage their own personal money from a beach. Now you’ve dumped money it a hedging strategy that you think will work when the time comes over the course of several years, but it’s simply not an option to continue with it.
  • The math of hedging tail risks might appear favorable and enticing in back tests. But there are a host of other risks and challenges that may make realizing the potential benefits exceedingly difficult to capture in practice. In contrast, owning a balanced portfolio that considers your capacity and tolerance for risk is a strategy with a long history of success.

Market Expectations for Interest Rate Policy

About this slide: This chart is a probability distribution table showing where the market believes the Fed Funds rate will be following upcoming Federal Reserve Interest Rate Policy Meetings, the dates of which are listed in the column on the far left.  The probabilities listed in the table are all derived from the prices of Fed Funds Futures Contracts that trade throughout the day.  The logic behind the calculations is that the current prices of various Fed Funds Futures Contracts only makes sense if these probabilities correctly reflect investor expectations.  Of course, this does not mean investors will be right or the future will unfold according to the expectations investors have today.

Key Takeaway:

  • In January, the market was pricing in nearly an 80% probability of the first interest rate cut taking place at the Federal Reserve meeting in March, with six total interest rate cuts of 25 basis points taking place through year-end 2024.
  • As incoming inflation data was firmer than anticipated in the first quarter, investors revised their expectations. Investors are now discounting the first rate cut in June (~60% chance) or July (~75% chance), with a total of three cuts taking place in 2024.
  • In our Q4 investment update, we noted that the market was pricing in more rate cuts than Federal Reserve officials had indicated to date. With recent revisions, market expectations are now more closely aligned with viewpoints of Federal Reserve officials.
  • As a side note, watching how this chart changes on a day-by-day basis is fascinating because you can see in real time how (1) investors consume incoming data about inflation, employment, etc., and then (2) revise their prior expectations about future interest rate policy accordingly. This is perhaps the best observable example of efficient markets at work. Efficient markets don’t mean that investor expectations will always be right in the future—it means that investors discount expectations about the future into current prices, they will revise their expectations as new data becomes available, and it is impossible to find systemic ways in which the market is consistently wrong (and therefore exploitable).

Data Source: CME FedWatch Tool

Interest Rates: U.S. Treasury Yield Curve

About this chart: This chart shows the treasury yield curve as of 12/31/ 2023 (gray dash) and 3/31/2023 (solid yellow).

Key Takeaways:

  • During the first quarter, the short end of the yield curve was largely unchanged, while maturities of 1-year and greater ticked higher (as it became evident that interest rates would stay higher for longer)
  • The yield curve remains inverted, with short-term treasuries yielding more than longer-term treasuries.
  • An inverted yield curve can create a predicament for investors as they choose between temporarily higher yields from short-term bonds (until the Federal Reserve cuts the fed funds rate) vs. potentially locking in higher rates for longer.
  • In our view, it makes sense to maintain diversified exposure to the yield curve vs. being highly surgical with our exposure. This means some of our fixed income exposure will collect higher yields at the front end of the yield curve, but we’ll also lock in higher yields with a portion of our fixed income allocation, too.

Data Source: U.S. Treasury

Calibrating Portfolio Positioning

About this Slide: Historical stock market data reveals there is a strong inverse relationship between starting equity valuations and future equity returns over an intermediate time frame of 10-15 years. When starting valuations are low, future returns tend to be above average, and vice versa.  Historical bond market data reveals a strong positive relationship between current yields and future fixed-income returns.  For example, an investor who buys a 5-year bond yielding 5% can expect to earn very close to 5% per year over the term of the bond (the only unknown component to the nominal return of a fixed income security held to maturity is the future interest rate at which income is assumed to be reinvested). Using this information, we benchmark the current investment environment by deriving absolute return expectations for fixed income and equity markets in isolation as well as relative return expectations between the two asset types (since asset classes are competing against each other for our dollars via expected returns).  This exercise helps us determine our portfolio positioning (i.e. the percentage weights of fixed income and equity securities) when equity valuations are high/low and real (inflation-adjusted) interest rates are high/low.

The diagram on the left illustrates how we characterize the investment environment using a quadrant chart with inflation-adjusted treasury yields on the horizontal axis and equity valuations on the vertical axis.  Along each axis, we denote the breakpoints used for segmentation; and within each quadrant we identify at least one period that stands out as having historical significance. We then calibrate our allocation positioning according to the quadrant chart on the right.  When equity valuations are low (bottom half), we want increased exposure to stocks, all else equal.  When real interest rates are high (right half), we want increased exposure to bonds, all else equal.  Importantly, we consider allocation adjustments when there are changes in the relative attractiveness of fixed-income and equity market segments.

Key Takeaway(s):

  • For the past several years, the investment environment has fallen in the upper left quadrant of our framework. With large movements in fixed-income and equity markets, clients might be wondering what we look for when considering adjustments to our investment strategy.
  • It is worth emphasizing that allocation adjustments are warranted only when we see large shifts in the relative attractiveness among asset classes as opposed to changes in the absolute expected returns of each asset class in isolation.
  • As depicted in the updated visual, we have not categorically shifted into a different investment environment such that a material allocation adjustment would be warranted.
  • While we welcome fixed-income yields that are considerably more attractive than they have been over the past decade, ~4-5% treasury yields are on par with their long-term average over the past 100 years. In other words, we have seen a return to normal fixed income yields, but not generationally high yields.
  • While aggregate valuations for capitalization-weighted indexes such as the S&P 500 and Russell 3000 remain elevated (although down from the peak), a select few mega cap growth companies (e.g. the so-called Magnificent 7) are driving this. Beneath the surface level valuation measurements, there remains healthy return prospects for fundamentally-weighted indexes that overweight companies considered to have low relative prices (i.e. value stocks), high profitability, and lower market capitalizations (i.e. mid and small cap stocks). In other words, we are more constructive on the return potential of our equity portfolio than indexes such as the S&P 500 for the next decade.
  • On balance, we continue to believe a moderate conservative stance towards risk in our portfolio positioning is appropriate.

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