Client Letter: First Quarter 2016 Review – Snap Back Recovery & Adjusting Our SailsSubmitted by Alsworth Capital Management, LLC on April 17th, 2016
First quarter market volatility presented our portfolios with a real world stress test scenario. It began with the worst start to a year in Wall Street history, as major equity markets dropped 10% to 16%, oil prices plunged, and fears of a global recession grew. Then beginning around mid-February, everything changed, though as is often the case, there was no clear catalyst for the turnaround. Oil prices spiked higher, stock markets rallied, and the dollar declined. In a welcome change for our portfolios versus recent years, emerging market stocks were among the highest returning asset classes.
This sort of extreme market turmoil illustrates the need to maintain diversified portfolios. Despite our strong convictions that valuations and fundamentals ultimately drive durable investment returns, we remain humble at the altar of investor sentiment. It also points out the unpredictability of short-term market movements. We continue to maintain broadly diversified portfolios and continue to take advantage of market extremes, such as the selloff in emerging market stocks last fall, to opportunistically add to attractive long term holdings.
As the market rebounded, our flexible and absolute return oriented bond funds were rewarded, while on the equity side, our allocations to emerging markets and U.S. stocks boosted performance, as each asset class ended in positive territory for the quarter (5.9% and 1.3%, respectively). Developed international stocks also rebounded dramatically off their mid-quarter lows, but trailed for the quarter, down just under 2%. The turn in the markets also favored many of our value oriented active fund managers that had lagged in 2015.
Portfolio Review and Positioning
We believe that part of successful investing involves riding out these nervous markets in which prices are driven by short-term news and investor cycles of emotion, staying focused on long-term fundamentals, and remaining committed to a disciplined risk management process. The quarter’s market volatility seemed to reflect a recognition by investors of some of the macroeconomic concerns we have expressed over the last few years, including the uncertainty created by unprecedented monetary policies (which have resulted in ultra-low and even negative interest rates) and the potential effects of an economic slowdown in China on global markets. Our assessment of these risks have not materially changed, and we have factored them into our asset allocation decisions.
Based on our analysis, and supported by a variety of commonly used valuation metrics, the U.S. stock market is overvalued and company earnings have been steadily declining from peak levels. The U.S. stock market remains surprisingly resilient despite trading at valuations that are now higher than they were when former Federal Reserve Chairman, Alan Greenspan, famously railed against “irrational exuberance” in stock prices. I think we have rung about as much out of U.S. stocks as one can rationally expect. Returns over the next five years are likely to be low not only in absolute terms, but also relative to the outsized gains we’ve seen in the post-2008 period. This assessment has been key in supporting our relatively conservative allocation to U.S. stocks in our portfolios.
On the other hand, the attractiveness of foreign markets is almost a mirror image of the U.S. market. We see the potential for faster earnings growth from current below normal levels and valuation levels we believe will expand somewhat as earnings improve. The news of Great Britain considering a referendum to exit the European Union (“Brexit”) hasn’t been helpful, however unlikely we think it is to come to pass. Economic growth also remains slow and elusive. However, a lot of bad news has been priced into foreign stocks and any recognition that the worst case scenario is unlikely to play out could provide upside potential. Our tilt toward foreign stocks has thus far, been a headwind for our portfolios. However, the performance of emerging-markets stocks versus U.S. stocks since the quarter’s turnaround may be hinting at a possible turn in the cycle.
Our diversified bond allocations reflect our assessment that in the current ultra-low rate environment, allocating to fixed-income calls for greater ingenuity than in a more normal environment. And while our core bond positions provide useful risk-management qualities (as illustrated during the downturn early this year) their longer-term upside potential is limited. As such, we are looking to our flexible and absolute-return-oriented bond funds to provide greater upside over the longer term, as they are better equipped to navigate a rising interest rate environment. We also believe we’ll continue to see positive return contributions from our tactical positions in floating-rate loans, as was the case when rates ticked up during the second half of the quarter.
The final piece of our portfolios is our allocation to managed futures and arbitrage/event-driven funds. We view these investments as alternative strategies because they should have different return drivers and risk exposures than traditional stock and bond funds. We believe these investments will also be additive to our balanced portfolio returns over the next five years. They provided meaningful diversification during the declines early in the year and have given back some of those gains as stocks rallied recently. This lack of correlation with stocks and bonds can be a meaningful risk management benefit to the overall portfolio by reducing volatile swings.
We will continue to selectively adjust our portfolios as valuation extremes unfold. We have been shifting toward higher quality holdings within the fixed income space. As the economic expansion gets long in the tooth, we prefer to hold more stable companies to weather eventual economic downturns. We have been building more cash in portfolios at the expense of equities in response to the snap back in stock prices. Nobody can time short term market swings, but we believe that it is prudent to respond to the winds of long term valuation extremes and adjust our sails.
As always, we appreciate your confidence and welcome questions about your individual situation.
Shane M. Alsworth, MBA, CFP®, CLU®, CIMA®
The views and opinions presented in this article are only those of Shane Alsworth and Alsworth Capital Management, LLC
Investments are subject to market risks including the potential loss of principal invested.
Asset Allocation does not assure or guarantee better performance and cannot eliminate the risk of investment losses.
Sources: Wall Street Journal, Morningstar/Ibbotson data, Research Affiliates