Fourth Quarter 2021 – FOMO and Diversification

Market Recap

Following on the heels of a strong stock market in 2020, the S&P 500 Index of large US stocks finished the year 2021 up a remarkable 28.7%.  Given that valuations were already at record levels, this was surprising, with a large portion of the runup coming in the last quarter.  Small US stocks, represented by the Russell 2000 index, ended the year up 14.8%, while developed international stock, represented by the MSCI EAFE index, were up 11.3%.  Emerging market stocks ended the year down 2.5%, as represented by the MSCI EM Index.  

While the Federal Reserve continues to support the bond market with massive programs to buy bonds in the open market to drive down interest rates, they have started to let up on the gas pedal ever so slightly.  This has caused interest rates to modestly pick up from historic lows, leading the Bloomberg US Aggregate Bond index to decline 1.5% for the year.  Floating rate bonds weathered the storm in 2021 and ended up 5.1% on the year, as represented by the S&P/LSTA Leveraged Loan Index. Gold ended the year down 4.33%.

US Investment Outlook

While we recorded positive returns for 2021, our portfolios trailed our strategic benchmarks due to our allocation to international stocks at the expense of US stocks. This was a year of divergence, as stocks and bonds moved in opposite directions and US stocks deviated dramatically from international stocks. We moved a portion of our bond allocation into stocks early in 2021, which helped performance. We also continued to shift our bond portfolio away from traditional core bonds, which improved the bond allocation performance on a relative basis. Conservative bond heavy portfolios held up in 2021, but the weight of declining core bonds and rising interest rates, capped potential upside returns. More aggressive portfolios experienced another strong year for returns, though our diversified approach led to more muted returns by comparison to the eye-popping returns of the US large cap stock sector.

The most significant divergence in 2021 returns was felt in emerging markets. The primary factor was the 21.7% drop in the MSCI China Index, which makes up a large portion of the emerging markets sector. Fearing the negative societal impact of large overly indebted real estate firms, the Chinese central government reined in access to additional debt, slowing down an important growth engine for their economy. They also instituted policies to address the widening wealth gap resulting from the meteoric rise of their most successful technology firms. These social policies are causing a reduction in investment in these sectors, which is putting a crimp on growth. Additionally, China’s economy was particularly impacted by the Omicron variant surge as they have continued to target a zero-tolerance policy toward regional spikes, instituting full shutdowns and proactive contact tracing. While vaccination rates are high in the country, they have relied largely on traditional vaccine technology and have little supply of the more resilient mRNA vaccines, which have proved more successful against the Omicron variant.

Through past market cycles, we are intimately familiar with the psychological strain of loss aversion, as well as fear of missing out (FOMO) or greed in financial markets. Most of the psychological pitfalls, which lead to damaging investor behavior, manifest themselves during periods of heightened volatility. In financial markets, that includes deep market declines, as well as strong recoveries. During the declines we need to remain vigilant in avoiding “killing the sheep,” so that we still have the assets to “shear” when markets recover. It’s difficult to contain our fear while we are in the eye of the storm, but it helps to have a plan and to stay committed to it. Similarly, when we have strong market recoveries, we need to contain the greed impulse. There is a natural tendency to suffer from “fear of missing out” or “FOMO” when one asset class strongly outperforms. This can lead to the understandable urge to shift allocations toward those asset classes that seem to just keep winning. These winners start to appear like obvious bets, despite all the price level warnings. Similarly, it can seem like a no brainer to move away from other asset classes that aren’t keeping up. Historically this has been a disastrous strategy, as anyone that chased technology stocks during the dot.com bubble can attest to. It is imperative to separate the story from the financial assessment in asset allocation.

The story is very good for consumer spending on technology and the exciting shifts to virtual reality. It is also impressive for the exponential impact of decentralized financial transaction technology (blockchain) and for electric vehicles. Much like the explosive power of the internet in the 2000’s, there is no reason to believe that these stories are incorrect. The cautionary tale, however, is in how we apply that to investments. Many of the sure bets of the 2000’s like AOL, Napster, Pets.com and eToys.com no longer exist. Not only do the companies that you invest in need to constantly evolve to survive, but they also need to be purchased at a price that leaves the potential for growth, despite ever evolving competition. Tesla is an amazing company that turbo-charged the shift toward electric vehicles. Their success forced all the other car manufacturers into producing competing electric vehicles. I expect that eventually some of those vehicles will be even better built with even better technology than Tesla’s, thanks in part to decades of prior manufacturing, engineering and business management experience. Perhaps Tesla deserves to be priced today at a level that exceeds the valuation of all other major global car companies combined. However, investments are made today with the expectation of receiving a return through future growth over the next ten plus years. I doubt the competitive market for electric cars will look the same in ten years as it does today. If you are of a certain age, you remember other companies that were once unstoppable that have gone through unimaginable cycles. Think for a minute about the triumphs and tears of global icons IBM, Dell, Kodak, General Electric, Xerox and Sears to name a few. Some have fared better, like Coca-Cola, McDonalds, Eli Lilly, Walt Disney and Walmart. Though, none of these companies stayed the same or retained their peak dominance throughout their history.

I believe in the prudence of keeping investments broadly diversified for a variety of possible future outcomes. I also believe that investments should be purchased with a cheapness margin for potential errors in expectations that stretch out more than ten years. The future is as uncertain today as it has been at every point in the past. I am convinced that our best approach to uncertainty is to remain optimistic about human ingenuity and advancement, while avoiding the psychological trappings found in the excesses of fear and greed.

Outlook 

Currently many US stocks are trading at valuations that exceed levels at any other point in history. We continue to maintain exposure to US stocks, since we can’t time when investor psychology might shift to risk aversion. We expect that the US economy will continue to grow at a solid pace, while corporate earnings continue to be strong, though at a slower pace than last year. We continue to favor international markets that are trading at lower valuations, though we may be shifting more toward developed international markets at the expense of emerging markets in the coming months, reflecting elevated risks. We continue to hold bonds as a hedge against a potential correction in stock market valuations. However, likely rising interest rates continues to loom over the bond market, and we are likely to continue to migrate toward active management, floating rate bonds and shorter-term holdings. Given our concerns about US federal debt levels and to some degree rising inflation, we continue to hold an allocation to Gold.

As always, I am thankful for the trust you have placed in our firm. Please contact us if you would like to setup a meeting to review your portfolio or any other financial questions.

Cordially,

Shane M. Alsworth, MBA, CFP®, CLU®, CIMA®

The views and opinions presented in this article are those of Shane Alsworth only

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: Morningstar/Ibbotson data, Ned Davis Research, BCA Research, Litman Gregory Research

All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability, or completeness of, nor liability for, decisions based on such information, and it should not be relied on as such.

The views expressed in this commentary are subject to change based on market and other conditions. These documents may contain certain statements that may be deemed forward‐looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur. 

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