Q3 2018 Market Commentary: What To Do When It’s Not Working


Written by Nathan Erickson, CFA®, CAIA, Managing Partner and Chief Investment Officer

To view and download a PDF of this commentary, click here.

September marked the 10-year anniversary of the 2008 financial crisis, punctuated by the failure of Lehman Brothers on September 15, 2008. The market began its sixteen-month drawdown in November of 2007, well before the failure of Lehman, as cracks in the financial system had begun to show months before. After a 51% decline, the market hit bottom in March of 2009 and began a substantial market recovery that has now become the longest in history.

While some argued at the time that diversification didn’t help prevent losses, it certainly reduced the magnitude of loss. Even a minimal diversification of 20% away from equities and into bonds helped soften the blow, with more diversification providing more protection:

While diversification helped during the financial crisis, it has not helped over the last nine and a half years, as the S&P 500 has been the dominant contributor to portfolio returns. Furthermore, performance has been concentrated in growth stocks and growth sectors, with technology stocks outperforming the S&P 500 by over 4% annually.

Those who believe in diversification, whether it be in international stocks, bonds, or other asset classes, or who favor value stocks over growth stocks, have been wrong. And frankly, nine and a half years is a long time to be wrong.

Yet this is not the first time that investors have experienced this type of market environment. David Swensen, who manages the Yale University Endowment and is considered one of the best endowment managers in the world, said this in his 2006 annual letter, three years after the dot com bust:

“Sticking with portfolio diversification can be painful in the midst of a bull market. When mindless momentum strategies produce great returns, market observers wonder about the time and effort expended in creating a well-structured portfolio. Consider the recent stock market bubble. For the five years ending June 30, 2000, the S&P 500 returned an amazing 23.8% per year, trouncing the mean educational endowment return of 16.9%. During a roaring bull market, diversification seems to punish investors. Indeed, institutional investors who sought diversification’s free lunch by holding foreign equities saw those assets lag terribly. During the five years when the S&P 500 produced 20%+ returns, developed foreign markets, as measured by the MSCI EAFE Index, generated an 11.3% return, while emerging markets, as measured by the MSCI EM Index, returned 1.0% annually. By the late 1990s, many investors questioned the wisdom of owning any assets other than U.S. equities, especially high-flying technology stocks, asserting the inherent superiority of American companies and the inevitable dominance of high-tech businesses. Making the mistake of extrapolating future returns from a strong historical base, investors picked the absolute worst time to abandon diversification and increase allocation to U.S. equities.”

Swensen looked at the five years leading up to the dot com bust but, prior to our current recovery, the period from November 1990 through August of 2000 was the longest recovery in history. Relative performance during that period looks eerily similar to what we are experiencing today:

Tech stocks led the way in the previous recovery. The S&P 500 outperformed foreign markets by a wide margin. Growth outperformed value in large cap. The only notable exception is bonds, where investors received an attractive return of 8% relative to the 3.7% annualized return in today’s market.

Investors in this position are faced with a difficult choice. It’s hard to look back at such a long period of time and not wonder if things have changed. Decades of data showing value outperformed growth or that international markets provided valuable diversification doesn’t matter when you haven’t experienced it. Truth and accuracy are not the only things that matter to the human mind.  Humans also seem to have a deep desire to belong. Said another way, we do not like missing out. As David Swensen said, many investors in this moment in the late 1990s abandoned diversification, certain that what had worked most recently would continue to work. It didn’t help that high-flying tech stocks flooded media conversations. The difficult choice for investors at that time was this: Do they ignore their feelings and the recent data and remain committed to their existing strategy, or do they trust their feelings and go with what is working and what everyone says is best?

As David Swensen said, this is a painful moment. Not difficult, painful. Perhaps more so because we don’t know when it will end. It is easy to look at the last recovery and see what happened from 2000-2002 after the 2nd longest recovery in history and feel justified about a diversified approach. We can see the beginning and the end. Right now, we don’t know where we are in the timeline. We could be very close to the next downturn, or it could be years away.

It is also worth noting that specific factors have contributed to this environment that cannot last in perpetuity. An accommodating Federal Reserve supported growth in the U.S. that didn’t occur in the rest of the world. At some point that trend is expected to reverse. A Republican-led White House, House of Representatives, and Senate passed a highly stimulative tax bill that is unlikely to be replicated once the stimulus runs out. The period of low interest rates that has forced investors to riskier assets in order to generate return will come to an end as rates continue to rise. Markets are never static. They ebb and flow above and below an average. Sandwiched between the two longest recoveries is one of the worst eight-and-a-half-year periods in history for a concentrated investor:

Tech stocks were the worst performer. The S&P 500 underperformed foreign markets by a wide margin. Value outperformed growth in large and small cap. And bonds were a critical stabilizing force in the portfolio.

Without the ability to foresee the timing of these shifts in leadership, the investor is left with that difficult choice. Do they ignore the emotional pull of recent results and remain committed to a diversified strategy? Or are they convinced that winners will continue to win, and it’s time for a change?  The free lunch of diversification is that an investor who owns asset classes that are unrelated to each other can earn a competitive return with less risk than with a concentrated portfolio. However, the key to eating the free lunch is staying committed long enough to receive it, and we are often surprised by how long we must wait. We as your advisors and you as our client have been waiting a long time.  Despite how we may feel, the right thing to do in this moment is to continue to wait.


Disclosure: Global Stocks – MSCI ACWI; US Bonds – Barclays US Aggregate Bond Index; Technology Stocks – Nasdaq 100 PR; US Large Cap Stocks – S&P 500; US Large Cap Growth Stocks – Russell 1000 Growth; US Large Cap Value Stocks – Russell 1000 Value; US Small Cap Growth Stocks – Russell 2000 Growth; US Small Cap Value – Russell 2000 Value; International Developed Stocks – MSCI EAFE; Emerging Market Stocks – MSCI EM

Written By

Mark Feldman

Nathan Erickson

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