We do our best to emphasise to clients that returns are unpredictable and that one should not react to short-term news, but instead focus on the wealth plan and stay invested to capture the long-term returns. Nothing highlights this better than what happened in September and then in October. Stocks fell in September as all sorts of concerns started to hit the markets, from supply chain induced inflation, to the possibility of interest rates rising earlier than expected, to higher bond yields affecting the discount rate of growth stocks, slowing economic growth in China, and slowing economic growth in the US, just to mention a few.
Heading into October, these concerns were still with us, in fact, energy prices shot higher, hitting consumers with higher electricity and petrol bills. Yet US stocks rose to new records and delivered the best performing month of the year.
How did markets go higher?
If you looked at the average index tracking developed world stocks, you would see Apple, Facebook, Microsoft and Google (Alphabet) floating around the top 10 holdings due to their size. While Microsoft and Google have done well, holding at year-to-date highs, Apple and Facebook are nowhere near their year-to-date highs. Instead, we have the energy stocks going up. Exxon was up almost 10% in October as oil prices went above $80/barrel, as an example of the boost that energy stocks gave to index returns for the month.
What this goes to show is that 1) it is hard to know which stocks are going to do well at any given point in time and 2) being diversified into many different stocks is more beneficial than owning just a few selected stocks over the long term.
Exhibit 1: S&P 500 Sector performance Oct 2021
Tech stocks have been the hottest sector for years, but in this past month, consumer discretionary and energy stocks outperformed by 4-6%.
Staying invested is important
Imagine if after the month of September, we had made a call because of all the uncertainty to switch our clients out of stocks and into cash. We would have absolutely missed the best month of the year in October, as there was absolutely no indication at the start of October that stocks would go up, and go up so quickly. That would have a big impact on returns, as missing the best days costs a lot in performance.
Exhibit 2: Missing the best days hurts performance
Diversification is important
Using energy stocks as an example, let’s look at the performance of the oil majors over the past month.
Exhibit 3: Oil major stock performance Oct 2021
Even within the high-flying energy sector (for Oct at least), not all stocks performed the same. Shell missed earnings estimates and as a result suffered a large fall in its stock price towards the end of Oct, while Exxon and Chevron posted some of their strongest quarters. Stock picking is difficult to get right all the time, therefore we want to remain diversified to make sure we have some of the best performing stocks at any period.
Having a disciplined investment strategy is important
A question we get often is what to do now that stocks have gone up a lot. Typically, this is born out of concerns that stocks are going to fall at some point and if it makes sense to sell now to realise the gains.
How we stay disciplined is with systematic investment strategies that are constantly rebalancing. Indexes are rebalanced regularly, typically every quarter, and this means that managers will have to sell some of the better performing stocks and buy some of the stocks that have not performed as well, along with adding new stocks that might have positive momentum and removing stocks with negative momentum from the index. (What this means is that a new up and coming company will likely get added to the index, while a company that might have a failing business model is removed).
For our Index Plus portfolios, the manager, Dimensional Fund Advisors, rebalances every day, constantly reducing exposure to stocks that have done well, and buying stocks that have a lower relative price.
What this means is that your portfolios are already regularly realising gains from stocks that have done well and allocating to stocks that are more likely to do well in the future. This discipline allows your portfolio to capture the market returns, and gives you the best chance of success in your wealth plan.
How did we do in October?
Exhibit 4: Dimensional fund and global index performance Oct 2021
Stocks did well overall, with large cap stocks and growth stocks doing better than value stocks for the month. Despite that DFA’s Core Equity Fund returned 4.86%, keeping up with the MSCI World return of 5.66%. Emerging market stocks had more muted returns, but stemmed the losses from the previous months.
Fixed income is where markets were challenging, with bonds falling over the month of October as yields rose. There was a sharp jump in short-term yields with the 2-year yield almost doubling in the space of a month, leading to bond prices falling.
Exhibit 5: US 2-year treasury yields Oct 2021
What we can see is that the negative correlation between bonds and stocks is still working, as stocks and bonds typically move in opposite directions, with bonds being far less volatile, so even though bonds fell, the magnitude of the fall is much smaller compared to how much stocks rose, leading to an overall positive return for portfolios that hold a mix of bonds and stocks.
Central bank action in focus
The bond markets are expecting that central banks (particularly the Fed and the ECB) have underestimated inflation, and are pricing in some form of rate hike to combat inflation in the future. It remains to be seen if the inflation is truly transitory, or if it will persist as economies continue to deal with the aftershocks of the COVID-19 pandemic. The Fed and ECB will be watched closely to see if they follow in the footsteps of smaller central banks such as the BOK or the RBA that have moved to tighten monetary policy in recent weeks.
As we head into the final 2 months of 2021, US stock markets are at all time records (for the nth time in 2021), bond yields have risen (leading to better returns on bonds) and Emerging market stocks have once again been battered. We are glad we do not try to predict what is happening in markets as we probably would not have gotten any of these outcomes correct, (looking back, there was a lot of optimism around EM stocks as Asia had dealt with the pandemic better heading into 2021) and instead we kept our discipline and stayed invested in diversified portfolios. That has led to a more successful outcome for our clients this year.
Thank you for your continued trust and support, and we hope that you are keeping well and healthy during these uncertain times.
We do not charge a fee at the first consultation meeting. If you would like an honest second opinion on your current estate plan, investment portfolio, financial and/or retirement plan, make an appointment with us today.