In the spring of 1786, Thomas Jefferson was in trouble. He had a huge dile
mma and was struggling with deciding what action he should take. Jefferson, a widower, had fallen in love with a married woman, Maria Cosway, during his time overseas as the US Minister to France. The conflict between his own emotions and his reason is depicted in a now-famous letter he wrote to Mrs. Cosway in the form of a dialogue between his "Head" and his "Heart."
It appears to us, that investors today have a similar quandary to Jefferson, particularly when it comes to the US stock market; emotion versus reason. The heart of the matter is that we are in euphoric times for US equity returns. Despite an obviously volatile October, this bull market in US stocks became the longest in history last quarter. The S&P 500 was up 7.9% in the third quarter, 10.8% for the first nine months, and a mind boggling 331% since March 2009. This continued rise in stock prices is rooted in robust corporate earnings and profitability.
Investors remain committed to US stocks, many if only for the fear of missing out.
Nonetheless, the "Head" can see cracks in the façade. Investors may not have reached an irrational exuberance level on stocks, but there certainly are signs of robust emotional enthusiasm. One telling sign that investors realize "FOMO" has contributed to returns, is just how swiftly the market entered correction territory earlier this week. No single factor was to blame of course, but after Amazon and Google reported earnings - which exceeded expectations! - the two stocks fell sharply on Friday because they reported a slowdown in revenue growth. And because those two stocks are so heavily weighted in the indices, markets fell right alongside them.
Growth stocks have significantly separated from value stocks which is reminiscent of the Tech Bubble era. Through the third quarter, the S&P 500 Growth index was up 17.7%. The NASDAQ 100 was up 20.2%, and FAANG (Facebook, Amazon, Apple, Netflix and Google) was up a whopping 42%. Meanwhile, the S&P 500 Value index was only up 3.5% for the same period. The growth/value separation reminds us of the extreme levels we saw in the late 1990's. Similarly, the IPO market is on fire with record absurd behavior. 83% of US listed IPOs through the third quarter of 2018 lost money in the last 12 months. Today's IPO environment is even more pronounced than 2000 when "only" 81% of newly listed companies were losing money. Additionally, over 300 companies in the Russell 3000 index are trading at more than 10 times revenue!
And like 2000, strong equity returns have been primarily a US party. Since 2009, US equity returns are almost two and a half times those of non-US stocks. The first three quarters of 2018 have been particularly hard on non-US stocks, especially in emerging markets. Led by a strong Dollar, non-US developed markets and emerging markets are down -2.7% and -7.7%, respectively. Much like the period before the Tech Bubble burst, any form of diversification beyond US growth stocks - into value, international, emerging markets - simply has not worked. Only time will tell if this current correction in US stocks will quickly rebound, if the downturn could lead us into recession. Our head, and experience, tells us these periods do not last forever and have the potential to end badly.
As a result of this environment, we have diversified our clients into more "credit" exposure which has provided excess return, something unique outside of US stocks. High Yield bonds performed well, up 2.4% in the third quarter, and 2.6% year to date. Business Development Companies (BDCs) continue to perform exceptionally well, notwithstanding a flat third quarter. The Cliffwater BDC Index for the year is up 9.3%. What makes BDCs so attractive, in addition to high yield, is the senior nature of the credit on the balance sheet of the borrowers. Master Limited Partnerships (MLPs), another diversifier, had a strong recovery last quarter as the Alerian MLP Index rose 7.5%. Finally, hedge strategies (Multi-Strat, Long/Short, Absolute Return) continue to frustrate investors. Simply said, it has not been a good environment for hedge as what is expensive has gotten richer and what is valuable has gotten cheaper. That atmosphere will not last forever.
As Jefferson agued with himself in 1786, his head recited, "The art of life is the art of avoiding pain
and he is the best pilot who steers clearest of the rocks and shoals with which he is beset." The "pain" of 2018 has been diversifying into any asset class that is not a growth oriented, US stock. History has not been friendly to such a myopic strategy. We continue to suggest, as Mr. Jefferson ultimately decided, that using one's head is best for the long run. Our clients remain well diversified because while we seek long term performance, we also want to avoid the "rocks and shoals" of downside volatility.
We invite you to view the accompanying exhibits and listen to an expanded version of our Market Outlook by clicking the video link above.
