After regaining their all-time highs over the summer months, stocks saw a resurgence of volatility in the beginning of October. The downturn was widely attributed to rising interest rates, as the yield on the benchmark 10-year Treasury note surged to 3.25% for the first time since 2011. It didn’t take long for the financial press to ring the alarm bells, reminding us that rising interest rates and falling stocks always go hand in hand.
But do they?
A closer look at the data says otherwise, or at least isn’t conclusive. Stock returns have ranged from a 15.56% loss to a 14.27% gain in months when the Federal Funds rate rose. And returns have ranged from a 22.41% decline to a 16.52% gain in months when the Fed Funds rate fell.
Bond prices fall when bond yields rise, and it’s enlightening to see the performance of the stock market during such periods of time. While stocks have certainly experienced prolonged downturns for portions of some rising interest rate cycles, the big picture is that rising bond yields have not been the damper on stock performance that conventional wisdom suggests when looking at the full rate cycles:
It’s been nearly a decade since the S&P 500 last experienced a true bear market (defined as a drop of 20% or more). From that perspective, it’s not hard to argue that stocks are overdue for a prolonged downturn, and market pundits are quick to seize on any perceived negative event (such as rising rates) as the reason that stocks are bound to plunge. But there’s also a lesson here, because those same pundits have been calling for a bear market for five-plus years now, and stocks have continued to climb all along the way. Investors who heeded the call to “protect” their assets in anticipation of the many predicted downturns that never materialized have instead cost themselves the significant gains that stocks enjoyed.
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U.S. stocks have outperformed international stocks in 2018, a trend that has continued for most of the past decade. When we go through an extended period of time when the stocks that U.S. investors are most familiar with lead the market, it’s easy for investors to wonder if there is any point in diversifying internationally.
When that thought pops to mind, it’s important to remember what the primary goal of strategic asset allocation is – and what it isn’t. Strategic asset allocation is a method of spreading assets across a wide variety of asset classes and investment styles – large and small, domestic and foreign, growth and value – in an effort to participate in the long-term higher returns that stocks have historically provided, while reducing or eliminating unnecessary risk.
As such, the goal of strategic asset allocation is not to make bets about which asset classes or investment styles will be outperformers going forward. Making such bets only increases the investor’s chances of guessing wrong and being concentrated in an under-performing asset class for an extended period of time.
The difference in performance between large and small stocks, and between growth and value stocks, often fluctuates significantly from year to year. But the fluctuations between U.S. and international stocks tend to be much longer in duration, with one outperforming the other for years and sometimes (as in recent years) a decade or more.
Given these long periods of time when U.S. stocks outperform foreign stocks and vice versa, it’s imperative not to be concentrated in either of them to the exclusion of the other. Large-cap international stocks provided a huge diversification benefit to investor portfolios in the turbulent years of the late 1980s and throughout the 2000s. We are confident that they will provide a similar benefit in the future – though exactly when no one can know.
Further, diversifying into international small stocks and emerging markets stocks over the past 15 years has significantly muted the relatively poor performance of international large stocks. As you can see in the chart below, international small stocks and emerging markets stocks have kept pace with their U.S. counterparts the past 15 years, even as large international stocks have trailed U.S. large stocks by about 3% annually.
One final thought on this subject, more on the behavioral level than the analytical level: Much of the angst that investors experience about asset classes over-performing or under-performing comes from the expectations they have beforehand. In other words, if we expect that international stocks “should” provide a tangible diversification benefit in every market cycle, we’re going to be dismayed when that benefit fails to appear. The same can be said of investor opinions about the merits of growth or value stocks, or large or small stocks.
The reality of stock investing, however, is that such periods of under-performance are going to happen at some point for every asset class and investment style, and they are inherently unpredictable. If they were predictable we’d have a lot more successful market timers touting their past success instead of their future predictions; for some reason, they are hard to find.
When it comes to investing, then, the key to contentment is the acceptance of the randomness of returns as a reality of the stock market. Diversification can, and does, smooth those effects, but it can never eliminate them. The only way to do that is to stay out of stocks entirely – and that’s no kind of investment strategy.
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