The first quarter of 2019 was excellent for stocks. Major U.S. indices were up between 11.81% (Dow Jones Industrial Average) and 16.81% (NASDAQ). Foreign stocks were also higher with the MSCI EAFE returning 10.17%. However, just focusing on the first quarter only reveals one-half the picture. The fourth quarter of 2018 produced a significant decline across stock markets that were symmetrical to the recent gains. This is a classic V shaped recovery. By analyzing a six-month return, it is evident that stock markets have been flat (but with massive amounts of volatility). Since September 30, 2018 (through March 31, 2019) the S&P 500 is down 1.73%, the Dow Jones Industrial Average is down .86%, and the NASDAQ is down 3.38%. Although these figures take some of the excitement off the first quarter rally of 2019, they illustrate that the fourth quarter sell-off was the anomaly.
As D’Arcy Capital opined during the depths of the 2018 holiday sell-off, the downturn in stocks was technical and not based on fundamentals. The decline was enhanced by computer trading and a persistent effort by investors to lower 2018 tax obligations. Tax-loss selling became a higher priority than finding investment opportunities in the final weeks of 2018.
With the start of the first quarter, the tax-loss selling stopped immediately. This reversed the priority back to investments with appreciation potential. Good fourth quarter corporate earnings released in January also supported a reflation of stocks throughout the first three months of 2019.
There was no shortage of alternate theories (versus D’Arcy’s technical/tax loss selling theory) for the fourth quarter sell-off. These attributed the selloff to reasons including: looming recession in the U.S., the .50 percentage point increase in Federal Funds Rate by the FOMC, and fears of an inverted yield curve. These explanations all proved to be wrong. It is a valuable lesson for investors. Do not make long-term investment decisions based on short-term conjecturing. Long-term investors should have welcomed the 4th quarter volatility as a way to reduce tax obligations, rebalance portfolios, and return a much needed risk/return relationship back into investing.
In other financial markets the first quarter experienced slightly lower interest rates, much higher oil prices, and stable gold prices. Interest rates (U.S. 10-year government bond) declined from 2.68% on January 1st to 2.37% on March 31st. During the same period, the price of a barrel of oil rose substantially from $46.93 to $60.28. Gold prices rose .92% during the first quarter.
Looking Forward
Stock markets continue to provide excellent opportunities for long-term investors. A diversified approach to building a stock portfolio should continue to provide wealth building returns, a hedge against inflation, and liquid access to assets. D’Arcy Capital is confident it can construct portfolios that meet the return objectives of investors while also managing risk.
The current major risk facing investors is hidden systematic risk (i.e. risk associated with a single or small number of companies). Many investors believe they are building a diversified portfolio but are dangerously doing the exact opposite. For example, the S&P 500 index (and the numerous index funds and ETFs invested in its constituents) should qualify as a diversified investment. In D’Arcy Capital’s opinion, it doesn’t. Investors assume that a portfolio with 500 securities (actually 505) would have almost zero exposure to individual stock risk. Wrong again. And at 505 individual holdings, there should be an average of .19% allocated to each individual holding. Nope (because it is a capital weighted index). It turns out 16% of the S&P 500 is invested in five stocks (Microsoft – 4%, Apple – 3.8%, Amazon – 3.3%, Google – 3.0%, and Facebook – 1.9%). And if that isn’t enough, the 6th largest holding is Berkshire Hathaway. Berkshire Hathaway is the third largest holder of Apple stock owning 255 million shares (or 5.55% of the shares outstanding). Compounding the risk is that the top five stocks are currently very expensive. If the P/E ratio of the entire index seems expensive at 18 times, the P/E on the five stocks that represent 16% of the entire portfolio should be terrifying.
Price-to-earnings ratios (5/7/2019)
Microsoft 29
Apple 17
Amazon 84
Facebook 24
Google (Alphabet) 29
The last “gotcha” in the non-diversified index products is the idea that spreading across multiple index funds (or non-indexed mutual funds) may not solve the concentration problem. An investor was recently overheard telling his broker that he wanted to invest in her firm’s S&P 500 fund because he had already put money in a different brokerage firm’s S&P 500 fund. He did not want to put all his eggs in one basket. However, that is exactly what he was doing. He was buying the exact same eggs (technically a different basket, but still same eggs). Don’t be fooled by different named index funds. The NASDAQ 100 index (QQQ), Total Stock Market Index (Vanguard Totals Stock Market), Large Growth Index (iShares Russell 1000 Growth), Global Funds (Vanguard Total World Stock), and some Technology Sector (iShares U.S. Technology ETF) all have the same top holdings.
D’Arcy Capital is currently avoiding any strategy that is materially exposed to Microsoft, Apple, Alphabet/Google, Facebook, and Amazon. D’Arcy capital also continues to favor active investment management over passive investment management to lessen risk. D’Arcy capital believes better risk adjusted returns can be found in high potential sectors such as the financial, foreign, emerging markets, and small caps. For the bond allocation, D’Arcy capital prefers shorter maturity fixed income versus long maturity fixed income.
A final recommendation to investors is to be very certain about what asset classes, sectors, and companies you have invested.
