Dorato News, April 2020
Updated: Jan 4, 2021
The Big Five
This is one of those times when diversification is offering limited benefits. Bonds have fulfilled their role, yes, but diversification within equities has actually hurt performance.
International stocks and small and mid-sized US stocks have performed worse than the S&P 500. And within the S&P500, consumer-related stocks, finance stocks, and energy stocks have been clobbered, while large technology companies have fared better than average. In fact, a good strategy for 2020 so far would have been to buy the top five stocks in the S&P 500: Microsoft, Apple, Alphabet (Google), Amazon and Facebook. Not much diversification in that strategy, but it would have been successful.
I suppose it’s reasonable that investors might seek shelter in stocks that have done well in the recent past. But here’s something worth thinking about, for all those people who keep gripping onto those companies: if you look at the top stocks in the S&P500 at the beginning of each decade, there’s often significant turnover by the end of the decade. (Source: Ben Carlson, Fortune). Exxon and General Electric were in the top five in 2010; they don’t even crack the top ten now. Keep going back, to 2000, 1990, 1980, and the story is the same: there’s quite a bit of turnover in the top five stocks in the S&P500.
You might argue that the current big five are especially well-run, or have particularly untouchable business models. But my guess is that investors thought the same thing about the top companies in each of the prior decades. Counting on the current big five to outperform the index for the next ten years, and making such an undiversified bet, seems a foolish wager to me.
A Shock to the System
The coronavirus has reminded us what a shock looks like. Shocks are events or phenomena that are unexpected, and that upset people’s assumptions about how the world works. Bad shocks, like the coronavirus, can cause recessions. We are almost certainly in one now, and what everyone would like to know is how deep a recession this will be, and how long.
There will be lots of people willing to give you an opinion, but no one really knows. The economic shut-down imposed by authorities seems designed to buy us some time to slow the spread of the disease, learn more about it, and develop procedures to fight it. In the best case, the threat will recede as the flu season ends. But public health officials don’t seem willing to commit to that scenario.
That uncertainty is what drives financial markets bonkers. How can you predict earnings and cash flows if you don’t know what’s likely to happen with the economy? In the short term, that makes the whacky swings in the markets more understandable.
In the longer term, looking several years out, the coronavirus looks less likely to have an impact. Just three months ago, I wrote that the expected return from stocks was below average. With the sell-off, the expected return has jumped to above average. The only way that’s not true is if the coronavirus causes long-term damage to the economy. I can’t see that.
The first three or four weeks of the sell-off were marked by indiscriminate selling — whether due to panic, program trading, or whatever, no one seemed to care about the prospects for any particular company. In normal markets, prices tell you something about what investors think. In frantic markets, investors simply seem crazed. In these last days of March, there finally seems to be some attempt to differentiate. These assessments will change as new information comes in, but at least people seem to be trying to make assessments, rather than throw out the baby, the bathwater, and the kitchen sink.
I continue to think that owning solid, dividend-paying companies is a good investment approach. Some of these companies may have to cut their dividends for a period of time, but not all of them. Eventually, people will look around and notice that dividend-paying stocks are one of the better investment choices out there.
The Federal Reserve and US Treasury are making the right moves to keep a shock from turning into a calamity. These decision-makers get to experience the joy of millions of people second-guessing their decisions. I think they’re doing an admirable job.
While expected returns for stocks have improved dramatically, the same cannot be said for bonds. High-quality bonds fulfilled their role during this stock sell-off, providing a cushion against the wild swings in stocks. But the yield on a 10-year Treasury is now less than 1% per year, not exactly a juicy income that will meet your future living expenses. And as the US adds to it’s debt pile, the risk of repayment isn’t an issue, but the risk of inflation is. I continue to recommend high-quality bonds only to offset the risk of stocks, and not for the paltry income they generate.
This is the part where I remind you to stick to the long-term plan. In periods like these, when we’re all trying to reassess our assumptions, it’s easy to succumb to a short-term view, to think that the crisis we face at the time will only persist or worsen. But it won’t. The long run is remarkably stable.
The key is that you don’t want to sell when stocks are down. Some people have to sell because circumstances change; that’s unfortunate but necessary. But most of us don’t face changed circumstances. For us, if we can avoid selling when everyone else is, we’ll be better off in the long run.
Sources: Economist, Wall Street Journal, Value Line, Vanguard, Morningstar