Dissecting Q3 2019
Stocks ended the quarter up, barely, as the Fed took action that helped soothe frayed nerves in a volatile Q3. Investors are in a period of heightened uncertainty. Is the economy heading to a slowdown? Will tariffs impact growth? How will securities react to impeachment proceedings? It is no surprise that Q3 was a bumpy ride for investors. There are signs that investors are becoming more cautious, but we would warn against trying to time this market. History is rife with examples of timing gone wrong. In the wise words of famed investor Peter Lynch, “Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.”
Recent trends continued with large-cap and domestic stocks outpacing small-cap and international stocks, respectively. We would still classify large-cap valuations as being in the normal range, albeit at the high end of normal. International stocks are valued in line with their long-term average, while small-cap stocks have slipped below trend.
Chart 1: Large-cap equity valuations at the high end of normal
Stocks were flat in Q3, but so were earnings, leaving valuations little changed.
Historically there are five stock characteristics that have been persistently rewarded: Good Value, High Quality, High Momentum, Small Size, and Minimum Volatility. Looking at performance through this lens for U.S. equities, we see that in Q3, Minimum Volatility was the most rewarded factor followed by Small Size. Minimum Volatility is a defensive factor that tends to perform best as the economy slows or contracts. Investors appear to be preparing for a late-cycle economy.
Chart 2: U.S. Factors. Minimum Volatility outperformed in an uncertain environment
Minimum Volatility was the star this quarter as investors were drawn to its defensive characteristics.
While equities were flat, fixed income was anything but. With growth tempering, trade tensions heightening, and inflation remaining stubbornly low, the Fed acted, lowering rates twice. Bond yields fell further, adding to an already impressive year for fixed income returns (as yields fall, bond prices rise). Investors are anticipating another 0.25-0.50% cut by year-end, which is somewhat in contrast to the Feds’ projection showing rates bottoming out just below current levels. Despite projections, we expect the Fed to stay nimble and ready to step in when needed.
Chart 3: The Fed proved nimble in Q3, cutting rates twice
The Fed cut rates twice in Q3. While they project we are near the bottom, investors are anticipating that more cuts will be necessary.
Gold was the best performing asset class in Q3, but year-to-date, U.S. large cap equities remain on top. Bonds put in a positive performance thanks in part to the Fed rate cuts. While the year-to-date performance figures in the chart below look impressive across the board, we would urge investors not to be complacent. The recent strong performance of Gold and Minimum Volatility stocks give insight into current investor sentiment: they are turning more defensive. Could we be moving closer to the end of the current cycle? Possibly. But it is also possible that after taking a breather in Q3, stocks are primed for another leg up. For investors, the goal should not be trying to predict the unknown, but rather to prepare for it with a well-diversified portfolio, poised to take advantage of any opportunities that the market offers.
Chart 4: Asset classes are up across the board this year
Gold made a big move up the chart this quarter, but U.S. large-cap equities are still the market leader.
The Q4 2019 Playbook
Investors appear to be turning a little more defensive, and it is hard to blame them. In addition to the uncertainty introduced by tariff wars and an impeachment inquiry, there are some signs of economic slowdown which are culminating in weaker leading indicator data, not to mention a partially inverted yield curve. In such an environment, how should investors be positioned as we enter the final quarter of 2019?
First off, this is no time to panic (in fact, there is never a time to panic in investing). While the U.S. economy is not without blemishes, we would still classify it as robust. The unemployment rate is low, wage growth is outpacing inflation, and the all-important consumer remains confident. And let’s not forget the Fed appears willing to do whatever is necessary to continue the expansion. Would-be market timers, ready to pull the plug on equities, have been forewarned.
In a maturing economic cycle, with uncertainty above average, our approach is to:
- Overweight investment “factors” that have shown to persistently advantage portfolios throughout the cycle: High Quality, Good Value, Small Size, High Momentum, and Minimum Volatility.
- Tilt our factor exposure toward Minimum Volatility, which has historically held up better in a slowing and contracting economy.
- Enhance equity diversification. We believe in owning just as much Small and Mid Cap exposure as Large Cap. In addition, we hold a sizable exposure to international equities, which not only provide natural diversification but also happen to be relatively inexpensive currently.
- Include Gold as part of portfolio protection. Gold provides some inflation protection yet has low correlation to the stock market, improving the risk-adjusted returns of the portfolio.
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