In 2019, investors across the globe welcomed in the New Year by licking their wounds from the worst annual returns for global equity markets since the financial crisis ignited roughly 10 years ago. Larger-cap U.S. stocks declined 9% in December alone and nearly 20% from peak to trough in the fourth quarter; smaller-cap stocks fared even worse, sinking over 20% for the quarter. We certainly weren’t surprised by this pullback, having expressed our concerns for some time regarding U.S. equity valuations being disconnected from supporting fundamentals, such as corporate earnings that embed unsustainable profit margins. And our portfolios have been underweight U.S. equities for some time to reflect this view. Yet the swiftness of the decline was certainly different than anything we’ve experienced since 2008.

Similarly, unlike 2017, when non-U.S. equity markets soared and seemed destined to lead global financial markets forward, foreign stocks suffered throughout most of 2018, with year-end losses in the mid-teens for both developed international and emerging markets (despite their relative outperformance versus U.S. stocks in the fourth quarter). The proverbial “herd” bolted from these markets early in the year as fears surrounding ongoing U.S.-China trade tensions and political and fiscal uncertainties in Europe escalated. Meanwhile, contrarians, us included, continued to seek the rewards of much more attractive valuations—relative to U.S. stocks—and more promising fundamentals than are currently reflected in these valuations. It should be no surprise then that our preference for foreign markets stung our performance in 2018.

What particularly stands out about 2018 is the breadth of negative returns across almost every type of asset class and financial market, whether bonds, equities, or commodities. Over 80% of Morningstar’s investment “categories” were negative for the year, and only a strong rally for Treasury bonds helped the U.S. aggregate bond index end the year basically flat. We have intentionally reduced the interest rate sensitivity of our portfolios’ fixed-income allocations over the past two years to reflect the asymmetrical outlook for interest rates (i.e., far more likely to go higher than lower). 

The Second-Longest Market Expansion in History

This recent year-end marked the 10-year anniversary since the eye of the storm of the Great Recession, when global economic uncertainty was at its peak and almost fully reflected in equity valuations that had declined more than 40%. While investors may not fully remember what happened or, maybe more importantly, how they felt, that historical period is a constant reminder to us of not only how severe downturns can be but also the opportunities that are presented when fears run high. This anniversary seemed like an opportune time to reflect on where we’ve come from, discuss how we have done for our clients, and align these reflections with our long-term disciplined investment process that emphasizes risk management as much as it does return generation.

It is exactly during these challenging periods that it is most critical, but also most difficult, for any investor to stick with their approach and remain disciplined in order to ultimately harvest the long-term rewards. For us, executing this approach with unemotional discipline and patience has proven its worth over time. 

In keeping with our disciplined, this environment isn’t unique to us but certainly the duration is testing even our patience. As we learned in Finance 101, “buy low—sell high.” Unless financial markets have ceased to move in cycles, the current conditions are unsustainable and we’re positioned to benefit when the cycle does in fact turn once again, as it always has. And for all our clients, despite the length of our history together, our portfolios are positioned to perform well moving forward, which is most important as historical returns are meaningless now.

The Next 10 Years

A year ago, equity return expectations were lofty as most investment strategists expected 2018 would bring a continuation of the synchronized global economic recovery. Today, those same strategists are debating whether the next recession will start in 2019 or 2020. In any case, the sharp market pullbacks witnessed this past year only reinforce our view that no one can consistently predict short-term market moves. Over the next year, given the uncertainty stemming from the same macro risks (political, trade, monetary), the range of potential equity market outcomes is just as wide as it was going into 2018. Our approach and preparation remain the same. We construct and manage portfolios to meet our clients’ longer-term return goals, which means successfully investing through multiple market cycles, not just the next 12 months. Given our current investments and positioning, we are confident our portfolios are positioned to perform well over the medium to long term and to be resilient across a range of potential shorter-term scenarios.

If the current recession fears are overdone, we expect to generate strong overall returns with outperformance from our foreign equity positions, especially if currencies are favorable; tactical managers who are taking advantage of recent price drops and non-traditional bond funds that make money independent of the direction of interest rates. On the other hand, if U.S. stocks slide into a full-fledged bear market, our portfolios have “dry powder” in the form of lower-risk fixed-income and non-correlated alternative strategies that should hold up much better than stocks. We’d then expect to put this capital to work more aggressively; for example, by increasing our exposure to U.S. stocks at lower prices and valuations implying much higher expected returns over our medium-term horizon.

In the period since the financial crisis, there has seemingly been little need to own anything other than U.S. stocks. But it should be particularly clear after this year (and past quarter) that isn’t a sound long-term approach. The results of the past 10 years are not sustainable, and they won’t be repeated over the next 10 or 20 years. Even after their fourth-quarter declines, U.S. stocks are still expensive.

However, many markets elsewhere are oversold, strengthening their appeal for long-term, value-seeking investors like ourselves. Europe is historically cheap, with a lot of the worries (e.g., Brexit, Italy’s political and debt concerns) likely already priced in. And the selloff in Asia has been particularly severe. Here again the market seems to be overreacting to potential risks (e.g., a slowdown in China) rather than reflecting the true value of emerging markets—a vast investment opportunity set that continues to expand at a faster rate compared to developed markets.

Despite the risks we see over the short term, we have a high conviction level that our investments in European and emerging-market stocks will earn significantly higher returns than U.S. stocks over the next five to 10 years. We’re becoming less contrarian in this view as many well-respected, valuation-driven investment firms are echoing our conviction. Ultimately, capital flows to financial markets that offer the best risk-adjusted returns. As Rob Arnott of Research Affiliates states, “…the most rewarding investment opportunities nearly always arise out of discomfort—that the best opportunities are often born from cheaply valued markets and fear-induced environments, while the worst tend to emerge from richly valued markets in conditions marked by comfort and complacency. What is comfortable is rarely profitable.”

In Closing

The air has been leaking out of the balloon with the Federal Reserve raising interest rates and reducing its balance sheet. Global growth has been slowing and the U.S. business cycle is nearing its longest period of expansion in history. It should be no surprise that markets are adjusting to these new realities.  For us, on behalf of our clients, successful investing is a process of consistently making sound, well-reasoned decisions over time, and across market and economic cycles. Our goal is never to track or beat a particular benchmark from one year to the next, but rather to provide our clients with the optimal return for the environment we’re given and the risk profile of their particular strategy. This is our sole mission!

Thus, in many instances, our investment decisions are motivated by a prudent desire to hedge significant economic and financial risks that might never play out (but were legitimate and with implications potentially devastating). Given this approach, it is normal—not unusual—for us to go through periods where we will look out of sorts with the broader market. As we continue to execute our approach with discipline and patience during the inevitable periods when it is out of favor, we will continue to achieve successful and rewarding long-term results for our clients, as we have over the life of our firm.