January 2021 Monthly Market Review
Cautious Optimism | Why Diversify with Market Cycle Mandates? | Avoid the Big Mistakes
- We believe 2021 should be one of the strongest years in recent history for the economy.
- But don’t be surprised if the overall U.S. stock market languishes.
- Why Market Cycle Mandates?
- We believe investors should diversify by investment strategies and by asset classes.
- How can investors avoid the “Big Mistakes,” including chasing performance?
- Advisors should encourage investors to rebalance and stay balanced.
Stock Market Outlook: Cautious Optimism
It will be an amazing party.
Can you imagine when this war with COVID is over? It’s going to be glorious. It will be like Mardi Gras and Easter morning all rolled together across the land. Families will get together, friendships will be reinvigorated, and new friends will be made. The economy should boom.
But, of course, the war with COVID is not yet over. As citizens and family members, we still have work to do. As investors, however, we don’t have to wait for the flowers to bloom to start participating in economic gains. In fact, the market is already trending up! That’s why price appreciation has been strong of late and will likely start the new year strong, too. The old rule of thumb is the market leads the economy by 3-6 months, but in a world that continues to accelerate, I believe that timeline has sped up. Hasn’t everything?
What happens, however, once the war with COVID is over and the economy is reopened, both physically and psychologically? Quite frankly, don’t be surprised if the overall stock market indices languish. In such a scenario, we as counselors will likely be asked, “Why isn’t the stock market doing better when the economy is booming?”
It won’t be unlike this past year when many asked why the market was strong despite historic GDP contractions. Even factoring in another +10% annualized GDP growth rate in the fourth quarter, real (after inflation) GDP is likely to contract for 2020; yet, the stock market had an above-average gain, basically doubling the long-term average! The stock market leads the economy. It doesn’t reward historical data.
The market may languish in 2021 not only because the recovery has been factored in, but because of how the stock market is measured and monitored. In addition, a potential sustained rotation in market leadership could contribute to its sluggishness.
To explain: The market in 2020 was led by the technology sector, particularly by the big five companies — Apple, Microsoft, Amazon, Alphabet (Google), and Facebook. Using the Vanguard Total Stock Market Index ETF as a frame of reference, technology made up nearly 25% of the index, and the top names nearly 20%. In the Standard & Poor’s 500 index, which is essentially actively managed (consider that Tesla was only added in late December 2020), tech still makes up nearly 25% as do the top six companies. (By the way, here’s a fascinating discussion on company No. 6, Tesla, that will surely make good cocktail party fodder.)
In other words, the market is concentrated in areas that have done particularly well during lockdowns and now sport above-average valuations. In a market rotation, these companies could underperform and weigh on the price performance of the stock market indices (especially the S&P 500). Interestingly, it’s quite plausible that the average stock will outperform the market indices in such an environment.
To say yet another way, even if the major stock market benchmarks have below-average returns in 2021, it could still be a good year for stock market investors, potentially even actively managed strategies, especially those that diversify and use the entire market and not just large companies.
The tagline for these monthly reports is “stay balanced.” In my current experience, I believe the most notable imbalance in investor portfolios is a strong emphasis on the leading large-cap growth names, such as the ones mentioned above. Depending on when they were purchased, they may have borne well for portfolios. Moving forward, however, investors need to keep in mind two of the most important activities of investing: diversification and rebalancing. The balance of this report focuses on these key action items. In addition, I answer one of the most common questions I hear this time of year.
Diversification: Why Market Cycle Mandates?
“Send your grain across the seas,
and in time, profits will flow back to you.
But divide your investments among many places,
for you do not know what risks might lie ahead.
When clouds are heavy, the rains come down…
Farmers who wait for perfect weather never plant.
If they watch every cloud, they never harvest…
Plant your seed in the morning and keep busy all afternoon,
for you don’t know if profit will come from one activity or another
— or maybe both.”
– King Solomon
Orion Portfolio Solutions, building on the experience of FTJ FundChoice, provides a curated, single-stop advisor experience when it comes to selecting investment strategies and constructing an investment portfolio. It’s called Market Cycle Mandates (MCM).
MCM is simple to use and provides the structure for advisors to confidently build well-diversified portfolios. Confident advisors are more likely to foster confidence in their client investors, which in turn creates better investor experiences. It’s a win-win: first and foremost for the investor, of course, and also the advisor.
The premise behind MCM is that great advisors help clients/investors navigate all market cycles with confidence. But that’s easier said than done. The markets are messy and volatile. Volatility creates emotional responses, which throw many investors off plan.
Market movement is responsible for nearly 80% of portfolio return variance, according to a seminal industry study initially published in 2010 by Roger Ibbotson and associates in the Financial Analysts Journal. MCM provides a unique way to diversify client portfolios — beyond the traditional blend of asset classes — to prepare clients to handle the uncertainties of moving markets. The process is simple, and the story is compelling.
The diversification process revolves around three unique market participation questions, a supplement to the traditional risk assessment. These questions are designed to frame the diversification discussion, priming clients to understand the role of diversification in their portfolios.
- Global markets, though volatile, have historically been great engines for long-term wealth creation. Should a portion of your portfolio be exposed to the returns and volatility associated with these markets?
- Would you expect a portion of your portfolio to be actively managed during periods of market volatility?
- Should a portion of your portfolio be excluded from market movement during periods of market declines? (In other words, should you be using additional strategies to ensure volatility is managed according to your objectives, risk tolerance, and unique considerations?)
A “Yes” answer to these questions leads to these mandate allocations:
Investment options that are designed to stay fully invested through market movement. When markets rise, these strategies may participate in the upside. However, when markets fall, these strategies may participate in a portion of the decline.
Investment options that are actively adjusted for changing market conditions. As markets become uncertain, these strategies may increase the defensive portion of your portfolio. Conversely, as markets rise, they may increase your ability to capture gains.
These investment options may disengage from market movement and provide new sources of potential return and risk. These strategies tend to move differently from the overall stock and bond markets. Fixed income traditionally serves this role, but so do alternative strategies.
The aforementioned study is important academic support for MCM. The case was also summarized well in a CFA Institute article, “Setting the Record Straight on Asset Allocation” by David Larrabee.
The Larrabee article refuted the fairly common view that asset allocation fully explains relative investment performance, as put forward in the BHB study. Larrabee argues that active management (individual security selection) and tactical asset allocation (making changes in asset allocation) are also important drivers, not only from an economic standpoint, but a behavioral one. Most investors want and need investment strategies to adapt to changing market conditions. As Larrabee writes, well-diversified portfolios should have exposure to strategies that behave differently in different market environments:
In “The Equal Importance of Asset Allocation and Active Management” from 2010, Ibbotson and colleagues James X. Xiong, CFA, Thomas M. Idzorek, CFA, and Peng Chen, CFA, studied 10 years of returns for more than 5,000 mutual funds in order to measure the relative importance of asset allocation policy versus active portfolio management. Through the use of cross-sectional regressions, they decomposed a portfolio’s return into its three components — the market return, the asset allocation policy return in excess of the market return, and the return from active management.
In my opinion, the key message from the study is that diversification is critical to long-term investment success. Diversification is one of the few free lunches in investing. As stated in Barrons:
Nobel Prize-winning economist Harry Markowitz is known for developing something called Modern Portfolio Theory, which is the basic philosophy behind many investment plans. We won’t get too deep into it here, other than to mention Markowitz’s update of the economists’ credo that “there ain’t no such thing as a free lunch.” Markowitz said “the only free lunch is diversification.” By that he meant when you build a portfolio, you can reduce your risk without reducing returns, simply by diversifying your investments.
Orion Portfolio Solutions’ Market Cycle Mandates are all about diversification, but the twist is to not only diversify by asset class but also by investment strategy.
Avoiding the Big Mistakes
“I will tell you how to become rich. Close the doors.
Be fearful when others are greedy.
Be greedy when others are fearful.”
– Warren Buffett
The other well-known “free lunch” of investing is rebalancing a portfolio, which Investopedia describes as the process of realigning the weightings of a portfolio of assets. Rebalancing involves periodically buying or selling assets in a portfolio to maintain an original or desired level of asset allocation or risk.
So, when should we rebalance, and why does the process work?
Some studies suggest portfolios should be rebalanced on a calendar basis, such as every quarter or year, while others suggest a portfolio-weight approach, such as when portfolio weights drift from a target percentage. In my opinion, there are good arguments for both.
When it comes to calendar-based rebalancing plans, while many investors like to rebalance before year-end, I believe it’s generally preferable for taxable investors to rebalance early in the new year. This allows capital gains to be taxed in a new year and defers taxes that need to be paid (it also allows more time to identify and harvest realized tax losses to offset those gains). However, rebalancing timetables should consider the unique needs of each taxable investor.
Rebalancing works from an investment management standpoint and an investment counseling perspective. Rebalancing is one of the primary reasons value investing works over time (just not all the time). The investment firm Research Affiliates has shown rebalancing takes advantage of the cyclical nature of the markets and the long-term record of mean reversion in prices. Yet, the process is difficult for many. Given my mantra of “stay balanced,” I suppose one could argue the concept of rebalancing is what I write about each month!
From an investment counseling perspective, however, the behaviors of not rebalancing and explicit performance chasing (buying what has already gone up and selling what has already gone down) create what is often called the “behavior gap.” The behavior gap was popularized by Carl Richards but has also been captured in Morningstar’s investor return studies.
As investment managers and counselors, we need to be aware of the behavior gap, whether we are constructing portfolios or advising investors. The well-known Vanguard Advisor Alpha study captures it well. A good advisory relationship can add approximately 3% per year in returns — it is estimated by Vanguard that half of that return is a result of behavioral coaching. Good advisors help investors avoid the big mistakes, as Richards’ sketches show here.
Bottom line: Advisors have many duties, but their role is more than just a job. It’s a calling. As I wrote in my book “Higher Calling” a few years back:
“Investment counseling is a higher calling. Their work helps people retire with the means to explore, create, help their communities, and pass their wealth onto their children. It ensures financial security and peace of mind. As Owen Hand, a financial advisor in Beaufort, South Carolina, put it, “I like people to be able to sleep at night.”
My Favorite Business Books of 2020
A common question this time of year is “What were your favorite books of the year?” I know, because I ask it often! I have a handful of favorites I read in 2020, and while these might be a bit late for holiday shopping, here are the titles I recommend.
The only “investment” book on my list is one I’ve already touted: Morgan Housel’s “The Psychology of Money.” This book is easy to read, with powerful insights that will surely help readers manage, save, and invest their money. I gifted it multiple times this past holiday season.
In an age of information overload, I finally found time to read a book a former colleague gifted me a few years ago. I shouldn’t have waited. “The Organized Mind” by Daniel Levitin was loaded with practical tips on how to organize our thoughts and lives.
If a good book gives you one good idea to use, then this next one is a great book. Ben Greenfield’s “Boundless” is loaded with biohacks and ideas to improve our brains and bodies, which was helpful during a stressful year when it was important to stay healthy and keep the immune system as strong as possible.
Related to the last book, but with only a few big ideas instead of thousands, Wim Hof’s “Wim Hof Method” also had an impact on me. In short, cold showers work!
Lastly, I’m a fan of Ryan Holiday and read some of his stuff every day. “Stillness is the Key” was the latest in his Stoic trilogy.
Thank You for Letting Me Serve You
As always, a sincere thank you for your time and trust. 2020 was a challenging year, with many silver linings and lessons. I’m sure you will agree 2021 should be a wonderful year when we harvest some of what we learned and lived through these past 12 months. I look forward to serving and working for you in the new year.
Stay balanced and be well. Happy New Year!
Orion Portfolio Solutions, LLC is affiliated with its parent company, Orion Advisor Solutions, Inc.
The CFA® is a globally respected, graduate-level investment credential established in 1962 and awarded by CFA Institute — the largest global association of investment professionals. To learn more about the CFA charter, visit www.cfainstitute.org.
The CMT Program demonstrates mastery of a core body of knowledge of investment risk in portfolio management. The Chartered Market Technician® (CMT) designation marks the highest education within the discipline and is the preeminent designation for practitioners of technical analysis worldwide. To learn more about the CMT, visit https://cmtassociation.org/.