Quarterly Perspectives: Q3 2024
Published October 14, 2024.
Transcript
Introduction to Quarterly Perspectives
Hello, and welcome to quarterly perspectives third quarter 2024.
My name is Josh Ernst, and I am a member of the investment strategy team at Buckingham Wealth Partners. I'll be your host for this presentation.
This presentation details quarterly equity and fixed income performance along the framework of absolute returns, relative returns, and future expectations for market performance.
We will then go on to discuss recent interest rate movements and inflation expectations.
Last, we examine how different asset classes contributed to an overall portfolio return.
We hope you enjoy today's presentation.
Now let's get started.
Overview of Major Asset Classes
We begin our discussion with a high level look at a collection of major asset classes.
As we can see from the illustration, US and emerging market stocks were up during the third quarter, continuing the positive trend from the second quarter.
Developed international stocks were also up during the third quarter, reversing the negative trend from the second quarter.
Returns for US and global ex US bonds were up for the quarter.
Next, I'll draw your attention to the upper right hand portion of the graphic.
The United States dollar was down four point eight percent for the quarter and down five point one percent over the last twelve months.
Now let's look a little deeper at what was driving the returns of stocks and bonds.
We'll start by taking a look at how global equities performed for the quarter, and we'll isolate the performance between US and developed international stocks.
The two charts show the performance of different investment styles between the US and international stocks.
The bright blue bars represent the performance of different investment styles and the dark blue bars represent the total market performance for the region.
US returns are measured with the Russell indexes, and international market returns are measured with the MSCI World ex US Index Series, which represents global developed market performance excluding the United States.
As we can see from the dark blue line on the chart on the left, the US market was up six point two percent in the third quarter compared to up eight point one percent for the developed international markets from the chart on the right.
Small growth neutral and value stocks and large value stocks on average outperformed the market in the United States.
Small value stocks led the pack domestically, which is a new trend compared to last quarter on a relative basis.
Internationally, small growth, neutral and value stocks, and large value stocks tended to outperform the market with international small value stocks posting the best performance for the quarter among international developed regions.
But no matter the recent trends, it's important to remember that we shouldn't make longer term projections based on short term performance.
Long-Term Performance Analysis
Now we take a longer view to see how different investment styles have performed for standard periods ending September thirtieth twenty twenty four.
Looking at annualized returns in the US, we can see that markets have shown resilience, especially over the trailing one year period when faced with significant headwinds, such as the continued conflicts of war across the globe, uncertainty surrounding the future path of interest rates and inflation paired with what the Fed is projecting, and growing dysfunction on Capitol Hill.
Despite these potential issues, US markets returned thirty five point two percent over the last year and have been nearing or exceeding twelve percent per year during longer time horizons.
Large growth stocks have the best performance for the trailing one year period gaining forty two point two percent, which beat the US market by seven percent.
We can also see that small in value stocks have generally been out of favor during these time periods.
Consequently, we expect that portfolios that have a small value tilt, such as those that we typically design for clients, will have underperformed portfolios that are market cap weighted or tilted to large growth stocks at these longer investment horizons.
Keep in mind that the very long term evidence demonstrates that on average, small stocks outperform large stocks and value stocks outperform growth stocks, but size and value factors can still go through extended periods of an underperformance like those shown above.
Turning to international markets, we see that large cap growth stocks have led the pack over the one year period.
At the longer time horizons, we see varying performance among different styles with value stocks, large cap stocks, and growth stocks, each posting leading performance over the trillion three, five, and ten year periods respectively.
Relating to the prior slides, we see that international markets have underperformed the US market by ten point four percent during the last twelve months as well as at longer horizons with the three, five, and ten year performance trailing by five point five percent, seven point two percent, and seven point one percent respectively.
It's also worth noting that the US total stock market has had an exceptional ten year run with the bulk of it being driven by richening valuations and strong corporate real earnings growth.
And a recent AQR research paper suggests that to expect the repeat of this performance over the next decade even with an aggressive increase in earnings growth, investors would have to continue to bid up valuations far above where they were at the height of the tech bubble.
Nonetheless, given the higher US return over longer term horizons, we expect portfolios concentrated in US stocks to have outperformed a globally diversified portfolio.
Evaluating Market Valuations
However, as we'll see in the next slide, these relative performance numbers aren't reason enough to abandon international stocks.
Thus far, we've discussed quarterly performance on a relative and absolute basis.
Now let's take a look at current stock market valuations and how they relate to future expectations of market performance.
The charts on this slide show how expensive stocks are by measure of the price to earnings ratio, a very common metric used to value equities.
The higher the ratio is, the more expensive the asset class is overall.
Thought of another way, these values depict how expensive one dollar of earnings is.
For example, as we can see in the chart on the top left, the average dollar of earnings for the total US stock market cost roughly twenty six dollars and ten cents.
Internationally, as we can see in the chart on the top right, earnings are cheaper at just over sixteen dollars and sixty cents per dollar of earnings on average.
The values represented here use historical fund and ETF data to establish the price ratios, and the average PE is reflected by the dotted line on the chart.
These averages start in the first quarter of two thousand four for US measures and in the fourth quarter of two thousand six for international stocks.
Noting the strong market performance during the last twelve months, we see both broad US and international markets are now trading close to or above their recent historical averages.
We can also see that small value stocks in global developed markets appear cheap relative to their recent historical averages.
All else equal, we would like to pay less for a dollar of earnings.
These valuation ratios aid in setting expectations about the future.
Low valuations today imply higher future returns and vice versa.
The recent strength of broader US market performance means that it is reasonable to expect lower returns than in the past when valuations were below their long term historical averages.
The opposite is true for international markets and small value stocks globally.
It is reasonable to expect higher returns than in the past when valuations were above their long term historical averages.
I'll emphasize that this is a long term relationship and that short term outcomes will likely be dominated by unexpected market forces.
Here we have the same analysis, but isolating US equities so we can see how valuations compare across different styles.
Recalling the annualized performance slides, we know that large growth has had an exceptional ten year period.
We can see that the growth in prices has exceeded the growth in earnings as the PE ratio has climbed to thirty five point seven to close the quarter, which is above its average since two thousand four.
Small value, on the other hand, has a PE ratio of thirteen point nine and remains under its average since two thousand four.
Although many investors may be interested in chasing the returns of large growth companies, we would point to these valuation charts as one reason to stay the course in a diversified portfolio tilted to small, relatively inexpensive companies.
Fixed Income Market Insights
Next, we'll take a look at fixed income performance, the shape of the current yield curve, and how the market is currently pricing inflation.
The charts on the screen show the average performance of different bond maturities and the segments of the fixed income market that we commonly track.
We typically prefer investing in bonds that are shorter maturity and higher quality compared to the broader market.
In the chart on the left side, we see that bonds of all maturity ranges had positive performance, but markets favored longer maturities relative to intermediate to shorter maturities, with the ten to twenty year segment posting the largest gain because of their sensitivity to rate cuts.
The chart on the right shows the performance of different intermediate maturity credit quality bonds.
We see that there was positive performance across the different credit qualities listed for the quarter with investors favoring corporate and treasury debt relative to other credit segments.
Next, we'll look at the treasury yield curve and what it means for returns going forward.
Here we plot the yield curve to show the current yields for treasury bond investments at different maturities.
The light blue line represents current rates. The dark blue line represents rates from the end of the prior quarter, and the gold line represents rates from one year ago.
As we can see from the yield curve, rates decreased for all maturities during the quarter. As stated previously, this complemented longer dated maturity debt.
Looking forward, long term expected returns for fixed income look to continue to decline due to the Fed's shift to cutting rates.
However, for fixed income investors, this is positive as a lower rate environment going forward serves to increase bond prices in the short term, resulting in capital gains.
The yield curve is no longer inverted, as it had been since the start of the third quarter in year twenty twenty two.
As stated in the past, when this happens, particularly between two year and ten year points on the curve, it is widely regarded as one of the precursors, but not as a guarantee, to an impending recession.
So it remains to be seen whether the prolonged yield curve inversion will prove to be an indicator of a recession.
Finally, we plot the market's forecast of inflation by taking the difference in yields between US Treasury bonds and TIPS at different maturity levels.
Like the last chart, the bright blue line represents current inflation expectations.
The dark blue line represents inflation expectations from the end of last quarter, and the gold line represents inflation expectations from one year ago.
Current market estimates for future inflation have been showing inflation beginning to cool compared to the prior quarter and this time last year.
Inflation readings have continued to moderate.
Recent favorable trends appear to convince the Federal Reserve that inflation may be under control as its two percent inflation objective is starting to show evidence that inflation is able to stay at that target in a sustainable manner.
To that end, the panel is recalibrating monetary policy and implemented a zero point five percent rate cut at their September meeting, representing the first rate change in a year and the first rate cut in more than four years.
The Fed has shifted its focus to the US labor market and maintaining full employment with suggested further rate cuts in the coming November and December meetings.
As these expectations continue to evolve, it is important to remember that these levels of inflation are baked into prices today.
The markets are pricing an average inflation rate of approximately two point one percent per year for the next five years, and the market collectively expects inflation to similarly outpace the Fed's two percent target over the next thirty years.
Not only are these expectations baked into bond prices, but they're also baked into equity prices.
Making a bet on lower inflation would mean that we expect inflation to fall short the current forecast.
Impact of Asset Classes on Portfolio Returns
Next, let's take a look at how some major asset classes contributed to a sixtyforty mix this quarter and how that index mix behaved during recent history.
On this slide, we look at the absolute impact of different asset class returns on the quarterly return of a sample sixty percent stock, forty percent bond index mix.
With stock and bond markets moving upward this quarter, we can see that equity and fixed income asset classes contributed to the overall increase of the index mix.
US large cap stocks were the largest contributor for the quarter, while emerging markets had the smallest contribution to overall return.
Diversifying stocks across geographies and investment styles as well as allocating to bonds helped avoid undue portfolio concentration risk while allowing for ample growth this quarter.
This resulted in the sixty forty index mix achieving a return of five point eight percent versus the US total market return of six point two percent.
The portfolio was able to achieve a smoother outcome with less overall risk given its diversification across different asset classes.
Here we see a collection of major asset class calendar year returns displaying on a quilt chart.
Looking at year to date returns in the right most column, we can see that all asset classes posted positive performance with the S and P five hundred, a popular headline index primarily tracking US large growth company performance, gaining the most value at twenty two point one percent.
We can also see that the performance of each individual asset class tile shows no predictable return or relative ranking from one year to the next.
A diversified index mix, such as the sixty percent stock forty percent bond index mix shown in the white tile, tends to stay away from the extreme returns, both positive and negative, on a yearly basis, and over time while also dampening the volatility of returns.
This is an example of the potential benefits of a well diversified portfolio.
It also helps us as investors to stay in our seats through any given quarter of market turbulence and not take away our ability to prosper from the many quarters to come.
Conclusion and Future Outlook
And with that, we've reached the conclusion of today's presentation.
Thank you for joining us. We'll see you next quarter.
Beacon Hill Private Wealth is an independent, fee-only, fiduciary investment advisor providing evidence-based wealth planning solutions that simplify our clients' financial lives. Founder Tom Geoghegan, CFP®, CIMA®, CPWA®, RMA® is also a member of the National Association of Personal Financial Advisors (NAPFA).
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