Not long ago, at the end of September, U.S. equities appeared on track for another year of double digit returns, as the S&P 500 Index returned 7.71% for the third quarter, its strongest quarter in five years. However, the fourth quarter provided a sharp reversal, with equities off significantly, and the S&P 500 Index nearly entered bear market territory with an intra-day low on December 26 that was slightly less than 20% below its September 20 high.
The exuberance at the end of the third quarter of 2018 seemed to lose cognizance of the fact that, in contrast to 2017, equity markets did not go straight up in 2018. Strong returns in the second and third quarters masked volatility that had stealthily crept back into the market.
The CBOE Volatility Index (VIX), a commonly referred to measure of perceived investor risk, hit its lowest level in more than 25 years during the fourth quarter of 2017 then spiked in early February 2018 and remained elevated through March 2018, before dissipating. While seemingly a distant memory, the equity market sell off in February, March and the latter part of June now appears to have been the harbinger of a renewed focus on risk that came into full focus with vengeance in the fourth quarter.
Equity markets sold off significantly in the fourth quarter, with the S&P 500 Index down -13.52% as investors reacted to concerns about the onset of the next recession, rising interest rates, disruptions from trade/tariffs, growing geo-political concerns and the prospect of slowing earnings growth in 2019. These risks have been apparent for the last few months, but really took hold in the fourth quarter.
Looking below the surface, the renewed aversion to risk is most apparent when considering the extent with which riskier stocks detracted from the S&P 500 Index return. Beta was the worst performing factor, and when combined with Residual Volatility (a measure of stock specific volatility), risk factors explained just over half of the Index’s negative return in the fourth quarter.
In this environment, riskier assets across the U.S. markets underperformed. Small cap stocks trailed large cap stocks with the Russell 2000 Index falling -20.2%. High yield bonds as represented by ICE BofAML U.S. Cash Pay High Yield Index were down -4.64%, underperforming investment grade bonds as the Bloomberg Barclays US Aggregate provided a positive return of 1.64%. High yield spreads widened significantly from 333 basis points (bps) to 539 bps, their widest level since the summer of 2016.
Non-U.S. developed market stocks also were off significantly, with the MSCI EAFE Index down -12.54%, but in a reversal of recent results, they modestly outperformed U.S. equities primarily due to a stronger December.
While investors fleeing riskier stocks is the headline, the outperformance of value stocks over growth stocks in the fourth quarter is also significant — the Russell 1000 Value Index outperformed the Russell 1000 Growth Index by 4.16%. While only one quarter, we see this as an indication that investors have a renewed cognizance that valuation matters, in contrast to the momentum-driven, risk-off markets of the past two years. Thus, many growth stocks that had become overpriced relative to their earnings prospects were prime contributors to the market downturn.
The silver lining amid the fourth quarter volatility is the potential for a better environment in which disciplined focus on risk and valuation are rewarded.
Successful investing boils down to thoroughly understanding risk, opportunity and assessing the price you are willing to pay for the risks and opportunities embedded in an investment. During so called “risk-off” periods when asset prices ascend unimpeded, there is muted volatility and little focus on risk and valuation. Conversely, heightened volatility is reflective of a sharp increase in investor concern that drives fluctuating asset prices. In this environment, patient investors can be rewarded if they properly assess risk and identify opportunities that have sold off beyond their longer-term intrinsic valuation.
Managing through volatility with a sustainable investing focus in equity portfolios
From a risk standpoint, we believe that higher quality companies, with sustainable business models, strong balance sheets and consistent earnings will be in a better position to weather an uncertain, volatile market environment. We also believe that to comprehensively assess a company’s risk, we need to have a thorough understanding of its ESG risks.
ESG risks have an indeterminate time horizon and may materialize anytime. A company with a poor and worsening safety record may fly under the radar for years until that one headline event shatters investor confidence, and its market value. In 2018, according to a report, extreme weather events linked to climate change caused ten events that cost more than $1 billion each, with four costing more than $7 billion each.
We believe that identifying which companies are better prepared to manage these ESG risks contributes to building a portfolio of stocks that are better positioned for the long term as well as during more uncertain times.
Volatility also presents opportunity. With the sharp sell-off, many companies that previously appeared overvalued relative to their long-term prospects, are now trading at more reasonable prices. One area of focus is Information Technology, where many higher quality companies with leading-edge products and sustainable competitive advantages are now trading at more attractive entry points.
Similarly, more cyclical companies that underperformed in the fourth quarter and are well-positioned to benefit from the transition to a more sustainable economy may now be more attractive. These companies have demonstrated leadership in addressing climate change, enhancing productivity and improving efficient use of scarce resources. These companies may be providing investors better valuations for investment.
For example, the long-term outlook for the internal combustion engine is growing ever less rosy, while projections of the global electric vehicle (EV) market are much more optimistic. In the fourth quarter, certain companies providing components to the EV market underperformed the broader equities. We believe this weakness is overdone, providing an attractive entry opportunity for long-term investors.
Addressing asset allocation
From an asset allocation perspective, the fourth quarter decline in the market brought equity prices to more attractive valuation levels. At year end, the S&P 500 Index price-to-earnings (P/E)1 was at 15.58x 2019 earnings, which is attractive both relative to its own history and investment grade bonds, particularly with the 10-year Treasury Note closing the year at a yield of 2.69%, significantly off its 2018 high of 3.24%. However, amid this volatility, we are assessing whether current valuations fully reflect a myriad of risks or if recent volatility overly discounted these risks.
Volatility has returned, and we expect it to have continuing significance as we look out at 2019. In this environment, long-term investors who comprehensively assess risk, ESG factors and valuation have the potential to identify attractive opportunities at the asset class and security level.
The S&P 500 Stock Index is an unmanaged index of large capitalization common stocks.
The Chicago Board Options Exchange (CBOE) Volatility Index (VIX) shows the market’s expectation of 30-day volatility. It is constructed using the implied volatilities of a wide range of S&P 500 index options. This volatility is meant to be forward-looking, is calculated from both calls and puts and is a widely used measure of market risk.
Russell 2000 Index measures the performance of the small-cap segment of the U.S. equity universe. The Russell 2000 Index is a subset of the Russell 3000 Index representing approximately 10% of the total market capitalization of that index. It includes approximately 2,000 of the smallest securities based on a combination of their market cap and current index membership.
ICE BofA Merrill Lynch High Yield Index tracks the performance of below investment grade, but not in default, US dollar denominated corporate bonds publicly issued in the US domestic market, and includes issues with a credit rating of BBB or below, as rated by Moody’s and S&P. One cannot invest directly in an index.
Bloomberg Barclays U.S. Aggregate Bond Index represents securities that are U.S. domestic, taxable and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities and asset-backed securities.
MSCI EAFE (Europe, Australasia, Far East) Index is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. and Canada. The MSCI EAFE Index consists of the following 21 developed market country indices: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, and the United Kingdom. Performance for the MSCI EAFE Index is shown “net”, which includes dividend reinvestments after deduction of foreign withholding tax.
Russell 1000 Value Index is a market capitalization-weighted index that measures the performance of those Russell 1000 companies with lower price-to-book ratios and lower forecasted growth rates.
Russell 1000 Growth Index is a weighted index that measures the performance of those Russell 1000 companies with higher price-to-book ratios and higher forecasted growth rates.
One cannot invest directly in an index.