July 8, 2022:
Our primary goal is to help our clients grow their investments over time, and hugely important to that pursuit is the avoidance of disaster along the way. This means steering clear of market “wipeouts” – huge losses that can take years or potentially even decades to recover from.
We approach these goals by carefully studying what has historically worked to generate long-term returns in a way that is prudent and minimizes the odds of a wipeout. And we invest based on what the evidence tells us, even if it’s not what’s “popular” at the time.
While careful, evidence-based portfolio management has worked very well for its practitioners over the long haul, it had a really frustrating run in the post-pandemic period. It made money during that time, but only a modest amount compared to the booming US stock market.
Now it seems that our period of frustration may be over. Stocks and bonds are both off to their worst start in decades, and many areas of the markets are crashing outright, but our accounts are – all things considered – holding up comparatively well. We believe that the huge imbalances that built up after the worst of the pandemic are now reversing themselves, and that this unwinding will continue to favor our cautious and historically-informed investment approach.
Below we’ll share a few more thoughts about that highly unusual period that followed the pandemic, the dramatic turnaround this year, and how far along markets are in reversing the excesses of the recent past.
Mid-2020 through 2021: A crazy market party
Some of the main investment principles we adhere to are: diversify broadly across regions and investment types; favor investments that are inexpensive compared to their history, and avoid investments that are at historically excessive valuations.
The evidence overwhelmingly supports these as sound investing practices that have been very beneficial over the long term. But while they’ve helped overall and on average, they’ve gone through many stretches where they temporarily detracted. The middle of 2020 through late 2021 was just such a stretch, as markets threw a stimulus-fueled frenzy of risk-taking in the wake of the pandemic. Investors who diversified and who focused on value during this time were punished for it.
Every investing approach goes through tough times, and while this was an unusually rough one, it was still in line with the more extreme episodes in the past. We’re also aware that bailing out on a long-term successful investing strategy after a few years of underperformance is actually harmful, as there is extensive evidence that this tends to be the point at which previously-underperforming strategies start to outperform, and vice-versa.(1)
Nonetheless, we are always questioning and re-examining our beliefs, and the past couple years were no exception. We performed countless deep dives on our approach, our assumptions, and our individual investments. But each time, we came away with the view that the process and investments were sound, and that this was probably a temporary rough patch. As frustrating as it was, our examination showed us that the most prudent thing we could do was to stay disciplined and stick to the process.
First-half 2022: The party comes to an abrupt end
Everything changed for markets at the start of the year. Stocks and bonds immediately began to decline out of the gate, ending with what would be the worst first half for both of them in over 50 years.(2)
It’s notable that stocks and bonds fell so hard at the same time. Investors have gotten used to bonds going up when stocks go down, cushioning their overall portfolios. Not this year.
Below is a chart showing how the US markets fared in the first half. We included overall US stocks and bonds, as well as growth stocks (the focus of the post-pandemic boom), and long-term Treasuries (preferred by some investors for their higher yields, but more vulnerable to rising rates).
The rightmost bar is the “classic” US balanced portfolio of 60% stocks/40% bonds. This portfolio just experienced its worst 6-month decline in the past 50 years, with the exception of the Global Financial Crisis in 2008-9.(3)
- Favoring cheaper value stocks over more expensive growth stocks, the latter of which outperformed for years but have crashed hard in 2022.
- Avoiding long-term bonds, which have fallen much more than short-term bonds due to their higher sensitivity to rising rates.
- Allocating to unconventional “liquid alternatives,” which move independently from stocks and bonds. These have held up the best of all of our investments this year, and have really helped us hold up better in this stock-and-bond storm.
Mid-2022 and beyond
As dramatic as this year’s market moves have been, they’ve only made modest headway towards getting recent years’ imbalances back to normal.
One example can be found in the spread of expensiveness between growth stocks and value stocks, which recently reached a level that surpassed even the dot-com bubble. (This huge valuation disparity was central to our belief that growth stocks had entered a bubble).
Relative Valuation of Global Growth vs. Value Stocks
Source: AQR (sector neutral; see footnote 4 for more details)
The relative decline in growth stocks so far has only brought us to just below the dot-com peak, and still higher than 95% of past times. If the relationship between growth and value is to get back near its average level, there is still a long way to go. (Markets don’t have to keep declining for this relationship to be restored – it could also happen by value stocks going up more than growth stocks).
The growth-value spread is just one example, as several market relationships have gotten out of whack in recent years. Unfortunately, history isn’t much of a guide to how long it will take to get back to normal, or what path will be taken to get there. But the evidence does very strongly suggest that we’ll get there, and it looks like the journey may now be underway. We think that being on the right side of this normalization will be critical to our goal of generating good returns while avoiding potential wipeouts in the years to come.
Excerpted from a letter sent to clients on July 7, 2022.
1 – A good review of the evidence is found in Investing Amid Low Expected Returns by Antti Ilmanen. Dr. Ilmanen’s colleague Cliff Asness sums up the effect this way: “One of the few things we do know is that over three to five years, pretty much everything has shown some systematic, if certainly not dramatic, tendency to mean revert… This means that when we rely on three- to five-year periods to make decisions—favoring things that have done well over this time period and shunning things that have done poorly (note the past tense)—we aren’t just using data meaninglessly; rather, we are using data backwards.”
2 – Source: New York Times. “The six months through Thursday were the stock market’s worst first half of a year since 1970… Analysts at Deutsche Bank had to go all the way back to the late 18th century to find a worse first-half-year performance for equivalent [to the 10-year Treasury] bonds.”
3 – Source: Bespoke Investment Group.
4 – This chart shows the valuation spread between global growth and value spreads, adjusted to be sector neutral. See AQR’s original post for various technical details. This was made on May 6, but the ratio between US growth and value stocks has changed by less than 1% since that time, suggesting that not much further progress has been made. (Source of that last stat is stockcharts.com, VTV vs. VUG).