The Underperformance That Comes With Outperformance
January 31, 2022
It is not really within human nature to comprehend that you may not know everything you think you know, and, further, that what you believe in could change on a dime.
—Seth Klarman
Global equity markets began the year with a large dose of downside volatility, and many investors are realizing that their definition of risk may need a revision. With the exception of the Coronacrash and Q4’18, the last 10 years have experienced record-low equity market volatility and well-above-average returns. To many, January served as a stark reminder that there is real risk inherent in equities and that the last decade may not be an appropriate analog when pricing in future risk.
While this month was an above average down month by almost 2x (the average negative month in the S&P 500 since 1900 is -3.7%), the speed of the decline from all-time highs during the first few days of January is especially hard on investors accustomed to the volatility environment of the past decade. We have heard numerous times this month about a client’s desire to now ratchet down their portfolio risk, as this environment was not in their plan.
Since 1900, months with a greater than 8% decline happened a little more than every two years. However, since the Financial Crisis, declines of this magnitude have been more like every 48 months. So, while large monthly declines have been less common since 2008, they are still a normal part of equity market participation for which investors should be prepared, particularly after long periods of above-average performance.
In this month’s Co-Founders’ Note we discuss the costs and benefits of generating long-term outperformance. It seems a universal truth that, to generate superior long-term results, an investor must also accept periods of underperformance. With trend following, this is a conscious choice and one where the potential costs and benefits are measured beforehand to ensure the appropriate emotional fortitude necessary to execute the long-term plan.
But first, here’s a summary of our take on what transpired in the markets in January.
Asset-Level Overview: Market Talking Points for Financial Advisors
Equities & Real Estate
A new year ushered in very different behavior in stocks. Equity asset classes were leading performers in 2021 but experienced dramatic reversals to become the poorest performers at the outset of 2022.
Specifically technology stocks, and more broadly growth stocks, suffered their worst months since the Coronocrash of 2020. Small/mid caps, followed by large caps, were next in line; they flirted with double-digit losses for the month.
In the U.S., value and high-dividend stocks were the best performers, albeit still posting losses. These two classes have consistently been some of the worst performers among U.S. equities since the Coronacrash. Exposure to U.S. equities will decrease in our portfolios due to the first intermediate-term downtrends to emerge since early 2020, but we will remain overweight because U.S. stocks remain the strongest globally, despite the recent declines.
In keeping with the theme of performance-flipping, previously poor performers did relatively better in January. International equities were the best performing equity segment, with emerging markets holding in positive territory for most of the month. Developed economies fared slightly worse but still outperformed their U.S. counterparts. International equities have underperformed consistently, so the relative outperformance in January does little to change its laggard status from a recent historical standpoint. In spite of relative outperformance in January, international stocks are still declining and downtrends are now in place across all timeframes, meaning our exposure will decline as well.
The largest decline in January 2022 has been real estate. After posting returns surpassing 40% in 2021, real estate ETFs and related stocks produced a jarring (if not somewhat expected) decline that exceeded double digits. At some point, what goes up must come down, and with the news of Fed tightening, it meant a return to earth for several inflation-correlated assets, real estate included. The long-term trends remain strong, so while our exposure will fall for February, portfolios remain poised to benefit if prices bounce back.
Overall exposure to equities and real estate will decline for February. With nowhere in the equity complex to relocate, allocations will move to fixed income for now. A quick rebound could mean returning this exposure to equities for March and beyond, but with risk materially increasing, our models and long-term historical research indicate it is better to moderate risk for now and wait for better direction from equity markets.
Fixed Income & Alts
One might assume that with equities struggling in January a flight to safety would have boded well for fixed income assets. This thinking would have been incorrect.
Bonds performed poorly once again, with almost all variations of fixed income posting negative performance for the month. Even inflation-protected bonds, which have performed relatively better in recent memory, badly faded and created downtrends that will cause significant portfolio reductions. For February, our fixed income exposure will be highly defensive. Durations will be as short as possible, and we’ll have only minimum allocations to intermediate-term bonds both domestically and internationally.
Looking at alternatives, gold remains range-bound but has created enough positive momentum for an intermediate-term uptrend. As a result, our portfolios will increase allocation but remain underweight. With equities correcting and fixed income providing little benefit, we hope assets like gold can contribute some non-correlative benefit to portfolios until stocks resume a climb.
3 Potential Catalysts for Trend Changes: Giving Clients the Context
On the Move: The Federal Reserve signaled it would begin steadily raising interest rates in mid-March, its latest step toward removing stimulus to bring down inflation. Fed Chairman Jerome Powell said last week that the central bank was ready to raise rates at its March 15-16 meeting and could continue to lift them faster than it did during the past decade.
Record Growth: The U.S. economy increased rapidly in the fourth quarter of last year, advancing to a 6.9% annual rate, capping the strongest year of growth in nearly four decades. However, last week’s report also had warning signs. Most of the fourth-quarter increase was due to companies’ restocking. Excluding the inventory effects, output grew at a modest annual rate of 1.9% in the fourth quarter.
Spend Baby Spend: Consumer spending, a key engine of economic growth, showed signs of stalling heading into 2022 amid rising prices and the Omicron wave. Consumer spending declined by 0.6% in December from the prior month, and the Personal Consumption Expenditures Core Price Index rose at 4.9%, which is the fastest pace in nearly four decades. This report comes on the heels of separate data showing retail sales declined last month, among other signs consumers pulled back in January.
Costs & Benefits Of Outperformance
Keep it simple and focus on what matters. Don't let yourself be overwhelmed.
—Confucius
Every strong structure has pillars, or focused areas where support is strongest and vital to the surrounding pieces. Remove a pillar and the structure tumbles. Maintain the pillar and complementary pieces can be arranged to supplement strength, appearance, or both.
Blueprint Investment Partners has investment pillars that allow us to create a repeatable process and thereby, in our view, provide advisors and their clients the best chance of achieving their goals.
One of these pillars is the concept of defining and subsequently limiting risk while leaving potential rewards uncapped. Practically speaking, this means first counting the cost of a particular approach, decision, and/or process; determining what rules or restrictions can act as a collar; and then deciding if the upside is worth it. Creating a systematic investment process is a mathematical and engineering exercise that takes a sometimes nebulous, subjective idea like “risk” or “reward” and turns it into a picture that everyone can see and touch.
While every market environment is unique in its own way, if you analyze historical data, you tend to see similar patterns. Market action witnessed in January is an example of something we have seen many times, and it serves as a real-time illustration of us practicing one of our pillar beliefs.
Taking the idea of trend following to its natural conclusion means pressing continued winners (right now that means technology and growth stocks) at the expense of laggards (showing up currently as value and dividend stocks) until it is clear that these long-enduring trends have truly changed. For a trend to change there must be divergent behavior for a meaningful amount of time. Stated more directly, outperformance is not free. If one wants to enjoy the benefits of growth over value or U.S. over international stocks and maximize that until it is clear the ride is over, then one must also be willing to pay the price of that reversal. Ideally, this cost is but a token charge on the ride to outperformance, leaving one much better off overall.
This is precisely how we view January’s performance against the backdrop of 2021. Our portfolios substantially outperforming comparable benchmarks in 2021. Then came January, and we (like the everyone) had no crystal ball to tell us anything would change in January. Therefore, we have continued to press winners, relying on price as our guide. To date, this has meant marginal underperformance versus the same benchmarks against which we outperformed in 2021. When viewed holistically, January’s underperformance is but a fraction of the trailing year’s outperformance and thus a cost we believe it is prudent to pay.
In addition to allowing us to stick with winning trends beyond a mainstream view of what’s possible, trend following also allows us to be highly adaptable. So, while we have steadfastly stuck to winning positions, we are unafraid to act decisively when dictated by trend changes. As a result, we can easily go from being more aggressive than a comparable benchmark in one month to more defensive by the next.
That is what will occur as we enter February. While portfolios will continue to participate significantly in long-term equity uptrends, shorter-term trends have indeed shifted, meaning we will react in a responsible way according to our rules. Should markets rebound quickly, then we will enjoy positive performance with an eye toward once again resuming full allocations to equities as early as March. If, on the other hand, these corrections remain in effect longer, portfolio risk will remain more balanced, with the possibility of further cuts in exposure on the horizon.
For financial advisors and their clients, we hope our disciplined and dedicated approach to our rules provides comfort in these uncertain times. Our adaptable approach means we won’t “go down with the ship” on any asset class. Instead, we will actively search for strength and emerging opportunities in the form of new trends as they occur.
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