Mid-Year Review

‘Sell in May, go away’ is a common adage among traders during the summer months. In general, the market often loses steam between May and October. Some speculate that this is a result of lower productivity as workers take time off. That makes some sense considering the phrase originally came about when bankers, merchants and aristocrats left London during the hot summer months a century ago.

That seasonal pattern seems to have taken a break starting in 2013. In the ten years since the end of the Great Recession, the stock market has had one of the best runs in history. Despite negative returns last year, the market appears to be back on track. The S&P 500 saw a 17.35% return over the last six months.

2019 S&P 500 returns YTD

This is good news for investors, though many continue to worry about the potential for decline as the market matures. The same headwinds we’ve faced over the last few years remain in place. The trade wars continue to hamper economic growth and most analysts agree that how they are resolved will have the biggest impact on the second half of the year.

About the only certainty moving forward I can see is that the political situation in the U.S. will continue to produce unnecessary roadblocks on the path towards prudent economic expansion. Despite this, the stock market continues to meet expectations. The average market returns since the election of President Trump are in line with the returns seen during the previous administration.

Comparison of Presidental Stock Market Retuns

Seeing the trend continue is good news for financial advisors. When building a financial plan, we’re not looking for maximum returns. Instead, we’re looking for a consistent range of returns coming from a well-diversified portfolio. A moderately invested portfolio should expect to see annual returns between 8% and 12%. We’re seeing year to date returns already near that, with most client portfolios averaging around 13% for 2019.

Morningstar Changes Bond Categories

The performance of the stock market is always of interest, but strong returns can’t compete with the news that Morningstar revamped its Intermediate Bond segment near the end of April. Some may find it hard to see how that effects investments. However, this change will have far more of an impact to your financial plan than most other stories.

To understand why this change is so important, we need to step back and talk a bit about how an investment portfolio is built. Everyone has their own unique financial goals and there are multiple paths one can take to reach them. You can aim for quick growth while risking heavy losses. On the other hand, you could take the safe route while taking a chance that your money might not grow enough. The optimal solution, however, would be to find the right balance somewhere in between.

This is why diversification is central to an investment strategy. Simply put, a diversified portfolio balances out risks and rewards. That balance is achieved by purchasing a pool of investments that perform differently depending on the economic cycle. This is called a negative correlation. A good example of negatively correlated investments are stocks and bonds, which often move in the opposite direction.

For most investors, an intermediate bond fund is the appropriate choice to balance out their equity positions. Perhaps this is the reason the category had grown to over $1.4 trillion in assets. That’s four times the size of the nearest segment. The growth of the class isn’t what prompted a change though. The decision was made because many of the so called ‘intermediate’ funds were investing in High Yield ‘Junk’ Bonds rather than more conservative choices.

This happened in response to the historically low interest rate yields we’ve seen over the last decade. Bond fund managers basically gave up safety in order to chase higher returns. The result has been bond funds that perform more like stocks. The shift away from safety is what prompted Morningstar to split the old bond class into two new segments.

The new ‘Intermediate Core’ category will invest primarily in investment-grade U.S. fixed income issues which include government, corporate and securitized debt with less than 5% of the total assets falling below investment-grade exposures. This category is more in line with what most investors expect from an intermediate bond fund. The ‘Intermediate Core-Plus’ style also focuses on investment-grade U.S. fixed income, but funds will also be permitted to hold noncore sectors such as corporate high yield junk bonds, bank loans, and non-U.S. currency or emerging market bonds.

What this change means for the laymen investor is that they will no longer taking on more risk than intended. While financial experts often dig deeper into a fund’s credit quality, duration, maturity dates, coupons, expenses and the like, these two new categories will simply the options available. This change will benefit investors for many years to come.

Mid-Year Investment Review

Two bond positions currently being used by this firm were moved to the Core-Plus category when the change was made. The funds were retained despite being recategorized. The allocation in high yield securities was noted prior to selecting the investments. The additional risk was in line with individual investors risk tolerance for those portfolios.

Reviewing underlying investments is key to maintaining a diversified portfolio. This is why the firm looks into each fund used in managed portfolios on a semi-annual basis. The process entails reviewing the most current prospectuses and semi-annual reports in addition to looking at several key performance statistics. The indicators we are looking at are geared towards ensuring the funds are still aligned with the goals set by each client and that those funds are performing in line with the expectations of the category.

Over 60% of the funds used in the managed accounts are performing better than the benchmarks they are measured against. Of the ones that were lagging, most were within a percentage of their respective benchmark. The worst performers this year performed far better than the benchmark last year. In contrast, the worst performers against their benchmarks of 2018 (ESG Investments) have well outpaced the their respective segment returns in 2019.

That shows us why diversification is so important. We simply have no idea where the future will take us. The review process is key to making sure the investments selected continue to remain appropriate for our needs. Of course, we also need to make sure that the allocations haven’t drifted to far from the original plan. As is always the case at the end of a quarter, managed tax-sheltered accounts were rebalanced back to appropriate risk tolerances.

The Second Half of 2019

The S&P 500 saw gains of over 19% in 2017. This was mostly due to the promises of tax reform and deregulation. Last year, the market ended in bear territory. This shows how fickle the markets can be. We’re up over 17% year to date, but will it last?

There’s plenty to be concerned about. Just the other day, the New York Time’s Editorial Board published an article about the record-breaking economic expansion over the last decade. The article also noted some of the concerns I’ve voiced over the last couple of years. Since taking office, the Trump administration has focused on growing the economy despite warnings that their policies could lead to a difficult recession.

A government only has a few tools in its toolbox to revive a stalled economy. Those tools are tax cuts, stimulus spending, and interest rate cuts. With tax cuts at historic lows, there will be little to cut when the next recession hits. The tax cuts have increased our national debt to historic highs, which will limit any stimulus funds. Finally, the administration’s constant pressure to keep interest rates low could limit the effectiveness of future cuts when we need them most.

Currently, our economy is showing mixed signals. May’s jobs report missed expectations, though June finished was better despite higher unemployment numbers. Of more pressing concern has been the inverted yield curve. The yield curve has remained inverted for the entire second quarter. The last seven recessions occurred after similar conditions.

Recession Chart

Recessions will always be part of any economic cycle. At this point though, there isn’t much evidence that the next recession will be as severe as the last. In fact, it’s still hard to be certain that the next one is near. Financial analysts would have expected to note other factors that commonly precede a downtrend at this point in the cycle. We should continue to remain vigilant. Earnings season will start next week and there is already information we may be disappointed by the results.

I don’t anticipate making major changes to portfolios in anticipation of a decline despite the headwinds we see. While moving some money to the sidelines may be prudent, I’ve seen many to people make the mistake of selling everything at the bottom only to buy back in at the peak. This only makes it harder to reach your goals.

Investors need to focus on long term growth even when they’re approaching retirement. After all, your savings needs to last 20 to 30 years after leaving the workforce. The stock market remains the best hedge against inflation despite the volatility we see. The last recessions shows that even the worst of times rarely last.

Stock Market Growth since Great Recession