Against the odds...

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Against the odds...

Expert Perspective

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June 30, 2023

And out of nowhere—equities have entered a bull market, up 22% from the October 2022 lows through June 27, 2023!1

While this will be the common theme of the second quarter postmortem commentaries about to hit your inbox, like many new bull markets, this one came when least expected. If we go back only a few months, we remember just how bad things felt when, last year, the Standard & Poor's 500 Index lost over 18% and the Bloomberg U.S. Aggregate Bond Index lost 13%.

With interest rates at yields not seen in 15 years, many predicted that the TINA (there is no alternative to equities) trade was dead and forecasted much better risk-adjusted returns for bonds. Heading into 2023 the average forecast of the S&P 500 as reported by Bloomberg called for a negative return in 2023—the first time since at least 1999.2

Despite such doom-and-gloom expectations for equities and competitive starting yields on money markets and fixed income, equities have rallied significantly from their lows last year and investors who were able to “tune out the noise” were rewarded for staying the course. What is most often lost in the conversation is not the rally in the markets from such dire outlooks, but whether your clients fully participated in the rally and if their allocation match their investment policy coming out of the 2022 bear market.

The 2022 to 2023 reversal was swift, as shown in Figure 1, below, and came without an all-clear signal.

 

Figure 1: Cumulative returns of select asset classes have reversed

And out of nowhere—equities have entered a bull market, up 22% from the October 2022 lows through June 27, 2023!1  While this will be the common theme of the second quarter postmortem commentaries about to hit your inbox, like many new bull markets, this one came when least expected. If we go back only a few months, we remember just how bad things felt when, last year, the Standard & Poor's 500 Index lost over 18% and the Bloomberg U.S. Aggregate Bond Index lost 13%.  With interest rates at yields not seen in 15 years, many predicted that the TINA (there is no alternative to equities) trade was dead and forecasted much better risk-adjusted returns for bonds. Heading into 2023 the average forecast of the S&P 500 as reported by Bloomberg called for a negative return in 2023—the first time since at least 1999.2  Despite such doom-and-gloom expectations for equities and competitive starting yields on money markets and fixed income, equities have rallied significantly from their lows last year and investors who were able to “tune out the noise” were rewarded for staying the course. What is most often lost in the conversation is not the rally in the markets from such dire outlooks, but whether your clients fully participated in the rally and if their allocation match their investment policy coming out of the 2022 bear market.  The 2022 to 2023 reversal was swift, as shown in Figure 1, below, and came without an all-clear signal.

Source: Vanguard Investment Advisory Research Center calculations

Notes: Cumulative returns were calculated using monthly total returns. Bloomberg Commodity Index Total Return used for commodities, FTSE 3 Month US T-Bill index Series used for cash, Bloomberg U.S. Aggregate Float Adjusted Index used for U.S. bonds, Bloomberg Global Aggregate ex-USD Float Adjusted RIC Capped Index (USD Hedged) used for non-U.S. bonds, FTSE Global All Cap ex US Index used for non-U.S. stocks and CRSP US. Total Market Index used for U.S. stocks.

Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.

Such dramatic changes in market leadership are not an uncommon occurrence as demonstrated in Figure 2, below, where we see the direction and magnitude of rolling one-year equity returns is random and often changes significantly from one quarter to the next. Rallies and declines do not come with pre-announcements, and the “announcements” we do see are often wildly off the mark.

Figure 2: U.S. Equity returns often change dramatically from one quarter to the next (1973-June 2023)

The line chart shows the rolling one year annualized total return of U.S. equities using quarterly returns from the beginning of 1973 thru June 19th, 2023 and also the average annualized total return of U.S. equities over the entire time.  It shows that there are a lot of large reversals in the rolling returns of U.S. equities and therefore uncertainty in how and when they will take place.

Source: Vanguard Investment Advisory Research Center calculations using data from FactSet, Inc.

Notes: Rolling annualized U.S. equity returns were calculated using quarterly total returns from the S&P 500 Index from 1973 thru 1974, Wilshire 5000 Total Market Index from 1975 thru April 22, 2005, MSCI US Broad Market Index from April 23, 2005, thru June 2, 2013, and CRSP U.S. Total Market Index thru June 19, 2023.

Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.

It has been extremely difficult to time the markets where just missing a few days in the market can dramatically affect the investors’ long-term return. This impact from getting it wrong is shown here, where missing the 10 best days since 1988 would have led to annualized returns 2.5% lower than staying invested. And unfortunately, the best and worst days tend to occur near each other in clusters.

While most investors won’t try to time daily ins and outs of the market, the impact of a more likely scenario, where an investor is out of the market for quarters rather than days can be seen in Figure 3. As expected, given the wide dispersion of quarterly returns, missing only a few of the best quarters can lead to significant underperformance; but what is often overlooked is the resulting impact on your client’s ability to meet their goals. In short, bailing from the market and subsequently missing quarters with positive performance can undermine the entire process of retirement and goals-based planning.

 

Figure 3: U.S. equity market annualized returns 1993-2022 missing the best and worst quarters

Bar chart showing how a U.S. equity market investor would have fared from 1993 through 2022 under various scenarios. The scenarios include being fully invested, as well as performance when missing the best 1, 2, 3, 4 and 5 quarters as well as the performance when missing the worst 1, 2, 3, 4 and 5 quarters. The y-axis shows annualized returns and the x-axis shows the various performance scenarios. Being fully invested returned 9.6%. Missing the 5 best quarters returned 6.7%, missing the 4 best returned 7.2%, missing the 3 best returned 7.7%, missing the two best returned 8.3%, and missing the best quarter returned 8.9%. Missing the 5 worst quarters returned 14.0%, missing the 4 worst returned 13.2%, missing the 3 worst returned 12.4%, missing the two worst returned 11.6% and missing the worst quarter returned 10.6%. The chart shows the dramatic change in performance that can result from being out of the market for just a few quarters.

Source: Vanguard Investment Advisory Research Center calculations using data from Morningstar, Inc.

Notes: U.S. equity market annualized returns were calculated using quarterly total returns from Wilshire 5000 Total Market Index from 1993 thru April 22, 2005, MSCI US Broad Market Index from April 23, 2005, thru June 2, 2013, and CRSP US Total Market Index thereafter removing various numbers of best and worst quarters.

Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.

The challenges of market timing have been well documented. Specifically, strategic asset allocation has delivered a tighter distribution of outcomes, which led to significantly better client outcomes, which is critical for advisory practices focused on goals-based financial planning. We found that strategic asset allocation strategies have significantly outperformed most tactical asset allocation strategies, averaging about 2.0-2.5% annually over the last 20 years. The significant underperformance of tactical strategies highlights the challenges these managers face in predicting the direction and magnitude of market shifts. In Vanguard’s Advisor’s Alpha®, we discuss a more prudent approach to improving your client outcomes.

So how did advisors and their clients do with staying the course with the whipsaw performances in 2022 and 2023 year to date?

Figure 4 shows that allocations to equities and bonds have held steady in the past few years and near their long-term medians despite many headwinds, including the poor performance in 2022, negative headlines, pessimistic outlooks, and money markets and bonds offering yields close to many equity forecasts. Advisors who remained steady benefited from equities rallying against predictions to the contrary. This is quite different from the dramatic reduction in equity allocations that we saw during the dot-com collapse, the global financial crisis, and even to a lesser extent, Covid-19.

 

Figure 4: Investors have not bailed on equities during this bear market

Area chart showing total allocations invested in open-end funds and ETF’s through time for Equity, bonds, and money-markets. Equity funds include U.S. funds, international funds, and emerging markets funds. Bonds include both taxable and munis. The x-axis ranges from 1992 through May 2023. The y-axis ranges from 0% to 100%. Allocations for all three asset classes vary through time. The chart shows that equity allocations range from 34% in 1992 to 59% in May of 2022. The chart shows that equity allocations are currently near long-term averages, even despite the poor equity market performance in 2022.

Source: Vanguard Investment Advisory Research Center calculations using data from Morningstar, Inc.

Notes: Illustration represents the U.S. total asset allocations through time using all U.S. invested assets in mutual funds and ETFs.

Despite the performance whipsawing and the doom and gloom narrative, most advisors have successfully tuned out the noise and have paid close attention to the 3B mental model we shared last quarter. These three Bs – business model (incentives to grab your attention), biology (fear and stress shrinks time horizons) and behavior (reacting to the noise and shorted time horizons during periods of stress)—are critical to understand when helping coach clients through uncertainty. Given asset allocations stayed the course, undeterred by the volatility in performance and the dismal headlines, we congratulate advisors for coaching their clients through these challenging times and giving them the best chance for meeting their goals. We’d encourage you to use the opportunity to review these decisions with your clients and reinforce the value that was added from doing so while also reinforcing these positive outcomes when the need for coaching inevitably arises once again. Our market hindsight tool can help make this real for your particular client situations.

This is another positive trend in the advisory community, as more advisors are moving further into goals-based financial planning where they have a much higher probability of adding value for their clients as opposed to trying to predict the future of the financial markets. This allows advisors to focus on their clients’ real questions—such as how much do I need to retire, how long will my money last, and how will taxes impact my spending. The long-term financial projections advisors use to answer these questions for their clients assumes their clients are fully invested in their target asset allocation over the entire planning horizon.3 As a result, being out of the market—even if only for a quarter—undermines the entire financial planning exercise given returns aren’t average and can vary dramatically through time.

Helping your clients stick to their financial plan and stay invested, even when it is difficult, gives your clients and your practice the best chance for long-term success!

1 Source: Vanguard using S&P 500 Index data as of June 27, 2023.

https://www.bloomberg.com/news/articles/2022-12-01/this-year-s-sour-stock-market-made-wall-street-bearish-for-first-time-since-1999?utm_source=charlies-newsletter-88171d.beehiiv.com&utm_medium=newsletter&utm_campaign=the-week-in-charts-6-18-23&leadSource=uverify%20wall#xj4y7vzkg

3 Advisors often employ some form of Monte Carlo simulations to stress test their clients’ portfolios and spending under many different return and inflation scenarios.

 

Notes:

  • All investing is subject to risk, including the possible loss of the money you invest.
  • Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income. Past performance is not a guarantee of future results.
  • Bond funds are subject to the risk that an issuer will fail to make payments on time, and that bond prices will decline because of rising interest rates or negative perceptions of an issuer's ability to make payments.

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