During the second quarter of 2018, it was a mixed bag, the Dow Jones Industrial Average (Dow) gained 0.7%, the NASDAQ Index gained 6.9%, and the S&P 500 Index gained 2.9%, while the iShares Barclays 7-10 yr. Treasury Bond ETF (IEF) lost 0.7%.
I have started my quarterly commentary with the above return data due to the dispersion of returns, especially within stocks. The three most commonly followed U.S. stock indexes are the Dow Jones Industrial Average, NASDAQ, and S&P 500. These indexes were individually created to provide a broad representation of how the U.S. stock market is performing, and each index competes to be quoted by the financial community and media. Historically these indexes moved in a more or less lockstep fashion, so this recent dispersion is resulting in some investors wondering about their own portfolio performance.
I mentioned “some” investors since the ones with greater performance rarely question why or delve into how much risk they are truly bearing to achieve their results. In the dot-com bubble period of 1995-2000 with its historic economic bubble and period of excessive speculation, it was only after the 5th year that many realized they made a mistake by taking on too much risk. From the March 10, 2000 high of 5,048.62 to the bear-market low of 1,114.11 on Oct 9, 2002, the NASDAQ Index lost 78% of its value.
I am not making a market action or value comparison from then to now since so many companies of the dot-com era did not have positive earnings which contributed to such a deep correction. What I would like to point out is that when a market moves in one general direction over an extended period of time, whether it’s up or down, participants tend to follow the trend more vigorously as time goes on. In an up market, it’s “I want to be in there, just buy it” while in a prolonged down market, it’s “I never want to hear about stocks again!” What typically follows an extended move is a reversal back to long-term historical values. In financial circles this is referred
to as a reversion to the mean ( x̅ ).
Today, with the ease and popularity of making investments through indexing and ETFs (Exchange Traded Funds) there is a growing allocation of analytical resources focused on the stock company composition within these investment vehicles to see what is making the investment vehicle move, rather than looking at the actual fundamentals of each individual company. A reduction in fundamental company research can lead to trouble as investment dollars chase past performance as a predictor of future performance with less regard to the risk they are taking. In other words, money is chasing a moving stock and not looking at the underlying value of the business. This may be especially true today.
The dispersion in this quarter’s index returns may well be a canary in a coal mine for the average investor who believes they can simply and inexpensively buy any index or ETF and recognize future gains without addressing underlying risk. Investors who do not understand such things as market-cap or price weighting, rebalancing, expirations, derivatives, cyclicality, concentration, cross holding and rotation to name several, may well be in for a rough and confusing ride in the future as these forces impact investing.
Last quarter’s broad index dispersion of returns pales in comparison to what is seen in sector indexes and ETFs, not to mention in leveraged ETFs. Also, the varying performance issue I addressed doesn’t touch the fact that many personal portfolios include fixed income holdings such as CD’s and Bonds which have recently experienced negative returns and further clouds risk and total portfolio returns.
I too often hear about investors and advisors suggesting all sorts of investment ideas by quoting past performance and then using those returns to extrapolate future investment growth. To me this level of care and attention is like walking into a Walmart Care Clinic when one is having a heart issue. Not to knock the physicians at Walmart for their affordable care, but it may be better to seek out a specialist for you and your family’s important needs.
Successful investing is not rocket science, but it can appear to be if one does not have the educational background, fortitude, and most of all the time to continually seek out and assemble all the pieces to the investment puzzle over several investment cycles. As a reminder, these attributes are what we have and do here at Torii Asset Management.
Going forward into the third quarter of 2018, I reassert what I said in the beginning of the year, that “Ultimately, the economy should continue to expand as corporate tax savings are in turn used for capital expenditures, but the stock market may have a bumpy ride through the year as it navigates the following risks:
- The magnitude of the change in interest rates and inflation could surprise investors and scale back projections of future earnings growth.
- China and Japan, our two largest creditors besides the Federal Reserve, reduce U.S. Treasury purchases causing an increase in U.S. debt expense.
- Mid-Term election results create political gridlock which cap or reverses growth initiatives.
- North Korean tensions escalate
- The stock market as measured by the S&P 500 is experiencing its longest run without a 3% drop which may indicate that investors are bidding up prices without properly considering risk.”
These five factors are just as relevant now as they were when I wrote about them in the January edition of our letter. Six months later, only the last point has concretely happened early in the year, the others are yet to be determined. It is quite possible the tenuous tariff situation along with the uncertainty of the mid-term election could cause a stock market downdraft during the less liquid vacation months of late summer or immediately prior to the elections. If the prospects of continuing economic and earnings growth have not been materially damaged, it may be a good time to add to stocks if your risk tolerance accepts it.
Circling back to earlier in my commentary I would like to make the following suggestions to investors in order to help them through the confusing investment landscape.
- Have a plan and stick to it
- Have a realistic view of your risk tolerance
- Don’t drive or invest by only looking in the rear-view mirror
- Don’t listen to cocktail talk, chances are it’s a fish story and you are only getting the juiciest sliver of what really happened.
- Enlist with a competent advisor who is in the business of investment research and decision making, not an asset gatherer.
Torii Asset Management is successful by applying a disciplined approach in conducting thoughtful research and using the findings which make intuitive sense. In this way we are positioned to take advantage of what should happen instead of chasing the past or a dream of what might happen.
To our existing clients, I extend my sincere thanks for your business. You have our continued commitment to your success. To prospective clients, I invite you to come and grow with us.
Very truly yours,
Martin L. Yokosawa