I hope your 2021 is treating you better than 2020! As this year rolls on, it looks like we are finally putting the past to rest. Still, 2020 was not all that bad… at least for investors. Despite everything that happened, the S&P 500 still had a 16.26% return in 2020. Since the beginning of 2021, we’ve seen the S&P 500 provide similar numbers. So far, the index has seen a 15.64% year to date return (as of 7/6/2021). That is near the 16.32% trailing three-year return average.
As we have reached the midpoint of the year, it‘s time to review and update our investment portfolios. If you have any self-directed retirement accounts, go ahead and rebalance your portfolio if you have not already done so. For managed portfolios, I’ve already done this for retirement accounts. Taxable accounts have had some minor rebalancing done this week, but I do not make larger changes on them until I’ve had a chance to review capital gains near the end of the year.
Based on the results of my semi-annual investment fund review, I do not anticipate replacing any of the funds currently held by clients. A few trends have developed over the last years’ time though. In June of 2020, there was a huge swing towards technology related stocks. This was a result of the stay-at-home economy shift. Now that the pandemic is lifting, the funds that had the best performance during 2020 are beginning to lag their peers.
Morningstar’s analytical tools rank investment funds against their peers and the indexes they track. Several funds that were in the top quartile of performers in January of this year have now fallen to the bottom quartile rankings. My interpretation is that the other funds within their categories have finally caught up. This doesn’t necessarily mean the funds have negative returns. What is happening instead is that the former top performing funds have fallen a few percentage points behind the returns of other similar funds.
Only a few of the investment funds currently held by clients have had a negative return in 2021. The other 85% of investment selections are showing positive year-to-date returns. That is a bit higher than one should expect with a diversified portfolio. This is a result of a hot stock market right now. The chart below shows this overperformance in the market right now.
What this one-year snapshot shows is the S&P 500 index compared to the moderate allocation use for as a core investment model (other funds may compliment your portfolio allocations). The chart shows that the S&P 500 had growth 38% over the last year while our diversified stock and bond portfolio had grown by roughly 32.5%. Below the performance chart is a comparison of the volatility of the S&P 500 compared to the moderate allocation. This one-year risk profile for that allocation is shows that the performance returns were achieved with much less volatility that the stock market experienced.
Despite these positive returns, I do have concerns with where the market is heading. One primary driver behind the stock market performance has been the flow of risk-free cash the Federal Reserve has created over the last few years. This has led to more inflation that we are accustomed to in recent years. As equities are often used as a hedge against inflation, it stands to reason we’re seeing stock gains continue. My concern with this is that the market valuations are far higher than they should be.
One yardstick we measure market valuation on is the price per share compared to earnings. This is known as the P/E Ratio. If a company’s stock is trading at $100 per share, for example, and the company generates $4 per share in annual earnings, the P/E ratio of the company’s stock would be 25 (100 / 4). To put it another way, given the company’s current earnings, it would take 25 years of accumulated earnings to equal the cost of the investment. Historically, the average P/E ratio of the S&P 500 index is around 18. It is currently at 37.48, which is far higher than the Wall Street Journal estimates its proper valuation should be.
This apparent market overvaluation may be in response to inflation, but investors are also moving towards equities as bond valuations continue to suffer in this low interest rate environment. Interest rates have been held down for so long that even the highest junk bond yields have fallen below the inflation rate. Bonds are basically providing a negative real rate of return.
Investors are basically being forced to seek yield elsewhere. Equities is one place, though there has been a slew of new ‘alternative’ investments gaining traction. This is big part of why we’re seeing investments in things like NFT (Non-Fungible Tokens) and cryptocurrency take off. This is extremely concerning to me as these investments do not have inherent value.
What’s a NFT you ask? It’s just like adopting an animal at the zoo. Cryptocurrency? It’s how Russia pays its hackers. I could spend quite some time debating folks who strongly believe in these investments, but it would take far too long to list the reasons why. I will continue to recommend against client’s using these alternatives for the time being. Suffice to say, there are some very basic fundamental flaws with either of these investments (Bitcoin is a good example. There will only ever be 21 million Bitcoin in global circulation despite the fact that there are over 205 million working age Americans… there’s simply not enough Bitcoin to work as an alternative currency).
While I have not sought out this sort of investment for clients, I have been looking to shore up portfolios for a potential decline. I’ve recently added funds like the Innovator S&P 500 Buffer ETF (BDEC) and the VictoryShares US Income Enhanced Volatility ETF (CDC). These funds are designed to mitigate losses in the event of a market downturn. These investments still capture growth while the market is rising but use either option strategies or stop loss provisions to limit risk. Rather than replace core investments, these add a layer of protection.
Outside of investment updates, the most important thing we can do to protect your portfolio is setting aside time to review our financial plan. I’ve already started talking to clients now that concerns over the pandemic have diminished. While Zoom meetings are still available if you’d like, I’m also open to meeting face to face once again. If we haven’t already connected for our annual review, make sure to reach out to me so we can schedule some time to chat.