September 2024 Monthly Commentary

Valuations Over Votes · Why Diversify with Alternatives and Real Assets · Staying Disciplined Amidst Volatility and Noise 

Portfolio Advice, Talking Points, and Useful Resources

• Even though it is election season, the key factors for stock market expectations for long-term investors remain earnings growth and valuations. 
• Diversifying traditional asset allocations with alternatives and real assets can enhance risk-adjusted performance over time. 
• Financial advisors can add significant value to client portfolios, including staying the course during election season.
   

As we approach quarter-end, it has been yet another fascinating period for our economy and markets, with no signs of that changing in the weeks ahead. The upcoming election is poised to be historic, and market volatility is likely to persist. In this environment, what should investors do?

In this month’s commentary, we believe that for most investors, the best course of action is to stay on their current path, assuming their portfolio is aligned with their objectives and risk tolerance. As we discuss, the fundamental factors driving stock market expectations remain unchanged—growth and the price one pays for that growth, regardless of who wins the election.

That said, investors may want to consider broadening the role of diversifying asset classes within their portfolios. This includes alternatives and real assets, which can help create a more resilient portfolio. In this commentary, we explore the reasons behind this suggestion.

Amid all the market noise, long-term investors are usually best served by remaining invested, diversified, and disciplined. This month’s analysis delves into each of these core principles, and we hope you find it insightful and valuable. 

It’s Election Season. Which Factors Drive Returns?

By Rusty Vanneman, CFA, CMT, BFA, Chief Investment Strategist

As election season heats up, many long-term investors naturally wonder which candidate will be better for stock market returns in the years ahead. But is this the best question for long-term investors to focus on?

While the stock market does follow earnings over time, successful long-term investing depends significantly on how much an investor pays for those earnings. When valuations are too high — meaning an investor is paying too much for a unit of fundamental value like revenue or earnings — it can hinder long-term returns. However, when valuations are low, it can set the stage for above-average returns and even offer a "margin of safety" if fundamentals underwhelm.

Despite numerous studies showing that one political party may outperform the other in the stock market, other factors, such as earnings and valuations, provide better insight into potential future returns.

Let us look at valuations. When valuations are high heading into an election, returns tend to be below average over the next four years, regardless of which party wins. Conversely, when valuations are low, returns tend to be above average, again, regardless of the election’s outcome.

Research by Nolan Mauk at Brinker Capital examined presidential elections dating back to 1900, using the CAPE Ratio (often also known as the Shiller price/earnings ratio) as a valuation measure. The CAPE ratio, which averages real (i.e., Inflation-adjusted) earnings per share over a 10-year period to smooth out cyclical fluctuations, has indeed shown a negative correlation with future S&P 500 returns, particularly in election years.

Mauk’s findings suggest:

• When the CAPE ratio is in its lowest quintile (indicating the market is most undervalued) during the fourth quarter of an election year, the subsequent four-year average annualized gain has been 15%.
• On the other hand, when the CAPE ratio is in its highest quintile (indicating the market is most overvalued), the following four years have seen an average annualized return of -1%.
• Interestingly, the S&P 500 tends to perform well in the first year of a new presidency when valuations are extended but often under-performs thereafter.

CAPE Quintiles

Average of S&P 500 NTM Return is the average return of the S&P 500 over the 12 months following the fourth quarter of an election year. Average of S&P 500 Next 4 Years Annualized Return is the average return of the S&P 500 over the following 4 years (the next presidential term).

This highlights that starting valuations play a crucial role in shaping long-term return expectations, and this holds true in all market environments—not just during election years. The evidence indicates that valuations, rather than election outcomes, are often a more reliable factor for investors to consider when projecting stock market performance, even during election years. 

So, where do we stand today? Current valuations place the market in the top quintile, which implies below-average, though still positive, returns in the coming years. It is important to note, however, that the overall market is heavily influenced by a handful of large companies, and concentration in the market is at historic levels.

Source: Capital Group.

Many of these top firms dominating the market today are raising the overall market valuation. Take these names out, and we believe there are still attractive areas within the U.S. stock market. For instance, small caps, which have averaged a 20% discount to the broader market since 2000, are now closer to a 50% discount.

*ETFs used where index data is unavailable. Source: FactSet.

Looking beyond U.S. borders, international markets are also offering value. Developed international markets, which have historically traded at an average discount of around 30% to the US market since 2000, are now at a 45% discount.

*ETFs used where index data is unavailable. Source: FactSet.

In conclusion, long-term investors may want to avoid placing too much emphasis on who will win the election when considering stock market expectations. Regardless of the election’s outcome, we believe the overall U.S. market is likely to deliver below-average returns over the next four years. However, most investors should stay invested and maintain diversification, as many global markets are offering attractive opportunities to enhance returns.

Why Diversify? The Argument for Alts and Real Assets

By Nolan Mauk, Research Analyst

J.P. Morgan recently released their quarterly Guide to Alternatives, an 80+ page slide deck full of relevant data on alternative investments across many markets. Here at Orion, we believe diversifying asset classes, including real assets and alternatives, are an important piece in resilient, long-term portfolios.

The term “diversifying asset classes” refers to investments beyond traditional markets (stocks and bonds), including real assets like commodities, natural resources, infrastructure, and real estate, as well as other alternatives like private equity, global credit, hedged equity strategies, and managed futures. 

Alternatives and real assets provide strong diversification benefits due to their lower correlations with traditional asset classes and potential to enhance risk-adjusted returns. Income-focused clients may also find value in their unique income-generation strategies.

Liquidity is often a concern for diversifying assets, as many require longer holding periods and lack liquid secondary markets. Investors with long time horizons who can afford to give up some liquidity can potentially be rewarded with higher and more stable cash flows due to liquidity premiums, but liquid alternatives (mutual funds and ETFs that deploy alternative strategies) offer another solution.

Now let us discuss the reasons investors may want to consider allocating to diversifying asset classes. The rise in stock-bond correlation in recent years has created a problem in many traditional accounts — fixed income alone may no longer be a sustainable diversifier from equities for many risk-averse investors. Inflation affects stocks and bonds similarly, which has recently led to the highest stock-bond correlation since the 1990s, as shown in this chart from Orion’s Quarterly Reference Guide:

1 Year Stock Bond Correlation

Source: Morningstar. Stock Index: S&P 500 TR USD. Bond Index: Bloomberg US Agg Bond TR USD. Data Ranges from 1/1/1993 – 6/30/2024.

Rising correlations means the traditional 60/40 portfolio (60% stocks, 40% bonds) has been subjected to unusually high volatility in recent years. Higher volatility than an investor was prepared for can make it difficult to stay disciplined throughout market cycles. As the next figure shows, the traditional 60/40 portfolio has endured standard deviations in recent years only seen before in the recession of the late 1980s and the Global Financial Crisis in 2007-2009:

1-Year Standard Deviation of a 60/40 Portfolio

Source: Morningstar. Data reflects rolling 12-month standard deviation of 60% stocks and 40% bonds. Stock Index: S&P 500. Bond Index: Bloomberg US Agg Bond TR USD. Data ranges from 1/1/1984 – 8/31/2024.  

Adding diversifying assets with lower correlations to stock and bond markets will reduce the overall correlation of a diversified portfolio, which may dampen volatility over time. But will investors be forced to give up expected returns in exchange for a smoother ride? This figure suggests they might not:

Source: J.P. Morgan Asset Management’s Guide to Alternatives – 3Q 2024, page 7. As of 8/31/2024.

These findings suggest that since 1990, adding alternatives to stock-bond portfolios has empirically increased expected returns while reducing volatility, making portfolios more efficient by lowering overall correlations.

Another current concern about the 60/40 portfolio is high valuations. As the chart on the left below shows, going back to 1985, the portfolio is currently near its most expensive levels ever and has been for about five years, pushing earnings and coupon yields lower. The chart on the right below plots each earnings/coupon yield since 1985 with its subsequent 10-year annualized returns. Based on this data, we would expect the 60/40 to return 5.2% per year for the next 10 years, among the worst 10-year returns in recent history.

Source: J.P. Morgan Asset Management’s Guide to Alternatives – 3Q 2024, page 4. As of 8/31/2024.

Certain diversifying assets may provide solutions to the issue of valuations as well. Commodities, for example, are trading well below their historical average and have been for over a decade:

Source: Bloomberg, as of 6/30/2024.

In addition, some alternatives strategies like private equity specifically target companies with lower valuations and look to quickly grow them over their holding periods. Investors looking for options in the current environment of lofty valuations may look to diversifying assets for cheaper investments.

In conclusion, we believe the traditional stock-bond portfolio faces challenges such as high correlations, extended valuations, and economic uncertainty. Allocating to diversifying asset classes may help lower volatility and increase returns, and many are trading at discounts compared to history. Investors making long-term plans should consider if alternatives and real assets have a place in their portfolios to better navigate market cycles.

Staying Disciplined Amidst Volatility and Noise

By Ben Vaske, BFA, Sr. Investment Strategist

One of the primary drivers of anxiety in our financial and non-financial lives is uncertainty. Uncertainty about our relationships, careers, portfolios, or politics can make us take actions that we would otherwise categorize as irrational or undisciplined. However, as we, and others, have written numerous times, one of the key drivers of success in investing is to keep a long-term disciplined approach. While headline-snatching proposals around the Fed’s “correct” next move or unprecedented changes to US tax laws can generally incite a short-term feeling of panic or need for preemptive action, generally, it is all just noise. 

Election cycles in particular are synonymous with societal volatility, as voters react to the ebb and flow of political developments - even more aggressively in the current day and age where the free flow of information is rapid, direct, and much of the time, overbearing. Some investors, too, are easily swayed by the deluge of information, predictions, and speculation that surrounds elections. This uncertainty can lead to emotional decision-making, where fear and greed overshadow rational analysis. True rational analysis, however, points to the case that decisions rooted in emotion are often overblown, or flat-out ill-advised. 

As financial advisors and coaches, it is pivotal to our clients’ success that we deploy advice that allows those who trust us to block out the noise and stick to their long-term plan. The financial media, for example, drives attention to their shows by inciting emotion, stress, or panic. Many times disguised as commentary or expertise, this constant clamor can easily derail investors into making decisions not best suited for their personal goals and aspirations. When these decisions take effect in portfolios, we are likely to experience what Carl Richards coined as “The Behavior Gap,” or in other words, the gap between the return of our selected investments and the return we truly take home due to our own decision-making.

Source: Carl Richards.

So, what can we do? 

According to a study from Russell Investments titled, “The Value of an Advisor,” financial advisors have the potential to add over 5% of value to client portfolios. The number one driver of that 5+% is Behavioral Coaching, accounting for about 2.4% of additional value apart from investment selection, asset allocation, or tax management. 

Behavioral coaching is about keeping investors on track during turbulent times and ensuring they don’t make costly mistakes, like panic-selling during a market dip or chasing the latest hot investment trend. It is about reinforcing the fundamentals: setting realistic expectations, sticking to a diversified portfolio, and rebalancing regularly. An advisor’s role is not just to provide financial strategies.

As we navigate through election cycles, market corrections, and other inevitable sources of uncertainty, it is essential to remind ourselves and our clients of the long-term goals. While it is tempting to react to every headline or market movement, history has shown us that a disciplined approach consistently outperforms short-term reactionary behavior. This does not mean ignoring new information, but rather integrating it into a well-thought-out strategy that does not abandon core principles.

In the end, it is about focusing on what we can control: our reaction to market events, our asset allocation, and most importantly, our behavior. By doing so, we can help clients build wealth not just in financial terms, but in peace of mind as well.

Thank You for Letting Us Serve You

Thank you for your time and trust. If you have any questions or feedback, please let us know. As always:

Stay invested, stay diversified, and stay disciplined.

Invest well and be well,

Rusty Vanneman, CFA, CMT, BFA
Chief Investment Strategist