Diversified investors have been missing out on U.S. stock strength

Diversified investors who strategically balance their portfolios across several types of assets might feel as if they have one leg running a race but the other dragging along behind, holding back their performance.

U.S. stocks continued to perform well through the end of September. The S&P 500 had a 9 percent total return year-to-date through the end of the third quarter. The Nasdaq index of more growth-focused stocks gained 16.5 percent.

But many investors who also own bonds and international stocks have experienced lower returns on their balanced portfolios in the 3 percent territory year-to-date. Foreign stock indexes and many segments of the global bond markets have posted losses returns, holding back overall progress compared to a portfolio that is heavier in U.S. stocks.

It’s natural for a balanced investor to be disappointed when something seemingly as simple as owning more U.S. stocks would have produced higher returns.

This situation is nearly the opposite of the decade of the 2000s — remember the Lost Decade? — when the S&P 500 had a negative return over the decade while most other asset classes posted meaningful gains. That left diversified investors happy with their results despite the underperformance of the U.S. stock portion of their portfolio.

For as much as U.S. stocks have advanced over what is now the longest bull market in history (in terms of days, not percentage gained), many people remain reluctant to believe this advance has even more life left in it.

Investors who have participated in the 331 percent gain of the S&P 500 from the bottom on March 9, 2009, through the end of September shouldn’t be faulted for thinking it a good idea to take some risk off the table and protect gains that have built up. It’s certainly preferable to prepare for a difficult market before it arrives.

But there remain strong indications that U.S. stocks are positioned for still more growth and are attractive even at today’s prices, relative to bonds.

When the Dow Jones Industrial Average of 30 U.S. stocks posted an all-time high in September, Ryan Detrick, senior market strategist at LPL, noted what a good sign this has historically been for the economy.

Since 1900, the economy has been in a recession six months after an all-time Dow high just 1.2 percent of the time. Stretch it out to 12 months after any all-time high mark since 1900 and the economy has slipped to recession just 2.5 percent of the time.

Stocks and bonds have no idea that people track them based on a calendar. But using the calendar makes for easy comparisons.

If we trust the past at all, we are entering a prosperous time to own stocks.

Over the past 20 years, according to Bespoke Investment Group, the fourth quarter has delivered seven times more investment gains than the other three quarters combined. From mid-1998 through mid-2018, the first nine months of the year have seen S&P 500 returns of 0.85 percent while the fourth quarter averaged 5.99 percent.

Stretch back 50 years and the edge is smaller for the fourth quarter but still more than three times the return of the first three quarters of the year.

Historical data doesn’t show what is going on in the world today that will drive investment returns of the next quarter, year or more. But quantitative historical data helps us understand whether markets are expensive or cheap compared to points in the past using just the numbers, not investor sentiment, global economic conditions or the madness of politics.

Jeremy Siegel, professor at the University of Pennsylvania’s Wharton School, has looked as deeply at historical stock markets as anyone. His research rearview mirrors back to 1802.

In the long run, U.S. stocks have generated annual returns of 6.7 percent per year after subtracting the impact of inflation. Siegel acknowledges that today’s projected returns are lower (about 5.5 percent annually for the next decade, he says) but that U.S. stocks are unquestionably more attractive than bonds during this period of rising interest rates in the United States.

“Stocks are overvalued on a long-term basis, but bonds are enormously overvalued on a long-term basis,” Siegel said in a presentation Sept. 18. “The valuation of stocks relative to bonds is actually among the more favorable in history.”

Even though the S&P 500 gained 9 percent year-to-date through the end of September, New York University market historian Aswath Damodaran notes that earnings and cash flow for S&P 500 companies have grown at a faster rate than the price of the index, so technically, the S&P 500 entered the fourth quarter a better buy than it was on Jan. 1.

Of course, it might be intuitively easier to leave existing money invested than to commit new money to stocks. Either way, if you follow a disciplined approach, rebalance your portfolio periodically and not try to time when to be in or out of the market’s ups and downs, you should be well positioned for longer-term success.