The S&P 500 has hit new records in recent days, completing a round trip that has been remarkable, rapid, resilient … and risky.
In a span of just 126 trading days, the S&P 500 went from peak to new peak, with a 34% drop in between. Below we offer some short, but important, takeaways on how we got here, what investors should have learned, what we are concerned about, and how we are investing going forward.
The financial crisis was painful for anyone working on Wall Street, but the period gets credit for improving at least one industry dynamic: The bar for effective communication from an asset manager has been significantly raised.
As markets plummeted, advisors, consultants, investment committees and other key fund decision makers demanded dialogue from their portfolio managers about the market collapse and what they planned to do going forward. The demand for increased communication continues today, and is an industry trend we applaud.
Advisors and consultants deserve shared insight from their investment managers, and an open forum for communication. In short, they deserve true partnership. We believe boutique asset managers are best positioned to deliver the partnership clients deserve.
As investor interest in ESG grows, so too are the number of ESG strategies to choose from. Already, 23 ESG funds have launched in 2020, and more than 20 others are in registration at the SEC, according to Morningstar.¹ This marks the sixth straight year of more than 20 launches.
With more fund launches, due diligence isn’t getting any easier. We believe one way advisors and other allocators can help their clients find the right strategy is to ask whether they want a fund that is directly engaging businesses to improve corporate policy around ESG issues.
Many ESG funds do not engage management teams on policies, but instead rely on ESG ratings to screen out non-ESG friendly companies and include companies with better ratings. That may well be enough for some clients.
With growth stocks on a historical run of outperforming value, many allocators are wondering if mean reversion is due and are questioning their allocations to both style boxes. But growth or value may be the wrong question to ask.
As Dana portfolio managers explained in a recent Q&A on the ways active managers can differentiate their strategies, core strategies may provide optimal exposure. The Q&A also runs through a classic example of the perils of overpaying for growth, and touches on a less discussed benefit of core strategies: tax efficiency. As our portfolio managers explain:
The S&P 500 bears an extreme risk: too few stocks account for too much of its weight. The index is experiencing extreme concentration risk not seen in the last 30 years, with its five largest stocks now accounting for more than 20% of the entire index.
The chart below shows just how out of balance the weightings of the largest S&P 500 stocks have become. Currently, the total index weight of the five largest holdings is more than five standard deviations1 above normal.
Innovation within the biotechnology, medtech and diagnostics industries makes the health care sector an exciting area to invest. Valuations also make it precarious.
At Dana funds, we have balanced the risk and opportunity within the sector with a steadfast focus on valuation discipline. We are investing in innovation within the sector – but at what we believe is a reasonable price. We also find opportunity with companies that have simpler stories, but nevertheless benefit from long-term, secular tailwinds affecting health care.
Stocks within both camps have been large contributors to performance over the past year, and are a primary reason stock selection within the health care sector has contributed to relative performance for our Epiphany Fund.
It’s a natural reaction to every bear market. As stocks plummet, clients start wondering whether they should pull money out of equities and wait on the sidelines until conditions improve. If you’re an advisor, you may have had several conversations along these lines recently. We salute your efforts to help clients stay the course.
At Dana, we realize the importance of staying fully invested and reflect it in our investment process, which dictates that funds hold minimal cash. Our view is that it is always better to stay fully invested because not even experts can perfectly time a rebound.
However, we know it can be challenging for advisors to keep their clients invested through a downturn. In the spirit of helping, below are five quick-reference stats and charts we’ve collected that paint a picture of why we believe it’s important to stay in equities through the entire market cycle:
As 2019 ended, the backdrop for the energy sector looked relatively solid. Oil prices were up more than 30% in 2019, and future demand appeared firm, as cooling trade tensions between the U.S. and China led many to believe the economy would improve.
It would have been hard for nearly any expert to predict what would happen next. The coronavirus has severely affected the global economy and, in turn, sapped energy demand. At the same time, a price war between Russia and Saudi Arabia has also driven oil prices lower. As a result, the S&P 500 energy sector is down nearly 52% this year, trailing well behind the next biggest sector laggard – financials – which is down 31%.
On the other hand, heading into 2020 few would have predicted utilities would be the best performing sector, down 13% so far this year, but outperforming others due to its defensive nature.
The only thing more striking than the depth of the recent market rout is its speed. It took the S&P 500 just 22 days to fall 30%, the quickest drop of that magnitude in history. The fast freefall has left little time for equity strategies touting downside protection to deliver it … but give it a moment. Stock selection can help navigate equity market downturns, but it provides greater value over a longer period than three panic-stricken weeks.
At Dana, we pride ourselves on the ability to outperform in sustained bear markets and our strategies did so through both the tech bubble and great financial crisis. This is largely what we would expect, given our investment process. We focus on high-quality companies that trade at a discount to their peers. These companies tend to outperform when the economic outlook sours and the rest of the market gravitates toward companies with stable balance sheets and steady earnings growth.
We see early signs the market is once again starting to differentiate between high and low-quality companies. But a bias toward smaller companies and a tilt toward value hasn’t yet helped us in the current downturn.
As stocks slid from record highs to bear market territory in a matter of days, not months, the thing that would really make a strategy shine in the current market environment is to increase one’s allocation to cash. We view this as a market timing call, however, and it’s simply not what we do.
Is Your Manager a Timer or an Investor?
In the earliest stages of a bear market – particularly this one – the best way to cushion the fall is to hide in cash or short equities. Undoubtedly, there have been some long-only managers that have probably benefited from holding excessive cash positions during the recent rout.
With stocks crossing into bear market territory, it’s been a tough period for equities. But credit the market sell-off for one thing: it’s been discerning. Stocks are down broadly, but lower-quality companies bore the brunt of the sell-off.
The volatility underscores why we take a high-quality approach to stock selection. In volatile periods the market typically recognizes stocks of companies with greater earnings stability and stronger balance sheets. Conversely, companies with higher debt levels or speculative growth models are typically punished harder in market downturns and have been again in March.
We believe holding a portfolio of these higher-quality companies leads to outperformance in periods of market stress, and, in turn, better relative performance over a full market cycle. The recent volatility underscores the value of this approach.