By: Matt Garrott

Cash and commodities were the only places to hide in the third quarter as stocks and bonds both posted negative returns.  The yield curve remains inverted.  A government shutdown has been delayed, but looms behind daily headlines of legislative dysfunction.  Strikes are hitting not only Hollywood and Las Vegas, but also places in the real world like the automotive and healthcare sectors.  High interest rates have made their way into the mortgage market and student loan payments that have been on hold for years will soon resume.

The crisis du jour changes, but the constant is the message that the world is a dangerous and unpredictable place unlike when you were growing up.  We see the past through rose-colored glasses, though.  Chances are good that your favorite song hit the radio (or satellite or streaming) when you were 13 or 14 years old.  Music has gone downhill since then, just like every past bear market was an opportunity while future drawdowns are threats.  Humans tend to project today’s bad news into the future, but this is a mistake.  Be cautious whenever someone declares something “the new normal”.  Thank goodness because no one wanted ska to be the new normal.

Last year, the S&P 500 dropped 18%.  This year, the S&P 500 is up 11.5%.  Stock valuations still look rich on the whole, but this is a case of the S&P 10 versus the S&P 490.  The top 10 stocks in the S&P 500 make up 32% of the index’s market cap.  These stocks have a price/earnings ratio of 25.9x, which is 28% higher than the average for the top 10 stocks.  The remaining 490 stocks have a P/E of 16.8x, 6% higher than the historic average.  Investors who are wary of overvalued equities don’t have to get out of the market altogether.  They may find it more palatable to rebalance into an equal-weighted index or other strategy that is less exposed to the S&P 10.

Last year, yields were low.  This year, bond investors are getting paid.  Cash used to be considered “on the sidelines”.  The sidelines have moved and cash also pays a yield today.  The question investors are wrestling with now is if they should extend fixed income duration and if so, when.  The Federal Reserve has indicated it expects to raise rates at least one more time this year.  The market expects the Fed to start cutting rates in the middle of 2024.  The Federal Reserve takes the stairs up and the elevator down.  That is, they hike slowly, but cuts are generally deeper and faster.  For now, reinvestment risk for short-term bonds has been low as yields have remained high.

As we usually do in the 4th quarter, we are revisiting asset allocations.  Are portfolios diversified enough?  Are they over-diversified?  Do we need to add asset classes or is there an asset class that is no longer additive to the portfolio mix?  It can be hard not to poke the portfolio even as the market is up double digits on the year and bond yields are palatable, but it’s not prudent to make change just for change’s sake.  Portfolios are in motion, but it doesn’t feel like it because the buying and selling decisions have already been made.  These decisions are rebalancing rather than being sold a fad investment.  Relitigating a portfolio’s asset allocation every quarter or every time the market is up/down 10% or when a new product hits a broker’s payout grid isn’t investing.