Leon Mehl

Monthly  returns  in  the  total  world  stock  index  slid  for  the  first time since the recovery began in April. Even with returns slipping  in  September,  the  total  world  stock  index  hangs  on  to  slim  gains  to  finish  out  the  first  three-quarters  of  the  year.  Returns in the total world stock index have been moved higher on the robust activity in the US large-cap segment of the index. Current  demand  for  US  large-caps  has  turned  the  landscape  of investing into a less diverse and more asymmetric place for taking on risk in the total world stock index.

Growing concentration in the US large-cap index has happened over  the  course  of  many  years  as  demand  for  ownership  continues  to  pull  investors  into  these  types  of  securities.  Currently,  over  a  quarter  of  the  US  large-cap  index’s  market  cap is held in the ten biggest company names that reside in the index. Even the popularized group that goes by the FAANGM expression  now  accounts  for  a  fifth  or  more  of  total  market  cap in the same index. With better returns coming out of the large-cap  index  for  such  a  sustained  period  of  time,  a  rather  large performance gap has grown between the returns of large-cap  and  small-cap  indexes.  Some  liken  this  to  1999  when  the  market cap representing the broad small-cap market slimmed to tiny proportions relative to the total world stock index.

Without a doubt, earnings growth has fared better in US large companies   compared   to   US   small-cap   companies,   which   has  led  to  the  performance  divide.  In  the  long-run,  however,  earnings  growth  is  meant  to  be  better  in  the  small-cap  index  allowing  for  a  small-cap  premium  to  be  made  by  investors.  This  is  necessary  to  compensate  investors  for  the  increased  risk of small companies.  Naturally, small-caps grow into larger companies  as  their  average  earnings  growth  compounds  at  a  larger  rate.  But  that  long-term  phenomenon,  known  as  the  small-cap premium, has gone missing now for some 15 years. As  long  as  money  keeps  pouring  into  the  large-cap  index  at  current  rates,  the  small-cap  premium  will  continue  to  fade  further into the background.

In  the  low  rate  environment  that  exists  today,  prices  paid  for  large-cap  earnings  have  expanded  at  a  much  faster  rate  compared to the same measure for uncertain earnings in small-caps.  Today’s  elevated  demand  for  ownership  in  large-cap  earnings  has  been  more  than  enough  to  overcompensate  for  the  losses  due  to  declining  earnings  in  large-cap  companies.  As  a  result,  large-caps  in  aggregate  stand  with  a  net  positive  gain for the year while small-caps still sits in a net loss position. In 2020, earnings declined in small-caps at a rate that doubled the decline for large-cap earnings.

Return  volatility  in  stock  indexes  is  still  above  average  over  the  recent  past.  Volatility  will  definitely  challenge  the  future  of investment returns as new money is committed in stocks at today’s  levels.  Now  that  the  US  election  season  is  underway,  volatility is likely to remain for some time before complacency can  come  back  into  the  stock  indexes.  The  political  divide  in  the  US  has  widened  with  the  debate  turning  towards  plans  for vaccinations, social order, and how government assistance should be used in an effort to end the current recession.

Stocks  were  at  least  helped  out  by  softening  changes  in  interest  rate  markets  in  the  third  quarter  of  the  year.  Interest  rates stayed latched on to their historic lows coming into the quarter and remained at that level. Many investors looking to invest new money are concluding that there is not much left for bond  returns.  The  next  best  alternative  for  return  is  then  the  earnings of stocks, which may explain why investors are more willing to pay higher prices for earnings relative to other times in history.

Investors are being pulled into stocks, which is good and can help  retool  the  economy.  This  allows  companies  to  access  cheap  capital  through  equity  markets  and  make  investments  in labor and assets. Companies being able to invest on public demand for equity is one solution for pulling this economy out of a crisis.

US  Stocks  posted  monthly  losses  across  all  market  caps.  The  average  total  return  outcome  in  the  month  of  September  was  -3.2%,   nearly   matching   the   decline   in   large-cap  stocks.  Small-cap  losses  in  the  month were a bit deeper at -3.8%. Mid-cap stocks held greatest relative strength with total losses dipping to -2.7%. For the year, large-caps  hold  gains  of  2.3%  while  mid-  and small-cap returns remain negative.

Foreign     Bond     returns     retracted     in     September  as  the  return  premium  asked  on  these  securities  rose.  The  emerging  market  bond  category  weighed  on  the  average   total   return   of   -0.2%   for   the   categories in the prior month. Last month’s return   in   emerging   market   bonds   was   -1.7%.  The  same  category  holds  a  -1.6%  return representing the cumulative change for  2020.  The  cumulative  return  for  the  total world bond category remains positive for the year at 3.7%.

Foreign  Stocks  experienced  more  relative  strength  in  their  total  return  losses  for  the  month  when  compared  to  domestic  stocks.  The  average  loss  among  category  averages   was   -1.5%   in   the   month   of   September. The month’s loss for developed country large-caps was -2.0% and -1.5% for emerging-market  stocks.  Emerging-stock  returns  provide  the  greatest  contribution  in  slimming  down  the  year-to-date  losses  in   foreign   stocks.   This   year’s   losses   in   emerging-market  stocks  stand  at  a  mere  -1.4%.

Hard  Assets  had  a  disappointing  month  bringing in an average return of -5.9% into the   diversified   portfolio.   Energy-related   assets  and  precious  metals  realized  the  biggest  declines  in  the  month.  Energy  lost -10.5% and precious metals fell -7.5%. Monthly  losses  in  real  estate  categories  were  much  slimer  averaging  about  -2.8%.  Recent   experience   in   most   hard   asset   categories   has   produced   a   cumulative   return   drag   in   the   diversified   portfolio   return.

US  Bond  returns  were  relatively  flat  as  interest   rate   changes   remained   more   stable  in  the  month  of  September.  Those  category averages experiencing losses hit the credit markets and inflation protected markets.     Credit     markets     eased     in     September as investors saw a need to raise the risk premium on default-risk securities. The   3.2%   year-to-date   average   return   among  category  averages  is  still  being  propped  up  by  the  returns  in  investment-grade securities.

Hybrids,  on  the  other  hand,  is  where  the  diversified portfolio experienced the most benefit  as  of  late.  The  year-to-date  losses  in preferred stock of -2.3% have been more than  offset  by  the  same  period’s  gains  of  18.5%  for  convertible  securities.  Recent  momentum  in  hybrids,  however,  slowed  in  September  along  with  the  declines  in  equity  market  securities.  The  convertible  category  has  largely  tracked  the  growth  return      in      growth-oriented      equities      throughout  the  year,  making  it  one  of  the  best performing asset classes.