What we know – Diversification is a hedge against future uncertainty in markets.

Let’s talk about what diversification is and is not.  Diversification is a hedge against uncertainty.  If we knew for certain which investment would be the best performer, we would make the rational choice of putting all of our investment dollars into that one asset. Investing in any other asset would reduce returns, and so the less certainty you have, the more diversification you need.

It’s important to note that diversification is not about increasing portfolio returns, it’s more about generating a smoother ride.  If you had a choice of two investments that generate the same return but with very different ups and downs, you will have the same return whether you own either one of the two, or both of them.  BUT the daily volatility should be reduced when you own them together instead of owning them separately.

Today’s problem is that portfolios today have VERY high concentrations- The past decade has favored market concentrations in investments that have worked!  Investors have owned US instead of International, Large companies instead of small companies, and Growth funds instead of value.  The levels of concentration today are at or near record levels.  As a matter of fact, the top 5 market cap stocks today make up 24.6% of the S&P 500 Index* (source RBAdvisors).  And 50% of the S&P 500 Index is in Tech, Communications Services and Discretionary stocks.  Next, 60% of investors’ portfolios are in US stocks and 60% of the US stock holdings are in Growth Stocks.  Talk about a lot of eggs in one basket!

As market leadership has gotten more narrow, the correlations have gotten higher- meaning that stocks are tending to move all at the same time in the same direction- Not what you want a portfolio to do!

One other piece of relevant information, bonds have appeared to top, and are now showing not only a downward trend, but also a lack of diversification vs stocks.  Also, not good for diversification.  Of note, the US aggregate bond market fell 6% over the first quarter of this year (source FastTrack database).  The FED-induced zero-interest rate environment of the recent past appears to have ended, and as interest rates rise, it will provide a headwind for stocks, and for growth stocks especially.

So here we are.  Today’s stock markets are more concentrated than they have perhaps ever been.  Investors have attempted to move to alternative choices in hopes of adding diversification, but most of these investments have high correlations with stocks and are likely to struggle during a period of rising interest rates.

To illustrate- here’s a chart showing US stock returns in RED (as represented by the S&P 500 Index) down -11.9% year to date, vs the US bond market in GREEN (as represented by the us AGG aggregate bond index) down -8.8% year to date, vs an actual alternative- the US general commodity market in GREY (as represented by the ETF GSG) up 37.9% year to date.

The stock vs bond comparison suggests that current diversification is extremely low.  This is not a desirable situation as we have the increased chance of higher inflation and higher interest rates, both of which may tend to produce slowing corporate profit growth and lower consumer sentiment.  We believe the prudent course of action is to actively seek diversification in portfolios by reducing concentration and searching for exposure to alternate asset classes and reducing exposure to innovation, technology, and growth.  Investors may argue that the risk (in avoiding the standard benchmarks) is too high.  But that is exactly my point.  Prudent investors seeking diversification today should own portfolios that do not look anything like the overly concentrated and highly correlated benchmark investments.

Ron’s Market Minute – UGLY Chart!

Can’t sugar-coat this one. Here is one of those new technical GONOGO charts I’ve shown to some of you. This is the SPY ETF- a daily picture of the S&P 500 Index* as represented by an investable security. We usually look at this index first as it represents about 80% of the investable securities (by dollar amounts) in the US markets. The color-coding makes it fairly easy to read and interpret.  You may recall that in a GONOGO chart, a dark blue daily bar indicates strong upward momentum for the security. You can see a couple of those in mid-May. A lighter blue daily bar indicates a less strong but still upward momentum for the security. More of those in April. The lighter purple bars indicate downward pressure, but not as strong as the dark bars. The dark purple daily bars indicate strong downward pressure – as in right now. Brown indicates that the market for this security is indecisive- markets are not clearly moving up or down. 

Chances are you can interpret the chart pretty easily yourself. But here’s the quick explanation. In mid-March markets were showing upward momentum, although prices were dropping a bit. When we reached the second week in April, markets entered an indecisive state- from which we were on higher alert to see whether markets could regain their upward momentum or lose support and turn down. Despite a couple of dark blue bars about the 19th of this month, by the 21st, markets turned down- but not strongly, until this week. As of the 26th the trend is strongly down. 

Note for the few engineers I’ve spoken with- the lower oscillator chart shows us that markets are now running into overhead resistance and appear to be turning back down. 

So, here we are. Markets are becoming increasingly correlated- and stocks as a whole are moving in the same direction. Unless you have a way in your own investments to access true non-correlated investments, there are no particularly good choices in stocks. The charts for non-US equities, emerging markets equities, and US bonds all look similar. 

So, here’s the spot of optimism. Pullbacks (note I’m not predicting a bear market yet) are part of the process of investing. In this environment, those who can avoid most of the drawdowns will have an opportunity when markets bottom and reverse, to participate in the next upswing. We are watching for indicators of the bottoming process.  

Ronald P. Denk, CFP®
Investment Advisor
Denk Strategic Wealth Partners
10000 N. 31st Avenue, Suite D406A
Phoenix, AZ 85051
Phone (602) 252-8700
Fax (602) 252-8701
Toll-Free (877) The-Denk


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