The Value of Diversification: Insights From Our Q3 Economic and Market Review

This is the value of diversification as our quarterly Economic and Market Review will clearly demonstrate. While a small group of stocks—the Magnificent Seven tech names—have dominated performance in the past few years, that was not the case in the third quarter. With inflation beginning to ease, the economy potentially slowing, and valuations for U.S. stocks easily outpacing their global peers, a new group of leaders emerged in the third quarter. Investors who hold diversified portfolios would have benefited.

Let’s start our look back at the third quarter with U.S. stocks.

U.S. stocks (represented by the Russell 1000 Index) surged another 6% in the quarter ending Sept. 30, bringing the year-to-date return to 21.2%, the highest Q1-Q3 performance since 1997. Can they continue to rise for the rest of the year?

That’s hard to say but if history is any guide, it’s worth noting that since 1984 there have been nine years in which Q1-Q3 U.S. stock returns have been above 20%—and only in one of those years was the Q4 return negative. That was in 1987 and was the result of the historic “Black Monday” crash in October that year.

What’s even more noteworthy about this year’s performance to date is that these strong returns have come in the face of weakened consumer sentiment due to ongoing inflation pressures, the upcoming presidential election and the accompanying headlines, an expanding war in the Middle East, two destructive hurricanes, and a port strike, among other issues.

Have the tables turned?

An interesting characteristic of the third quarter was that the usual suspects weren’t the drivers of return. For the first half of the year, the Magnificent Seven technology names led performance globally, which meant that large U.S. growth stocks beat all others. The tables turned in the third quarter, with non-U.S. stocks beating U.S. stocks, small cap beating large cap, and value stocks beating growth stocks.

We’ve talked about needing more market breadth. The Magnificent Seven have so dominated performance in the past few years that by the end of June this year, they came to represent one-third of the S&P 500 Index. But that changed in the third quarter and U.S. large-cap stock performance was easily beaten by that of international stocks, emerging markets, and especially real assets. This is why we always emphasize diversification of your portfolio. And even though investors would have done well owning the Magnificent Seven over the past few years, it’s never good to put all of your eggs in one basket and you can never predict when the trend will reverse.

This is why you ideally own a lot of different things in a portfolio!

Stocks outside the U.S. are on sale

Non-U.S. equities have had lower valuations than U.S. equities for quite some time now but the difference widened significantly this year. U.S. valuations are at the highest level they’ve been for several years while international and emerging market stocks are at lower valuations. That means they are cheaper than U.S. stocks even relative to history.

Meanwhile, their dividend yield is bigger. What’s not to love? Non-U.S. stocks are not only on sale, they also pay out higher income. Moreover, the potential for the U.S. dollar to weaken as rates come down could help boost returns. Sounds like a win-win-win situation to me!

Even without these attractive attributes, including international and emerging markets stocks in a diversified portfolio helps give investors exposure to sectors and industries that aren’t as prevalent in the U.S. Additionally, it’s useful to remember that emerging markets represent 85% of the world population and 60% of the world’s economy.

Another important change seen this year that became more noticeable in the third quarter is the reduced dominance of China in the emerging markets universe. Before, investing in an emerging market index was placing a bet on China. Its dominance in those indexes has fallen now.

Ballast is back

When I said everything did well in the third quarter, I mean everything did well! And that goes for bonds, which have been kind of unloved in the past few years. The decline in interest rates in the quarter boosted the value of bonds. Meanwhile, investors holding bonds also enjoyed strong yields. Conservative investors who held on to their bonds through thick and thin are now seeing their payday.

Some of the recent disillusionment with bonds is that not only did yields fall significantly, their performance correlated with equities, so their primary role as a stable diversifier to stocks kind of went out the window. But it appears the ballast is back! And once again, it shows that holding a diversified portfolio is generally the best option for investors.

Interest rates go down, real assets go up

Real assets were among the biggest winners in the third quarter as interest rates fell. Lower rates have a double-barreled effect on real assets: they mean lower borrowing costs and the yields from real estate investment trusts (REITs) may start to look more attractive than bond yields.

I know there’s been some reluctance to hold REITs due to the perception that they mainly represent commercial real estate—those downtown office towers that are still not at full capacity as we recover from the impact of the COVID pandemic. But when you look under the hood, a good percentage of U.S. and global REITs are composed of data centers, warehouses, health care facilities, retirement homes, and so on. And what can I say about infrastructure other than the world needs to build more roads, bridges, ports, airports and tunnels to keep the global economy running and to meet the needs of rapidly developing emerging markets like China and India.

Balanced portfolio holds out historically

What does this chart show? Well, for one it shows the value of long-term investing. Asset class performance can vary significantly over a one-year horizon, but over five years, the majority of asset classes have historically posted positive performance, and the odds get greater the longer the period the assets are held. More importantly, however, a balanced portfolio has the best chance of positive performance over any period greater than five years.

And what else does this chart show? That no matter how old your clients are, they have lived through a decline in U.S. stocks of more than 20%. Most would have lived through a decline in U.S. stocks of more than 50%. In spite of that, the average return for a balanced portfolio over any rolling 10- or 20-year period was around 7%. This goes to show that investing success is fundamentally about time in the market, not timing the market.

The bottom line

There’s a reason why we’re perpetually hammering home the benefits of portfolio diversification and taking the long view in investing. It’s because both strategies have proven, time and time again, to be critical components of a successful portfolio.

Look, market trends come and go. Asset prices ebb and flow. A balanced portfolio built for the long-term captures today’s opportunities and manages tomorrow’s risks. We’re here to help along the way.

Disclosures

These views are subject to change at any time based upon market or other conditions and are current as of the date at the top of the page. The information, analysis, and opinions expressed herein are for general information only and are not intended to provide specific advice or recommendations for any individual or entity.

This material is not an offer, solicitation or recommendation to purchase any security.

Forecasting represents predictions of market prices and/or volume patterns utilizing varying analytical data. It is not representative of a projection of the stock market, or of any specific investment.

Nothing contained in this material is intended to constitute legal, tax, securities or investment advice, nor an opinion regarding the appropriateness of any investment. The general information contained in this publication should not be acted upon without obtaining specific legal, tax and investment advice from a licensed professional.

Please remember that all investments carry some level of risk, including the potential loss of principal invested. They do not typically grow at an even rate of return and may experience negative growth. As with any type of portfolio structuring, attempting to reduce risk and increase return could, at certain times, unintentionally reduce returns.

Frank Russell Company is the owner of the Russell trademarks contained in this material and all trademark rights related to the Russell trademarks, which the members of the Russell Investments group of companies are permitted to use under license from Frank Russell Company. The members of the Russell Investments group of companies are not affiliated in any manner with Frank Russell Company or any entity operating under the "FTSE RUSSELL" brand.

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Russell Investments Financial Services, LLC, member FINRA, part of Russell Investments.

Bloomberg U.S. Aggregate Bond Index: An index, with income reinvested, generally representative of intermediate-term government bonds, investment grade corporate debt securities, and mortgage-backed securities. (specifically: Bloomberg Government/Corporate Bond Index, the Asset-Backed Securities Index, and the Mortgage-Backed Securities Index).

FTSE NAREIT: An Index designed to present investors with a comprehensive family of REIT performance indexes that span the commercial real estate space across the U.S. economy, offering exposure to all investment and property sectors. In addition, the more narrowly focused property sector and sub-sector indexes provide the facility to concentrate commercial real estate exposure in more selected markets.

MSCI AC World ex-USA Index: An index that tracks global stock market performance that includes developed and emerging markets but excludes the U.S.

MSCI EAFE (Europe, Australasia, Far East) Index: A freefloat-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. and Canada.

MSCI Emerging Markets Index: A float-adjusted market capitalization index that consists of indices in 24 emerging economies.

MSCI AC World ex-USA Index: An index that tracks global stock market performance that includes developed and emerging markets but excludes the U.S.

Russell 1000® Index: measures the highest-ranking 1,000 stocks in the Russell 3000 Index.

The S&P 500® Index: A free-float capitalization-weighted index published since 1957 of the prices of 500 large-cap common stocks actively traded in the United States. The stocks included in the S&P 500® are those of large publicly held companies that trade on either of the two largest American stock market exchanges: the New York Stock Exchange and the NASDAQ.

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