For a very long time, seemingly beyond memory, the economic backdrop has been low-moderate GDP growth, low inflation, and historic-low interest rates. This 2% GDP Growth, 2% inflation condition, along with the unceasing flow of assets into indexes, has been extraordinarily supportive of a very select few sectors of the stock and bond markets.
The population of suitable index-centric stocks (the mega-caps, with index-grade share trading liquidity) has become ever more concentrated, the largest 100 of the 500 stocks in the S&P now accounting for two-thirds of its value. The same stocks will be simultaneously found in Growth and Value and Low Volatility and U.S. and International ETFs. On a daily basis, these officially diversified style and factor funds nevertheless correlate with the S&P 500 to the tune of roughly 95% to 98%.
What has also occurred is a crowding out of cyclical and hard-asset type companies that would contain significant return optionality under certain conditions outside of the 2%, 2% comfort zone, conditions that could be quite injurious to mainstream equities, such as a rise in the inflation rate, or a deflationary environment. The S&P 500 now has a zero representation (rounded) in gold mining companies, and zero in marine shipping. The Energy sector, at less than 5%, is the lowest weight on record, below ExxonMobil’s individual weight not so long ago. In essence, the index has lost any resilience in the event of a shift from the temporary 2%, 2% balance point; that shift is a certainty.
Surely, the role of an investment manager is to prepare for such an eventuality, to incorporate some positions that are likely to do well in a variety of environments. Surely a portfolio should avoid certain sectors that appear to hold extreme valuation risk. This review maps out where investors are currently positioned relative to the risks of economic condition outside of the temporary ‘comfort zone’, what truly diversified companies can actually do under those varying conditions, and how these are incorporated into our portfolios.

Download: 3rd Quarter 2019 Commentary