As we navigate through the first half of 2024, the investment landscape has presented a fascinating array of opportunities and challenges.

The performance of various asset classes during this period has sparked a significant debate among investors: should they continue to ride the momentum by overweighting US large-cap equities, which have shown strong returns, or should they rebalance their portfolios toward underperforming asset classes such as bonds and real estate?

This note will explore the year-to-date performance of key asset classes and offer a perspective on whether you should rebalance at this time.

Overview of Asset Class Performance in H1 2024

To frame this discussion, let’s first review the performance of major asset classes during the first six months of 2024. The below heat map shows the total return of major asset classes for the last five years.

Some Takeaways:

Performance Relative to Expectations

US Large caps have vastly exceeded expectations, everything else except Commodities has been a big disappointment.

Our long-term expectations for asset class returns and risk are developed as a function of current valuation, risk, and growth expectations starting with a prior base of historical norms. We believe that there is a strong link between risk and return. As such riskier asset classes should command a premium over less risky alternatives.

In the chart below we show the trailing 5-year annualized returns to each of the major asset classes in our asset allocation portfolios (in green). We also show the annualized expected return (in blue) of each asset class.

A couple of comments are in order:

• Actual returns to US Large Cap Equities are nearly twice what we would have expected from a bottom-up fundamental perspective such as that of our asset class forecasts. The main culprit - ever higher valuations for this group of stocks. The Fab-7 term was borne during the pandemic.

• The return to Commodities has also exceeded our long-term expectations primarily because inflationary trends surprised on the upside.

• US Small Cap Equities have been a disappointment. Investors have not been compensated for the extra risk of holding this segment of the equity market. We still believe in the existence of a small-cap premium, but investor sentiment is currently at odds with this historical anomaly.

• International assets have underperformed expectations as growth outside of the US especially after COVID-19 has lagged and the strong US dollar has further dented returns to US-based investors.

• Bonds have been the clear under-performer of the last five years. US Bonds as proxied by the US Aggregate Bond Index (AGG) have returned 0.2% annualized over the last five years. This is not too surprising given the actions of the Federal Reserve to tighten monetary conditions yet still disappointing.

Our Current 12-Month Ahead Asset Class Views

Smart investing is a combination of evaluating fundamentals and current market sentiment along with the prior anchor of historical norms. At heart, I believe in a Bayesian adaptive process whereby my expectations are revised based on the arrival of new data but solidly rooted in historical risk/return relationships.

Here are some high-level observations:

• At this time we are still slightly Overweight equities as an asset class but the composition of our equity bucket is tilted toward an overweight to small cap and emerging markets. We remain Neutral on US Large Cap and believe that investors should trim exposure.

• We have gone from Underweight to Neutral on bonds. Given the underperformance of the asset class over the last few years we encourage investors to increase their allocations to fixed income. Monetary authorities around the world (with the exception of Japan) are cutting rates that will provide a nice boost to bond investors.

• Our neutral stance on Bond is offset by an Overweight to Cash holdings. This is reflective of our belief that equity markets are vulnerable given the exuberant nature of current investor sentiment and the inverted yield curve. There is no cash drag at this point so from a risk-adjusted perspective cash looks more attractive than bonds.

• Similar to our stance on Bonds, we believe that investors should have a small Overweight in US Real Estate. The fundamentals are improving and lower interest rates will do wonders for cash flow management. This call is admittedly controversial as the sector is clearly out of favor with investors.

• We also would encourage investors to take profits from Commodities and trim exposure. We do not anticipate a further spike in inflationary conditions.

Our asset class views provide a directional perspective as to what we expect in the next six months. Investors should consider risk factors as well in terms of constructing their portfolios.

Most importantly, investors should always keep in mind their objectives and constraints before making any asset allocation adjustments. Asset allocation is about balancing return opportunities with a healthy respect for risk all in the context of your risk appetite and financial objectives.

Going Against the Grain & Rebalancing

Given these factors, I advocate for rebalancing rather than continuing to ride the momentum of large-cap equities.

While it may be tempting to chase past performance, doing so often leads to suboptimal results.

The better an asset performs relative to its fundamentals, the lower its expected forward return. In other words, the recent outperformance of large-cap equities has likely already priced in much of the expected future growth, leaving less room for substantial gains. Valuations are stretched at this time.

By rebalancing, investors can lock in gains from high-performing assets and redistribute their investments into underperforming areas that have the potential for recovery and growth.

This approach helps maintain a well-diversified portfolio and aligns with the principle of buying low and selling high. For instance, reallocating some of the gains from large-cap equities into bonds and real estate can provide a more balanced risk-return profile, especially as these assets stand to benefit from anticipated rate cuts.

Moreover, diversification is a critical component of a resilient investment strategy. While large-cap equities have delivered strong returns, they are not immune to market corrections and economic downturns.

By spreading investments across different asset classes, investors can mitigate the impact of volatility in any single market segment. Bonds and real estate, despite their recent underperformance, play a crucial role in reducing overall portfolio risk and providing steady income streams, particularly important for retirees or conservative investors seeking regular income.

In addition, rebalancing towards bonds and real estate allows investors to take advantage of attractive valuations. Lower prices in these asset classes offer better entry points for long-term investments, potentially leading to higher future returns. As market conditions evolve and interest rates decline, the value of these investments is likely to increase, rewarding those who have the foresight to rebalance now.

While it is essential to recognize the current momentum in large-cap equities, it is equally important to acknowledge the risks of overconcentration and overvaluation.

The smart move, in my view, is to rebalance and not get too greedy. As we have seen time and again, markets are cyclical, and what goes up must eventually come down.

By adopting a disciplined rebalancing approach, investors can ensure that their portfolios remain aligned with their long-term financial goals, reducing risk and positioning themselves for future opportunities.

Equities:

• The big “MO” won again in the first half of 20024. Last year’s winners continued winning in the US equity market.

• The size effect worked in reverse. Bigger companies vastly outperformed mid and small-caps.

• Value underperformed growth in H1 20024 by 9%. Over the last 5 years, Growth has outperformed by 7.5% per year. That’s massive. The probability going forward of such a large margin is small. Most likely the gap will close down.

• Dividend yield strategies, always popular with retirees, underperformed the S&P by almost 10% in the first half of 2024. These returns include dividends so it’s a pretty massive difference. Over the last three years, however, dividend yield strategies have only trailed the S&P 500 by 0.9% annualized due to their strong performance during the 2022 bear market.

• In terms of sectors (using the Dow-Jones classification system) the big winners this year have been Technology stocks, up 23.1%. The worst-performing sector was Telecom, down 3.2% year to date.

• A surprise performer thus far is the Utility sector, up 11.4% in H1.

• In terms of major global equity markets the US as proxied by the S&P 500 has been the standout performer this year, up 15.3%. For a while it looked like the Japanese and Chinese equity markets might top the US but both markets cooled off.

• The Netherlands equity market performed almost as well as the S&P 500, trailing by only 0.5% in H1 2024. The Dutch market is heavily exposed to Technology stocks with approximately a 1/3 index weight exposure to the sector.

• The Chinese equity market is currently trading at much cheaper valuations compared to all other major markets. The economy in China has shown some recent growth yet sentiment is still firmly negative. I like Chinese equities given their low valuations but recognize that it’s a contrarian bet with significant timing risk involved. I wouldn’t bet your retirement on Chinese equities but it’s worth a serious look as a way to diversify away from the S&P 500.

Bonds:

• Fixed-income investors have been waiting for the Federal Reserve to save their bacon and lower rates. But no help has been forthcoming up to this point.

• Long-term interest rates are higher than a year ago hitting long-duration strategies hard.

• Credit strategies have fared better than Treasuries.

• Anything with related equity exposure such as Convertibles and High Yield has outperformed.

• The winning trade in H1 2024 has been overweight to credit and short duration.

Alternatives:

• Silver has been on a tear while other metals and energy-related commodities have also performed well in H1 20024.

• Agricultural commodities have lagged as supply remains ahead of demand conditions.

• Natural gas had a horrible start to the year but has recovered in the last couple of months netting a 3.5% gain for the year.

• In terms of currencies, the US dollar has been strong. Versus a broad basket of trading partner currencies, the USD is up 4.5% for the year.

• In the last three years, the USD has appreciated 4% on an annualized basis which is a very significant level of appreciation.

• The Yen has depreciated significantly this year (12%) despite the Bank of Japan's intervention in the FX markets.

• Over the remainder of 2024, the consensus expectation is for the US dollar to give back some of this appreciation especially if and when the Federal Reserve cuts interest rates. A weaker USD will boost holders of international securities after many years of currency losses.

What’s Coming on Premium Wednesday😀 

• No publication on Wednesday due to the 4th of July Holiday.

While I was born in the US I was raised primarily in Latin America and Europe. My mother is from Costa Rica and my father hails from Germany. My perspective on being an American is often a bit more nuanced than that of friends and family who have spent their whole lives in the US.

I am currently concerned about our country and its lack of direction and divisiveness. I am concerned that we are not more vigilant about preserving the foundations of our democracy which at the end of the day is what makes the US such a wonderful country. I am concerned that we are not investing in our democracy and without true commitment, our desire to find the common good is slowly evaporating.

I hope that on this 4th of July, we all take a moment to appreciate this wonderful country and reflect on what we individually may do to preserve our democratic foundation.

It might be simply trying to see other people’s perspectives and politely agree to disagree without judgment. It might be simply taking a pass against negativity and vitriol. After all, small acts compound. We’re all in this together and our democracy needs our attention. We are all jointly in charge.

Disclaimer: This newsletter is not trading or investment advice but for general informational purposes only. This newsletter represents my personal opinions which I am sharing publicly as my blog. Futures, stocks, and bonds trading of any kind involve a lot of risk. No guarantee of any profit whatsoever is made. You may lose everything you have. We guarantee no profit whatsoever, You assume the entire cost and risk of any trading or investing activities you choose to undertake. You are solely responsible for making your own investment decisions. Owners/authors of this newsletter, its representatives, its principals, its moderators, and its members, are NOT registered as securities broker-dealers or investment advisors either with the U.S. Securities and Exchange Commission, CFTC, or with any other securities/regulatory authority. Consult with a registered investment advisor, broker-dealer, and/or financial advisor. By reading and using this newsletter or any of my publications, you are agreeing to these terms. Any screenshots used here are the courtesy of Global Focus Capital and Retirement With Possibilities. The data, quotes, and information used in this newsletter are from publicly available sources and could be outdated or outright wrong - I do not guarantee the accuracy of this information.