In this newsletter, David Smith, Managing Director and Chief Investment Officer at Rockland Trust, addresses some timely questions that have been raised by clients given the volatile beginning to 2025.
After reaching all-time highs, the stock market appears to be selling off as a reaction to recent uncertainty. Should I be making any changes?
Uncertainty has always been present in the markets, and pullbacks occur every year. Even with long-term annual returns averaging near 10%, the average stock market selloff since 1980 during any calendar year is about 14%. The most popular valuation measure of the stock market is the Price to Earnings ratio (P/E). The higher the figure, the more expensive the market is as investors have to pay a higher market price for each dollar of anticipated earnings. Even with recent weakness this March, the current forward P/E ratio stands a little higher than 20x, while the 30-year average P/E has been closer to 17x. Typically, market highs indicate optimism about the future. Recent elevated valuations reflect the belief that 2025 and 2026 earnings will grow much faster than average. Rather than attempting to time each market top or bottom, we focus more on the needs of each client, and the timing of when cash flows are needed from their portfolios to determine the proper allocation necessary to achieve their goals.
Given the dominance of U.S. Large Cap stock performance, why diversify?
As U.S. Large Cap stocks have been the dominant asset class for nearly a decade, it is hard to believe that the S&P 500 underperformed most every major asset class from 2000-2009. Though international performance has trailed that of the S&P 500 in recent years, dollar weakness this year has made international exposure more valuable. Domestic large caps have always been the anchor for our client’s equity exposure, but complementary investments are important, too. Diversification offers downside protection, meaning your portfolio does not depend on the performance of any single investment or industry. Investing in other types of assets, whether it be size (mid-cap), style (growth and value), or geography (international and emerging markets) can improve your portfolio’s performance and reduce risk. By spreading your money across various assets, you effectively smooth out volatility without sacrificing performance over the long term.
Much of the recent positive performance of U.S. stocks has been attributed to the outsized influence of a handful of mega-capitalization technology oriented names. Even dominant companies can experience significant price fluctuations due to market conditions, regulatory changes, or technological disruptions. The unbridled excitement around artificial intelligence has come into question recently. When DeepSeek unveiled its new AI model earlier this year, there was a sharp market sell-off. The combined market capitalization of the Magnificent Seven companies dropped by over $1 trillion. Having a diversified approach can help mute these kind of market reactions.
Bonds and cash are also important to the foundation of a well-diversified portfolio. While bonds offer lower expected returns than stocks, they pay regular income and are mostly less volatile, balancing out risks in the stock market. It is always good to have a cash reserve for expenses and emergencies, as well as peace of mind when markets are turbulent. Knowing you have a cash cushion, you may be able to invest when prices are down, or at least less tempted to sell at a bad time.
Do you prefer active or passive exposure to these diversifying asset classes?
Given the intricacies and constraints of some diversifying asset classes, we tend to favor active managers who are better able to identify opportunities or disparities and quickly adjust portfolios in response to market changes. For the same reason, we believe active managers can outperform the market by selecting securities they believe will perform well. We select active fund managers who align with our investment philosophy. The advisors use in-depth research and analysis of financial condition and industry position, as well as currency, market, and economic conditions to select investments.
What about private credit?
There has been a lot of buzz about the high yields in the private credit area as banks tighten lending due to challenging regulations. It is an intriguing space we have been following for some time. We like the concept but are hesitant that the results and prospects look very attractive in the absence of any nearby economic recession. It is difficult to track the vintage of the portfolios to assess the risks of the underlying securities as each vintage is different and not necessarily repeatable. Considering these entities are illiquid, unregulated, and have a fluctuating income stream, we favor other fixed income vehicles with more favorable risk-reward profiles, including: bank-loans, high-yield, emerging markets, convertibles, and reinsurance bonds. We will continue to monitor this asset class for inclusion in portfolios.
How will tariffs impact my portfolio?
The consensus expects higher costs and slower growth, but how tariffs play out is yet to be seen. Some believe that tariffs are beneficial because the U.S. is such an important market that foreign companies will cut prices and accept lower profits. Tariffs may also even spur certain suppliers, such as those for automotive parts, to relocate to the U.S. On the other hand, some insist that tariffs will damage the economy. Any company that relies on global supply chains will be impacted. Higher costs may weigh on consumer wallets and possibly spark more inflation. Tariffs, effectively sales tax on foreign goods, are not paid by exporters, but rather by businesses that import products. When more tariffs are in effect, they will raise prices for consumers and could hurt more American manufacturers than they help. However, there is a growing belief that we will not follow through fully on many of the tariff threats, as we have already seen announcements followed quickly by delays and exclusions. Our analyst team evaluates the potential effects of these costs in their research to make the best decision for our portfolios.
I thought inflation was behind us. Where do you see interest rates going?
Inflation has been stubborn but remains in check for now near 3%. The announcement, delay, and repeal of tariffs, potential layoffs and other factors may lead to higher prices and inflation at the same time restrain economic growth. What impact changes in tariffs and immigration will have on prices and wages remains to be seen. Regardless, it will take time to work its way through the economy. We expect the Federal Reserve to maintain its wait and see approach and closely monitor data including price growth and strength in the labor market in determining the future path of rate cuts. The bond market is now pricing in a possible 25 bps (.25%) cut this May, and three by the end of 2025.
Why don’t I hold (fill in the blank) stock in my portfolio?
Just because we may not own a particular security does not mean that we are not considering it or will not own it when it becomes attractive. Our investment team uses a proprietary screening process to identify quality companies with competitive advantage(s) and solid earnings growth. From there, our analysts perform extensive research and collaborate with the portfolio management team using a long-term view to build our working list of stocks. We regularly review our investments to ensure that we are implementing our best ideas from a quality and valuation standpoint.
Our disciplined approach to asset allocation is designed to participate in market upswings and also mitigate downside risk. We invest in sound companies with earnings growth and solid long-term fundamentals. Our diversified portfolios are positioned to protect you throughout changing political, economic and geopolitical landscapes.
