The value of diversification: Insights from our Q3 Economic and Market Review

Executive summary:

• Market leadership changed course during the third quarter of 2024, with small cap stocks beating their large cap counterparts, value stocks besting growth stocks, and non-U.S. stocks outperforming U.S. stocks. This was a stark reversal from the first half of the year, when U.S. mega cap growth stocks dominated global market performance. 
• We like the opportunity set in international and emerging market equities, due to favorable valuations and yields relative to U.S. stocks. Both asset classes also provide investors with exposure to sectors and industries that aren’t as prevalent in the U.S.
• Bonds returned to their traditional role of portfolio diversifiers during the third quarter, helping cushion stock losses by providing positive returns.
• The decline in interest rates during the third quarter helped boost the performance of real assets.

Financial markets moved higher yet again in the third quarter of 2024, and this time everyone joined in! By that I mean it didn’t matter how you were invested—U.S. stocks, international stocks, emerging markets stocks, bonds, or real assets such as infrastructure and real estate investment trusts (REITs)—you did well.

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?

Source: Morningstar. Top 50 U.S. Stocks: Russell Top 50 Mega Cap Index; U.S. Large Cap Growth: Russell 1000 Growth; U.S. Large Cap Value: Russell 1000 Value; U.S. Small Cap: Russell 2000; U.S. Small Cap Growth: Russell 2000 Growth; U.S. Small Cap Value: Russell 2000 Value; U.S. Large Cap: Russell 1000; Non-U.S. Growth: MSCI World ex-USA Growth; Non-U.S. Value: MSCI World ex-USA Value; Emerging Markets: MSCI Emerging Markets. Index returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment. Indexes are unmanaged and cannot be invested in directly.

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

Source: Morningstar, Data 10/1/2004 – 9/30/2024. U.S.: S&P 500 TR Index; Non-U.S. Developed: MSCI EAFE Index; Emerging Markets: MSCI Emerging Markets index.  Index returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment.

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

Source: Morningstar. U.S. Stocks represented by S&P 500 Index. Bonds represented by Bloomberg US Aggregate Bond Index. Index returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment.

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

Source: Russell 1000 Index, FTSE NAREIT REIT Index, FTSE EPRA Nareit Developed Index, S&P Global Infrastructure Index, Russell 1000 Index, MSCI World xUS Index

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

Source: Morningstar Direct. Equity: MSCI World; Fixed Income: Bloomberg U.S. Aggregate Bond Index returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment. Balanced: 60% Equity, 40% Fixed Income. Based on rolling quarterly time periods. U.S. Equity: S&P 500 Price Index. Indexes are unmanaged and cannot be invested in directly. 

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.