In the third quarter, equity and fixed income markets recorded positive returns as optimism was fueled by continued economic growth coupled with moderating inflation, strong corporate profits and lower interest rates. Offsetting this optimism were concerns around an escalating war in the Middle East, the ongoing war in Ukraine, weaker global growth (particularly in China), and divisive election rhetoric. For all periods since this bull market began in 2022, the equity market has been dominated by a select few mega cap darlings known as the Magnificent 7. However, during this quarter equity performance broadened: the S&P 500 returned 5.87% while the 8 companies with market capitalizations greater than $1 trillion returned just 0.15%. Microsoft, Google, Amazon, Nvidia and Berkshire Hathaway all posted declines for the quarter. Smaller cap issues also did well and investors like Heron Bay whose portfolios have diversified representation across the market capitalization spectrum enjoyed higher returns. In our case, the portion of our portfolios represented by small to mid-cap companies returned over twice as much as the broader average. Value stocks, both large and small, were ahead of growth stocks for the quarter. It is important to note that value stocks and small cap stocks have underperformed growth and large caps for several years and the valuation gap remains wide. If this is the beginning of a true reversal for these parts of the market, these performance trends may persist. We caution that the market will continue to be volatile. The valuations of the AI-related stocks and the “darlings” remain stretched.
Risk
As the stock market has reached record highs of late, has advanced over 60% from its bottom two years ago, and is still dominated by a handful of stocks with high valuations, risks of decline are elevated. In general, risk refers to the possibility of loss or injury or other adverse effects of unforeseen or underappreciated events. In the arena of investing, risk is muti-faceted and layered. There are two main categories of investment risk: systematic risks that are nearly universal and cannot be diversified, and idiosyncratic risks that are unique and can be diversified. The Heron Bay team spends most of their time addressing these risks so that clients don’t have to. However, behavioral risk can become prevalent at a time like this.
As humans, we are hardwired for survival, where speed is often of the essence. We are subject to fears such as loss aversion (the pain of “loss” is much greater than a “win”) or the fear of missing out (FOMO), which is the need to follow the crowd. With the latter phenomenon, we tend to project recent positive events and trends into the future. As these biases and emotional reactions play out, we are prone to doing precisely the wrong thing at the wrong time, specifically buying high and selling low! With the S&P 500 up over 30% in the last year, we’ve seen a lot of “chasing,” a practice that is inherently dangerous and often harmful to wealth accumulation. Studies and experience show that buying into high valuations leads to only modest returns or worse in the long term. Momentum – herding into what is hot recently - is fickle and can turn quickly. Though it seems counterintuitive, the more an asset goes up, the riskier it becomes. This is because the market price exceeds its intrinsic value; it is worth only what some fool might pay.
Conversely, fear of permanent loss can cause some investors to panic and “pull out”. In 2008-09, many could not bear to see their portfolios at lower levels than in 2007 and projected the downturn well into the future. Economic decline dominated the headlines back then and market sentiment was dark, to say the least. The response of many was to sell to ease emotional pain. But selling at a market low ignored the fact that any positive change would have a dramatic affect thereafter. The more a market or a quality business goes down, the less risky and more attractive it becomes (“positive asymmetry”). We must remember that volatility is a feature, not a bug, and buying when valuations are low leads to high long-term returns. A quote from Baron Rothchild that was repeated frequently by the great investor John Templeton sums this up: “The time to buy is when there’s blood in the streets.”
Calling attention to investor behavior can attune investors to their biases. As equity market investors, we actively choose to endure volatility as owners of an underlying business. So long as that business is enduring and has competitive advantages, equity owners will reap the rewards as a long-term owner of the business. If you are feeling uneasy or your personal circumstances have changed, we want to speak with you. We know that these are interesting times in the markets and would look forward to any conversation or financial planning exercises to reaffirm the long-term strategy.
Heron Bay Capital Management Update
We mentioned in our last newsletter that we have some very talented new hires at our firm. We are very pleased to report that each have made important contributions to Heron Bay. They have uncovered sources of value for our portfolios, increased our research depth, and added operational capacity and specialization. Everyone is very focused on providing you, our clients, with portfolios that will perform well in the long term to meet your needs and to minimize risk along the way.
We thank you for your continued trust and support and we look forward to a positive end to 2024.
Disclosure
Heron Bay Capital Management, LLC (“HBCM”) is a registered investment advisor. Advisory services are only offered to clients or prospective clients where HBCM and its representatives are properly licensed or exempt from licensure.
All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information, and it should not be relied on as such.
The views expressed in this commentary are subject to change based on market and other conditions. These documents may contain certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur.
The information provided is for educational and informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. You should consult your attorney or tax advisor.
Index returns are unmanaged and do not reflect the deduction of any fees or expenses. Index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income. You cannot invest directly in an Index. Data is sourced from FactSet and Orion.
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