Welcome to the third installment of our series, "A Piece of the Puzzle," where we pause to share our insights on what we can anticipate in the markets and the economy for the upcoming month.
In today’s article, we’ll first discuss the market volatility we have seen over the past several weeks. Next, we’ll take a look at what the major political events over the past several weeks may portend for the upcoming Presidential race in November. And last but not least, we’ll take a look at Private Equity and discuss how that asset class can provide benefits to a diversified portfolio.
After reaching a (then) record closing high of 41,198 on July 16, the Dow Jones Industrial Average (DJIA) closed at 38,703 on August 5, a drop of nearly 2,500 points, or 6%, in the space of just 20 days. The first three consecutive trading days of August alone contributed to 2,100 points of that drop, or more than 5% during that time period.
Source: Yahoo! Finance
What was the primary catalyst of the drops in August? First, on July 31, the Bank of Japan raised its key interest rate to 0.25% from a range of zero to 0.1% in response to the Japanese Yen’s significant weakening against the U.S. Dollar this year. This interest rate increase – only the second one this year after no raises in the previous eight years – panicked investors; the Nikkei 225 index, posted its largest drop ever on August 5, with some calling it “Black Monday.”
Source: Bank of Japan
Another reason – closer to home – could have been the Federal Reserve’s hesitance to lower its key benchmark rate at the conclusion of its last Board of Governor’s meeting on July 31. Although widely expected, the Fed kept its policy target rate (5.25% to 5.50%) where it has remained for the past 12 months:
Source: Federal Reserve Bank of St. Louis.
Following the steep market decline in early August was a three-week rally to close out the month, where the DJIA gained nearly 3,000 points, or more than 7%, during this time:
Source: Yahoo! Finance
Alas, this was not to last as September 3rd saw a drop in the Dow Jones Industrial Average of more than 600 points, or 1.5%, with the S&P 500 and NASDAQ dropping more than 2% and 3% respectively.
While there has been recent volatility in the markets, it’s important to keep a sound mind. One of the good things to have come out of the recent volatility is the unwinding of some of the unhealthy concentration of capital into just a few stocks in the market. In the first half of the year, Nvidia was the darling of the market but has clearly had some challenges as of late:
Source: Bloomberg
Sector concentration has also been another major issue, in particular Technology (including Microsoft, Apple, Nvidia) and Consumer Discretionary (including Amazon and Tesla). After reaching a market high in mid-July, we have seen an unwinding of the Technology and Consumer Discretionary trade:
Source: Bloomberg
Lastly, in a past edition of “Piece of the Puzzle,” we discussed the outsize effect of the so-called “Magnificent Seven” stocks on the S&P 500 index. While the Mag 7 had performed wonderfully well earlier this year, their recent performance has dragged down the index to the point where non-Mag 7 stocks have been positive since the index market peak on 7/16:
Source: Bloomberg
So turning back to the original question of whether market volatility during the past several weeks is a momentary scare or something more concerning: The jury is still out. But the main takeaway is this: Regardless of what is causing this recent market volatility, having a proper long-term plan in place and staying the course with that plan, is still paramount.
Next, let’s discuss what the upcoming Presidential election might imply for an investor’s portfolio.
The past couple of months has been some of the most disruptive in modern politics, from the attempted assassination of former President Trump to the stepping down of current President Biden from running for a second term to Vice President Harris’ ascendance to becoming the Democratic nominee. (To say that these events are disruptive is almost an understatement, since the last time a sitting or former President had an assassination attempt on his life was Ronald Reagan in March 1981, and the last time a sitting President decided to step down after having begun campaigning for a second term was Lyndon B. Johnson in March 1968).
Shortly after Biden withdrew from the Presidential race on July 21, Kamala Harris quickly became the presumptive Democratic nominee after the Party coalesced behind her. The events shaking up the race have been reflective in the outlook for the race, as shown by the futures predictions markets for the winner of the Electoral College as shown below.1
Source: RealClearPolitics
Some noteworthy observations from the above chart:
With the seismic shift, some investment prognosticators forecasted that the stock market might suffer compared to when Biden was in the race and polling at a double-digit deficit to Trump given that a Republican president is often viewed as more business-friendly than a Democratic president.
This brings up a major question: Do GOP Presidents really help the stock market more than Democratic ones do? And given the answer to this question, should an investor reposition his or her portfolio going into the final two months of election season?
One of the first data points we can examine is the performance of Presidents under various party administrations. Looking back at nearly a century and a quarter of data, we see that Democratic Presidents have earned a very slight 20 basis point advantage on an annualized basis over Republican Presidents. (The Annualized Return ranking can differ from the Percent Change ranking because the latter does not take into account the length each President served office).
Source: BeSpokePremium. Past performance is no guarantee of future results.
So at the very least, the above data shows that Republican presidents don’t outperform their Democratic counterparts. As we’ll now see, this evidence is even more convincing in more recent times.
Consider two investors: Investor A who invests in the S&P 500 index only during Republican administrations and Investor B who invests only during Democratic administrations. Since the 1950’s, Investor A would have grown her initial investment by about 27 times. However, Investor B would have more than doubled her money relative to Investor A:2
Source: BeSpokePremium.
But this only tells half of the story. What about another person, Investor C, who decided to keep her money invested the entire time (a.k.a. the storied “Buy and Hold” investor)?
The difference is massive and trumps any difference between Investor A’s and Investor B’s results. Put simply, the Buy and Hold investor grew her money by nearly 1,700 times or some 60 times better than Investor A and 27 times better than Investor B.
Source: BeSpokePremium.
Putting this altogether, the Equity markets have rewarded those who have stayed the course regardless of who is leading the Executive Branch (or, for that matter, any adverse events):
Sources: Bloomberg, Russell Investments. As of December 31, 2023. Past performance is no guarantee of future results.
Bottom Line: Being a market timer is always difficult and trying to time markets during election season is no exception. As is often said, time in the market is much more important than timing of the market. Those investors who stay invested, regardless of who’s in charge in Washington D.C., should be rewarded in the very long term.
Let’s now discuss a way to invest in companies beyond traditional stocks via Private Equity.
Most high-net-worth investors have ownership in public equities, whether they be through direct holdings in individual stocks or indirectly via index funds or mutual funds. Indeed, investing in public equities has been the bedrock of portfolio management since that asset class is the primary driver of asset growth over long periods of time.
While stocks provide an avenue for investors to be owners within companies, Private Equity (P/E), is another asset class also accomplishing this objective. At its core, P/E refers to capital investments made in companies that are not publicly-traded.
The size of P/E investments in the United States is quite large, at an aggregate of more than $6 Trillion as of early 2024. Given the significant capital needed to making private company investments, large Alternative Asset managers dominate the landscape:
Source: PrivateEquityList.com
Like its public counterpart, P/E can also be invested via various sub-strategies; among the most common ones are (in order of increasing risk):
Source: KRR. For Illustrative Purposes Only.
In terms of the motivations for investing in P/E, one consideration is that of the declining number of public companies in recent decades. After peaking in the mid-1990’s at over 8,000 companies, the number has been closer to 6,000 in recent years, a decline of some 25%.
Source: J.P. Morgan Guide to Alternatives, Q2-2024.
Moreover, given that many companies are staying private for longer, those companies that are public inevitably become much larger in size. In order to access “true” small-cap exposure, investing in private companies becomes increasingly necessary:
Source: J.P. Morgan Guide to Alternatives, Q2-2024.
The upshot of the above phenomena is that performance of P/E funds have been quite strong, averaging over 15% on a net basis over the past decade, which is on par with or better than those achieved in the public markets during the same time period:
Source: J.P. Morgan Guide to Alternatives, Q2-2024. Past performance is no guarantee of future results.
In addition to having potentially higher performance, P/E investments may provide diversification benefits to a portfolio of purely public equities. Consider the chart below, which shows the relationship between the performance of public and private equities using a metric called the correlation coefficient (which can range from between -1 and +1). Any figure below 1 provides some level of diversification.
In the case of North America, private equity provides modest diversification to public equity while in Europe, the diversification benefits are more dramatic.
Source: Burgiss & Refinitiv Eikon. Past performance is no guarantee of future results.
How can an individual invest in P/E? Traditionally, most investors would invest directly with a P/E manager, who would employ a so-called “drawdown” structure whereby an individual commits a certain amount to the fund after signing a subscription agreement and becomes a Limited Partner in that fund. The P/E manager (also known as a General Partner) will then call capital as needed throughout the earlier years of the fund’s lifecycle to invest in portfolio companies.
While a "drawdown" structure may offer benefits such as higher performance resulting from an illiquidity premium, extended lockups and the unpredictable timing of capital calls may make a so-called “evergreen” structure preferrable, whereby an investor can subscribe to a vehicle that invests in multiple funds and both subscriptions and redemptions are available in perpetuity. Notice the differences in effective portfolio asset allocations over a ten-year period, which is a typical length of a drawdown fund:
Source: KKR. For illustrative purposes only.
In summary, Private Equity is a rapidly-expanding asset class that provides investors with the opportunity to earn higher returns than public equity. For those investors who have evaluated the risk considerations of P/E and have a growth objective in mind, combined with a portfolio of traditional public equities, Private Equity can provide an avenue for increasing an investor's risk-adjusted returns over long periods of time. Please speak to your financial advisor to discuss if investing in this asset class is right for you and the different P/E options available to invest in through First Foundation Advisors.
[1] RealClearPolitics is an average of six different online sites where individuals can wager on the outcome of the U.S. Presidential election.
[2] In this illustration, Investor A and Investor B are assumed to earn a 0% return during non-Republican and non-Democratic party administrations respectively. Note that the main takeaway here is not so much the dollar amount of the growth in wealth of the initial investment but rather the final amounts relative to each other.