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Is Diversification Dead? Join our Monthly Newsletter February 2020

Junius V. Beaver, III

Co-CIO, Principal

As I revisited my partner Carl’s article from last month, it made me really think about the last decade. I have been in the business since 1992. Everything I was taught, learned and experienced over the course of my career has always led me to believe that diversification across various asset classes has meaningfully reduced risk as well as enhanced returns over the full market cycle.

As I pondered the last ten years, I started wondering if things have just changed. Was a new paradigm upon us? People certainly considered this in 2000 after experiencing two decades of superior returns from equities fueled by a steady reduction in inflation. They also said the same thing about home prices in 2006-2007 as real estate climbed over 90% since 2000, driven by lower interest rates and a crazy relaxation of loans for everyone. They only go up – we had never seen a period in history where housing had declined.

Now I sit here today and wonder the same thing. We just completed a ten-year period where US equities have outperformed every other asset class with very little volatility. Can this continue? What I thought might be valuable is to take a look back several decades and see if this run in US equities is just an anomaly or a trend.

The chart below shows how the S&P 500 has performed over a multi-decade basis and the drivers of return: earnings growth, inflation and earnings multiples. As you can see, in the 1980’s, the earnings growth rate was 5% and inflation was also at 5%. The real factor was the Price/Earnings (PE) multiple. It started the decade at 7 and ended at 15x, thus the annualized return was 17%. The 1990’s were more of the same, but even better! Growth was up to 7%, inflation declined to 3%. PE multiples expanded from 15 to 28x, thus leading to an 18% return. Let’s keep in mind for a moment that the historical PE multiple (100 years) for the S&P 500 is ~15-16x.

The stock market then collapsed in 2000, as people began to realize trees don’t grow to the sky and valuations matter. PE’s went from 26 to 14x, and the overall rate of return was negative. Just to put that into context, the bond market outperformed the equity markets and provided ~6% a year. Finally, from 2010 through the end of last year, we saw fantastic earnings growth of 8%, low inflation of 2% and multiple expansion from 14 to 19x leading to annual returns of 13%+. The driver – you guessed it! Lower beginning multiples as we were all quite timid coming out of the Great Recession.

As I analyze this decade by decade, there are certainly times when owning US equities is the way to go. The grades above reflect that. Can the drivers of the 80’s, 90’s and 10’s continue to provide the same level of boost going forward? History suggests, unfortunately, that equity returns will be more subdued.

We believe diversification at this point makes a ton a sense. Valuation levels are now well above historical PE norms. The fixed income markets aren’t likely to provide much if any return as well as provide little buffer to drawdowns in the stock market going forward. We also believe that real estate will likely outperform, given our view that interest rates will not move significantly higher anytime soon. Hedge funds will also outperform in our view, given that they have much more latitude in terms of how they invest and a probable increase in volatility. They will provide downside protection and still participate on the upside given their risk profile.

In conclusion, we are still firm believers in diversification. There is no question that there are periods where US equities outperform by a fairly wide margin. History suggests the next decade will provide that opportunity. Please consider your overall allocation at this time. Unless you have been rebalancing on an ongoing basis, it is likely your equity position is much higher that you might think. How much risk are you willing to assume?

Junius V. (Trip) Beaver III, is a co-founder of Lanier Asset Management and serves as its Co-Chief Investment Officer. Trip has been a financial advisor delivering high-value investment solutions to affluent individuals since 1994. In addition to his work at Lanier, Trip donates his time and investment expertise to charitable organizations such as the Library Foundation and the Metro United Way.