Morningstar Indexes strategist, Dan Lefkovitz, has urged investors to “abandon preconceived notions” in the wake of 2023 market outcomes that confounded expectations on interest rates, valuations and bonds.
In a new paper, Lefkovitz highlights five ‘unlearnings’ from last year including the need to ditch assumptions that higher rates are always bad for growth stocks or good for banks.
Growth stocks, mainly US technology giants, notched up spectacular returns despite expectations that sharp interest rates in 2023 would weigh on performance. Conversely, banks – typically buoyed by wider margins as rates increase – suffered a lacklustre 2023.
The Morningstar analysis also notes small cap stocks failed to fire last year, playing against type as outperformers during periods of economic recovery.
But the paper argues a naïve correlation of broader economic conditions with small cap performance obscures sector biases that can undercut convention.
“Small caps are thought to possess a long-term performance advantage. Decades ago, academic research postulated that small caps compensate investors for their extra risk,” Lefkovitz says. “They are less proven, less liquid, and more volatile. Small caps have led during many periods, including the early 2000s. Diversification and valuation are better reasons for small-cap exposure than economic forecasts.”
And investors counting on a mean reversion in non-US stocks on the back of persistently low valuations were similarly disappointed last year, the paper says. Citing a 30 per cent bump in Japanese equities in 2023 following corporate reforms, the Morningstar study argues markets require “other catalysts” other than depressed prices to drive returns higher.
“Lower valuations alone aren’t enough to prompt a leadership rotation, but widening the opportunity set is a sensible move for investors,” the report says.
Valuation-based strategies require a long-term approach, Lefkovitz says, as “prices and intrinsic value can take years to converge”.
Finally, he says investors need to ditch simplistic models of bonds as a diversifier of equity risk in all market conditions.
“No one complains about positive correlations between stocks and bonds when both asset classes rise, as they have in 2023,” the paper says. “The fact is that relationships between assets are dynamic. Diversification across stocks and fixed-income instruments of different types is a sensible long-term strategy but won’t always benefit investors in the short term.”
Overall, Lefkovitz warns investors to be “skeptical of conventional wisdom” before dishing out some of his own.
“Uncertainty surrounds the forces that move markets, how assets interact, and which investments best suit the macro environment. Rules of thumb about investing are hardly the immutable laws of physics,” he says.
“Tuning out the noise, sticking with a strategic asset allocation, and rebalancing periodically is a sensible approach. Tactical bets are extremely difficult to get right. Investors persistently miss out on returns by mistiming purchases and sales.”