The month of October was full of both tricks and treats, spooking investors with an uptick in volatility, but delivering gains in the US markets. October has historically been the most volatile month for the stock market, with the crashes of 1929, 1987 and 2008 culminating in the ghoulish month. True to form, volatility increased in October as more than half (52%) of the trading days saw gains or losses of more than 1%. It’s a significant increase in volatility when you consider that over the previous nine months of the year, only 11% of days moved as much.
Amidst the volatility, US markets managed to generate positive returns with small cap stocks outpacing large companies. Developed non-US markets remained in the red with small and value stocks giving up slightly more than large growth stocks.
Within the US markets, small caps dominated with the Russell 2000 posting a positive return of 6.59%, well in front of the 2.44% return of the closely followed S&P 500 index of large US companies. The Dimensional Funds that are most commonly represented in our portfolios were mixed relative to their benchmark indices. The DFA US Vector equity gained 2.84%, edging out the Russell 3000. The DFA US Targeted Value fund added 3.12%, trailing the 6.99% return of the Russell 2000 Value. This demonstrates the magnitude of the small cap outperformance for the month. The DFA US Targeted Value portfolio has an average market cap of $2.2 billion, nearly double the $1.2 billion average market cap of the Russell 2000 Value.
Among the Developed non-US markets, returns were similar across the board. The DFA International Value fund lost 1.70%, slightly better than the 2.02% loss for the EAFE Value index. The DFA International Small Company and International Small Value funds lost 2.04% and 2.20% respectively, both better than the 2.53% and 2.44% losses respectively for the EAFE Small Cap and EAFE Small Cap Value indices.
Emerging Markets gained in October with the MSCI Emerging Markets index adding 1.18%. The DFA Emerging Markets fund gained slightly less at 1.06%.
The story of the markets so far this year is the US large cap stocks have been the runaway winner. The S&P 500 stands at a year to date gain of 10.99% as of the end of October. Large US value stocks are close behind with the Russell 1000 Value closing October with an 8.07% year to date gain. However, small cap stocks have not fared nearly as well with the Russell 2000, small cap index down 4.41% through October. International stocks are also in the red for the first ten months with the EAFE and EAFE Small Cap indices down 2.81% and 4.52% respectively.
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Periods like this are a strong reminder of what we call the “Frame of Reference Risk”. Media reports tell a story of markets reaching all-time highs, but the reporting is restricted to the narrow large cap growth US indices of the S&P 500 and the Dow Jones Industrial Average. Diversified portfolios, which include small cap US stocks and international stocks, are flat or down for the year, leading to possible dissatisfaction relative to the perception created by the media of what performance should look like.
Hearing the media reports of the superior performance of the S&P 500 and the Dow Jones may tempt an investor to ditch the small caps and the international stocks. But imagine an investor at the end of 2009 who discovers that the Emerging Markets portion of his portfolio grew by 66%, while the S&P 500 only gained 23.5%. Based on that, he moves the entire portfolio into Emerging Markets. It doesn’t sound sensible, and of course, it isn’t. Smart investors don’t abandon the principles of diversification because one asset class is a clear leader in a particular year. Even if that one asset class is large US stocks.
We don’t know when market leadership will change, but if history is a guide, it will be when investors least expect it. Diversification works, not because we expect that small caps, value and international stocks will always beat out the “nightly news” S&P 500 and Dow Jones, but specifically because we don’t know when they will. But, again looking at history, we know that they have more often than not.
