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Magnificent 7 Outperformance May Not Continue

The Magnificent 7 stocks continue to capture the focus of investors as these large growth names have outpaced the bulk of global equities. Their outperformance is notable because eye-popping returns for top stocks tend to occur before they reach the top of the market. Once there, subsequent returns tend to lag the market.

This is a cautionary tale for investors expecting continued outperformance from the Magnificent 7. In fact, rather than seeking additional exposure to these mega-cap stocks, investors should ensure their portfolios are broadly diversified to capture the returns of whatever companies ascend to the top in the future.


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Country Debt and Stock Returns

US government debt reached 121% of the value of the country’s gross domestic product (GDP) last year. Many investors have expressed concern over the impact that servicing this level of debt could have on the stock market. But the historical data show little relation between the two. Since 1975, there have been 153 observations of a country exceeding 100% debt/GDP for a year. Stocks were up for that country/year in 104 of the 153, or about two-thirds of the time.

There are numerous examples of countries carrying high debt for extended periods. Italy and Belgium have both been over 100% debt/GDP in more than 30 of the past 48 years. Meanwhile, their stock markets have returned an average of 10.8% and 12.0% per year, respectively. Japan has been over 200% since 2010 while its market averaged close to 6% per year over that period.

Stock markets set prices to the point where investors have a positive expected return given current information. Country debt is a slow-moving variable, so it’s sensible that current prices reflect expectations about the effect of government debt. And it’s unsurprising to see stock performance has generally been positive even amid high-debt conditions.


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Stocks Can Still Go Up if the Government Shuts Down


The US government temporarily averted a shutdown after the House and Senate passed a 45-day funding deal on September 30. But the specter of a shutdown still looms if a longer-term funding resolution fails to materialize before the stopgap ends.

The US government has faced 14 funding gaps since 1981, 10 of which resulted in shutdowns.


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The Power of Compounding - in Health and Wealth

Compounding is one of the most powerful forces in the world. Just ask Albert Einstein, who’s said to have called it the “eighth wonder.” The seemingly small decisions we make every day gain power over time. That’s why it’s important to take the long view and come up with a plan—in both wellness and investing—that creates momentum in the direction of our goals. Don’t squander the power of time when you can recruit it to work in your favor.

Most of us understand that little things add up. Nowhere is this more evident than in our exercise and nutrition habits. Trading just 10% of your calories from meat for calories derived mostly from plants can extend your lifespan. And don’t feel like a failure if you can’t reach 10,000 steps per day. Another study shows that 4,000 are enough to reduce the risk of dying from any cause. The bottom line? What we do today really matters in the future.

No one expects to get stronger by lifting weights just one day per month. But when it comes to investing, there are folks who think the occasional big win is their ticket to success. This is simply not true. Just as your muscles benefit from the incremental increase in strength that comes from consistent training, so too do your investments benefit from a long-term time horizon. Because when it comes to investing, compounding means more than little amounts just adding up. The potential exponential growth provided by compound returns proves that time is literally money.


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Investing Is a Science, an Art, and a Practice

Dimensional was started in 1981 around a set of beliefs. These ideas remain core to their business and key to the experience they deliver.

 1. Investing is a Science

Professional money managers have offered their services for centuries, but until the 1960s, there was no empirical way to hold them accountable for their results. When computers became powerful enough to analyze immense amounts of data, researchers could start gathering and learning from historical stock returns. Now economists could measure the success of different investment strategies compared with the performance of the broader market. The science of finance took off.

 Early pioneers of this new academic discipline discovered that:

  • Diversification reduces risk.
  • Uncertainty creates opportunity.
  • Flexibility adds value.
  • Conventional active management isn’t worth the cost.

“Conventional active management” is just another way of naming a strategy that relies on stock picking, market timing, or both. Stated a different way, it’s people who think they can beat the market. Once historical stock-return data had been analyzed, early empirical research showed that conventional active management delivered inconsistent returns and charged high fees. Not only did active managers not beat the market, they actually did worse than the market on average.


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When Value Delivers


The first half of 2023 marks the 10th time since 1926 that value stocks have underperformed growth stocks by more than 20 percentage points over a two-quarter period. More often than not, value has responded like the hero in an action movie, beating growth over the following four quarters in seven of the nine previous instances and averaging a cumulative outperformance of nearly 29 percentage points.

The sample size may be small, but a positive average value premium following a large negative period is not too surprising. In fact, looking at the other side of the value performance distribution, there have been 19 two-quarter periods with the value premium exceeding positive-20%. In 11 of these, value outperformance continued over the next four quarters. The average premium across all 19 was 3.6%.

It’s notoriously challenging to find an indicator that consistently predicts negative value premiums. Regardless of value’s recent performance, investors should expect positive value premiums going forward. That’s a strong incentive for investors to maintain a disciplined stance to asset allocation, so they can capture the outperformance when value stocks deliver.


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