2019 Key Takeaways
Larger-cap U.S. stocks were once again at the top of the leader board among global investments. The S&P 500 Index posted gains in every quarter to end the year at an all-time high. Its 31% total return was its second-best year since 1997. (It was up 32% in 2013.) Smaller-cap U.S. stocks rose 25.4% for the year.
Foreign equity markets were also strong. European stocks gained 24.9% for the year. After struggling in the third quarter, emerging-market (EM) stocks shot up almost 12% in the 4th quarter and returned 20.8% for the year.
The core bond index gained 8.6% for the year. This was its best annual return since 2002. High-yield bonds gained 14.4%.
Why did both stocks (risky assets) and bonds (defensive assets) appreciate sharply in 2019? The key driver was the Federal Reserve’s sharp U-turn toward accommodative monetary policy. This was followed by other central banks across the globe. We would prefer gains to come from stronger corporate profits rather than government policies of intervention, but we are left in a world that has “all eyes on the Fed.”
Late 2018, the Fed was indicating it expected to continue to raise interest rates. This led investors to fear that higher rates could tip the U.S. and global economies into recession, bringing an equity bear market with it. The ongoing U.S.-China trade conflict didn’t help matters. The 4th quarter of 2018 was volatile which resulted in a loss in most portfolios for 2018. (As a reminder, 2017 was a strong year for the U.S. stock market.)
Ultimately, the Fed ended up cutting rates three times in the second half of 2019; thus markets experienced a sharp turn around early in 2019. Late in the year, it also started expanding its balance sheet again via purchases of Treasury Bills in order to boost banking system reserves and inject liquidity into the short-term lending markets. Other major central banks also cut rates and/or provided additional stimulus to the markets during the year. This lessened recession fears.
Meanwhile, inflation (and inflation expectations) remained at or below central bank targets. This removed concerns that interest rates would be hiked anytime soon, and the bond market rallied.
U.S. equity investors responded to the Fed policy reversal and stimulus much as they have during the past 10 years – by bidding up stock prices and valuations. A détente in the U.S.-China trade war late in the year (the “phase one” deal) was an added boost to market sentiment.
We enjoy watching stock markets accelerate higher. However, the gains have not come from corporation earnings growth, but rather investors’ willingness to simply pay more. The trend of increasing stock prices without supporting earnings growth increases a key risk in U.S. stocks, which we have highlighted for some time now. Logic does not always explain the dynamics of the complex stock market valuations. Trends can continue (both positively and negatively) longer than the rational thinker can explain. In contrast, international equity market valuations are not as stretched as U.S. equities.
There are reasons to be cautiously optimistic for financial markets in 2020: Monetary policy is easy, recession risks seem to be receding, and some geopolitical risks have abated. That said, we are watching a number of potential short-term risks. We think recent positive rationale has largely been incorporated into prices and valuations, leaving markets particularly vulnerable to any disappointments or negative surprises.
Fourth Quarter 2019 Investment Letter
Market and Performance Recap
Our portfolios generated strong returns for 2019, a bullish year for nearly all financial markets. Returns in individual portfolios have been commensurate with the level of risk each investor accepted. The positive broad-based returns marked a dramatic (and welcome) turnaround from 2018, a year in which nearly all asset classes faltered.
This year’s surprising returns were fueled by a U-turn in monetary policy, as policymakers shifted gears to support a weakening global economy. After tightening financial conditions (raising short-term rates four times) in 2018, the Federal Reserve reversed course and began implementing a more dovish monetary policy (lowering short-term rates three times). Other major central banks also cut rates or provided additional stimulus to the markets via quantitative easing during the year, lessening global recession fears.
U.S. stocks rose in every quarter and surged an additional 9% in the 4th quarter as the United States reached a tentative “phase one” trade agreement with China. The S&P 500 Index’s 31% total return was its second-best year since 1997 (bested only by 2013’s 32% gain). Smaller-cap U.S. stocks rose 25.4% for the year.
Foreign markets were also strong. European stocks gained 9.9% in the 4th quarter and 24.9% for the year. After a weak 3rd quarter, emerging-market (EM) stocks shot up nearly 12% in the fourth quarter and returned 20.8% for the year.
The 10-year Treasury yield dropped dramatically from 2.70% at the start of the year to as low as 1.45% in September, ending the year at 1.92%. As yields dropped, the value of investment-grade bonds gained nearly 9%. Credit markets also rallied amid this supportive monetary policy environment: high-yield bonds earned 14.4% and the floating-rate loan index rose 8.6%.
What’s Next for 2020???
After a year like 2019, the obvious question looking ahead is how much higher can equities go? For many years, assets have been flowing into U.S. stocks on the back of a strong U.S. dollar and the United States’ perceived safe-haven status relative to other global economies. In this respect, 2019 was largely an exclamation point on the decade’s investment pattern.
As we look ahead in 2020, there are reasons to be cautiously optimistic for financial markets. Accommodative central bank monetary policy and easier financial conditions should continue to support at least a modest rebound in global economic growth. As just one point of reference, the Global Manufacturing Purchasing Managers’ Index (PMI) has risen for four consecutive months and inched into expansion territory (above 50) in November. Along with reduced U.S.-China trade risk, this suggests the global economy may be on the rebound. The U.S. consumer also remains in good shape as ongoing labor market strength, wage growth, and low interest rates should continue to support consumer spending and the housing market.
This modestly positive outlook is consistent with the consensus view, meaning that financial markets have already responded positively to these developments. The risk of an unpleasant market surprise or deterioration in the macro environment in 2020 shouldn’t be ignored.
A critical question for fundamentals-based investors like us is always, “What’s already in the price?” In this regard, we note that it wasn’t corporate profit growth that drove U.S. stocks higher in 2019. Reported earnings for the S&P 500 were actually flat over the first three quarters, and mid-single-digit percentage growth is projected for the 4th quarter. The lion’s share (roughly two-thirds) of the S&P 500’s 31% return came from a sharp expansion in valuations. Therefore, our tone has been cautious as we proceeded throughout the year. We believe such stretched valuations potentially leave U.S. stocks vulnerable to disappointment or negative surprises. However, there is an old phrase “Markets can stay irrational longer than investors can remain solvent.” Just because logic can point to analysis that should explain a particular course of direction doesn’t mean the stock market will follow. Investing is not like playing a game of checkers, or even the more complex game of chess. Markets are more like playing a three-dimensional game of chess with multiple players at the same time.
Despite recent positive developments, the U.S.-China trade war could reignite or a different area of geo-economic conflict between the two countries could escalate. This would hurt a still weak manufacturing sector and impact capital spending and business confidence; (CEO confidence is already at recessionary levels).
U.S. election uncertainty, inflation surprises, and international politics are also among the myriad risks that could impact markets over the coming months. As always, geopolitical risk is also a major unknown. As of this writing in early January, global tensions are extremely high following the unexpected killing by U.S. forces of Iran’s military commander. Thus far, markets have largely taken this in stride.
Portfolio Positioning and Outlook
While we watch and weigh the ramifications of short-term risks, it’s important to reiterate that we don’t invest based on 12-month market forecasts. The uncertainty is too high and the unknowns are too many. More important and most relevant for our investment process is our outlook for the next several years, not months. In this respect, our assessment of the risk and opportunities remains consistent with what it’s been in recent years.
Even with the abatement of recession concerns and cautious optimism for the U.S. economy, U.S. stock market valuations are expensive. Foreign stocks provide a better value for each dollar of earnings than U.S. stocks, but foreign stocks always come with higher uncertainty and Americans remain biased toward our own home country.
We have been projecting for several years that with any positive global growth, we would expect foreign stocks to outperform U.S. stocks. To be honest this has not happened. At the same time, foreign stocks returning in the mid-20% range is not too disappointing. The U.S. dollar has been strong, and this lends to stronger U.S. stocks. Any weakness in the U.S. dollar will assist foreign stock returns.
Our exposure to private real estate has been particularly attractive, especially in consideration that this sector has lower risk than U.S. stocks.
2019 has been a year where most every type of investment has won. We don’t anticipate this continuing, and we strongly believe in the core investment rules of staying diversified, holding high quality investments for the long term, and controlling your spending habits. We all need to keep in mind that 10+ years of unprecedented central bank stimulus and interest rate repression have inflated the prices of most financial assets.
We love reporting over the top investment results, but we also know that excess profits need to be reinvested to buffer the inevitable disappointing years that always come around. As they say, “this isn’t our first rodeo” and “we need to act like we’ve been in the end zone before.” We are pleased that our clients hold these values and don’t become giddy and spend excessively during the good times.
If you know of any friends, co-workers or acquaintances that could use our services and advice, please do us the honor of helping them make a connection with us.
As always, we appreciate your confidence and trust in us. We wish everyone a happy, healthy,?and peaceful New Year.
Ron Dickinson, CPA, CFP®, MPA-Tax
[Financial Planning and Investment Management Services offered through Dickinson Investment Advisors, Registered Investment Advisor. Statistics and market information provided by Litman Gregory Advisor Intelligence.]