January 17, 2020 – We finished 2019 at near record highs with a gain of 31.5% on the benchmark S&P 500 Index including dividends. The Federal Reserve’s market-friendly interest rate and liquidity policies fueled the rally. A preliminary trade agreement with China calmed trade jitters and encouraged optimism toward trade. And improved economics for the U.S. and key foreign economies built additional confidence in the markets.
While this is an impressive performance by any measure, remembering where we started in 2019 provides clarity for the year to come. In the fourth quarter of 2018, the index fell by over 19% before beginning a rebound that continued through the first quarter of 2019. As a result, the first 15% of this year’s gains was a recovery from the sharp end of 2018 loss. However, stocks did add on an additional 16% for the year, averaging the annual return for the past three years to over 15% per year.
As we launch into 2020, there is more risk in the markets than last January due to the strong price gains of 2019 with corporate profits that remained nearly unchanged. Nevertheless, increased risk is not a negative indicator for the year to come. In fact, it is the acceptance of risk that generates real returns. In investment management, the short-term Treasury Bill is the proxy for a risk-free rate of return, currently about 1.5%. Anything above that rate is risk premium. Anytime you expect returns above the Treasury Bill rate, risk is paying those returns. Josh Brown of The Reformed Broker says it this way:
“It is the risk you are taking that pays you, and it doesn’t pay you all the time. Acceptance of this is mandatory if you intend to earn a return on your investable assets. There are those who tell you they can mitigate, or even eliminate these risks but even if they can, there is a price to be paid – sometimes a price higher than what the risks you were trying to avoid in the first place would have extracted from you!”
We view the current U.S. stock market as slightly over valued. In 2019, prices rose to highs well above those of the prior year, while earnings growth slowed to nearly zero for the year. That makes valuations higher. The ratio of the price paid divided by a year’s worth of profits, the primary valuation metric, was stretched in the past year. It is now near the high-end of the historic range. This makes the overall U.S. stock market somewhat less attractive than this time last year. Corporate profit growth will be more critical this year if stock prices are to continue to appreciate. Even so, high-quality U.S. stocks are the most attractive investment globally with interest rates and economic growth still supportive.
International stocks are generally priced at lower valuations than U.S. stocks and, therefore, have considerable upside potential if global economic growth gains momentum. Emerging markets particularly have lagged global markets for most of the past eight years and now have the most potential for gains, but many emerging market countries are also dependent on Chinese demand for trade.
| Market Total Returns (including dividends) | Oct. – Dec. | 2019 | |
| Large Co. U.S. Stocks | S&P 500 | +9.07 % | +31.49% |
| Small Co. U.S. Stocks | Russell 2000 | +9.94 | +25.52 |
| Foreign Stocks | DJ Global (ex. U.S.) | +9.08 | +21.56 |
| U.S. Taxable Bonds | BloombergBarc U.S. Agg. Bond | +0.18 | +8.72 |
| Commodities | Bloomberg Commodity | +4.42 | +7.69 |
| Real Estate | DJ U.S. Real Estate | +0.79 | +28.92 |
U.S. bonds performed surprisingly well in 2019 gaining 8.7%. The 10-Year Treasury ended the year with a yield of 1.92%, lower by 0.74% for the year. We expect interest rates to remain in a narrow range in coming months, so returns are expected to be near the coupon yield. We continue to buy bonds primarily for risk reduction in portfolios when needed, and we use a conservative approach, monitoring interest rate risk and favoring shorter maturities and higher credit quality. When appropriate, we build core portfolios of individual municipal or taxable bonds and supplement with small allocations to specialty bond funds. We diversify portfolios by including small positions in real estate which has benefited from falling interest rates for some time. An eventual rise in rates would put downward pressure on real estate prices.
Although we provide an overview of many areas of the market, our focus when managing your portfolio is your personal goal and an individualized strategy to reach that goal. We welcome your feedback and questions.