My F&M

2019 Market Commentary

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2019 was the best year for stocks since 2013 with US stocks rising more than 29% (Russell 3000) and international stocks up more than 21% (ACWI ex-US).  As yields fell, bonds returned more than 8%, well in excess of bond coupon rates.

We are unaware of anyone who was forecasting such strong returns a year ago.  Recall that this time last year, the market mood was negative.  The fourth quarter of 2018 witnessed a nearly 20% decline for stocks, and virtually all asset class returns were somewhat negative for the year.  What a difference a year can make!

2019 was certainly nice, but we should remind ourselves that such investment returns in a year are unusual.  That kind of recent experience can influence the otherwise level-headed reason of some investors to incline us to embrace stocks and to avoid bonds.  At such times, we will all do well to remember the timeless adage from Warren Buffett: “We simply attempt to be fearful when others are greedy and to be greedy when others are fearful.”

Last year’s market was quite strong, but it was narrow, with much of the gains coming from technology stocks.  The Tech-heavy NASDAQ Index was up 35%, and half of those gains came from just two large stocks: Apple and Microsoft – the two largest stocks in the US.  We note this because markets that are strong but “narrow” can be a sign of future market weakness (as in 1999), and because historically the very largest stocks have tended to deliver sub-par long-term returns.

The economy has kept plugging along with extremely low unemployment, low inflation, and low interest rates.  Fears of recession that were prevalent a year ago have faded.

That paints a generally positive picture, but there seems to be an underlying weakness in the economy and in markets in our view.  In late 2018, the Federal Reserve didn’t actually hit the “brakes”, it merely backed off the “accelerator” a bit.  Yet, the stock market responded to that reduction in monetary easing with a rapid nearly 20% drop and signs of looming economic recession started flashing “red”.   So, of course, the Fed dutifully “gunned it” again, and we had a great year.  Easy money is nice for markets … while it lasts, and we have had varying degrees of easy money from the Federal Reserve (and from global central banks) for nearly all the last decade.  But whenever inflation forces the Fed to become not just neutral, but restrictive, with money creation, neither markets nor the economy look likely to be able to handle that in stride.  In fact, the longer the Fed persists with easy money policies, the more debt companies, consumers, and governments take on, leaving them more and more exposed to the pinch of higher rates whenever they arrive.  

None of this is intended to convey that we have a negative short-term or long-term view of markets.  This is just a reality check – when markets are as strong as they have been of late, it is good to remember risk: that long-quiet inflation can rear up without warning and force the Fed to tighten.  We should also remind ourselves that confidence can turn on a dime, and that economic and political upheaval can arise without warning.  [Note: this was written before the recent increase in tensions with Iran.]  In other words, that prudence and reasonable caution should never go out of style.

Stock valuations started the year relatively high.  With aggregate earnings only growing less than 2%, stock price growth obviously outpaced earnings growth last year, so valuations expanded.  This means nothing with respect to the near-term outlook, but since long-term returns are substantially determined by starting valuations, it does mean that long-term stock returns are highly likely to be smaller from this point forward than from a year ago.

Yet, even as stock valuations are high and dividend yields low, interest rates are even lower.  Over the past 65+ years, whenever stock market dividend yields exceeded treasury bond yields, stocks advanced over the next year more than 80% of the time (historically, stocks have advanced in 73% of all calendar years since 1925).

Separately, this year is a presidential election year, and even though that brings added uncertainty, stocks have historically risen modestly on average in such election years and have gone up nearly 80% of the time. 

If – and we emphasize IF – the Fed can remain easy and interest rates can stay low, 2020 could certainly be a positive year for stocks, but we don’t know.

Much more important is the long term.  Fortunately, that is much more knowable.  But unfortunately, high stock returns from here in the long-term don’t look likely.  Without belaboring the details of derivation, our own LONG-TERM (30 year) return expectation for large US stocks is 5-7% annualized, with likely 1-2% per year more from international stocks, and as much as 2-3.5% more per year from emerging international stocks.  Such returns are well below what we experienced in 2019, and for US stocks, are somewhat lower than we experienced over the past 10 years.

As we mark not just the turn of the year but also the turn of the decade, we should look back to review recent decades as well.  We know US stocks outperformed international stocks and that growth stocks outperformed value stocks lately, but a longer view shows a pattern of alternation:

In the 1980s, international stocks (EAFE Index) outperformed US stocks (the S&P 500) by nearly 4.5% per year, and Value stocks (Russell 3000 Value Index) outperformed Growth stocks (Russell 300 Growth Index) by nearly 3% per year.

Then in the 1990s, international stocks lagged US stocks by over 11% per year, and Value stocks lagged Growth stocks by more than 4% per year.

In the 2000s, international stocks outperformed US stocks by over 2% per year as Value stocks outperformed Growth stocks by more than 6.6% per year.

And in the decade just ended, international stocks lagged US stocks by over 8% per year, and Value stocks lagged Growth stocks by more than 3% per year.

This is not to imply perfect alternation.  We share this only to illustrate that just because one investment type did better than another for as long as a decade, there is no reason to expect it to continue to outperform.  In fact, the historical record implies that the reverse is most likely.  International stocks have lagged US stocks for some time now and Value stocks have lagged Growth.  History suggests that a turn for each is most likely in the decade ahead.  Similarly, the strong stock returns experienced in the 2010s (+13.6% per year for the S&P 500 Index) are unlikely to be repeated in the decade to come (the return of the S&P 500 Index for the entire decade of the 2000s was negative 0.95% per year).

Markets fluctuate.  Sub-markets move in and out of favor.  Economies mostly grow, but sometimes contract.  The Federal Reserve sometimes smooths the way with easy monetary policy, sometimes it doesn’t.  All of this implies the prudent investor will remain invested but will want to hold some bonds and cash to cushion the inevitable bumps and drops along the way.  The fact that we have not experienced either an economic recession or a bear market in the last decade should incline us more to caution in our investment selection and diversification than to ramping up the most aggressive holdings to seek maximum return.

Here’s wishing us all and hoping for a Happy, Prosperous, and Healthy New Year and New Decade!  While we hope for the best, we should also continue to give balanced attention to risk, and to exercise the caution and prudence that demands.