Welcome to a New Year and New Decade:
Don’t Look Back!
2018 was a most trying, difficult year during which nothing seemed to work outside of cash. On the other hand, in 2019 financial markets, especially in the US, performed spectacularly to finish the decade on a strong note. US stocks, as measured by the broad-based S&P 500 Index with reinvested dividends returned over 31%. The US investment-grade bond market, as measured by the Barclays Capital US Aggregate Bond Index, returned 8.7%.
2019: A year like no other
After a brief interest-rate-normalization head-fake the Federal Reserve Bank reversed course to go back down the monetary policy path of artificially-low, short-term interest rates and asset purchases, aka “quantitative easing.” Outside the US, the central banks of Europe and Japan took “easy money” to the extreme by facilitating NEGATIVE interest rates! How did markets respond? Up, of course. Why? With bonds at record low-to-negative yields stocks were viewed as the only game in town, so to speak. (One of the biggest investment lessons learned from the last decade and reinforced last year: “Don’t fight the Fed!”)
There have been a number of justifications offered for the Fed’s about-face: heightened recession risk and inexplicably low inflation (in spite of monetary and fiscal stimulus, low unemployment and rising wages), US-China trade war, etc. Some have speculated that the Fed succumbed to President Trump’s relentless criticism and, therefore, yielded to the undermining of its independence. Others have pointed to the long-postulated theory that the Fed has been in cahoots with the US Treasury to “monetize” our nation’s $23 trillion and growing debt burden, fueled by endless budget deficits. (Whatever the reason, it cannot be good.)
Easy money has arguably been the most important factor driving stock and bond market performance over the last decade. Corporations have leveraged their balance sheets to finance stock buybacks (at the expense of long-term company growth) in order to engineer short-term stock price appreciation. Income investors have been forced into buying junk-bonds and, even, stocks to overcome low-to-negative yields in high-quality bonds. Equity investors have eschewed actively-managed investment funds and fundamental stock analysis, opting instead for passively-managed stock index funds and price-driven momentum strategies. (By the way, investing in a passive index fund is an active investment decision.)
2019 and the 2010s are in the books. What’s Ahead in 2020?
This is the time of year when market strategists and economists issue their market forecasts and predictions. Here’s ours: most market predictions will be wrong! Not trying to be flippant, but we could all do ourselves a favor by not putting weight on these. It is human nature to desire certainty, and market pundits are happy to oblige.
Our best piece of advice for preparing for the coming year(s) is to fight complacency. Given the decade-long run-up in financial markets it is easy to assume that the trend will continue and to extrapolate past results into the future. Instead, we should all take to heart the oft-cited and oft-dismissed investment industry disclaimer, “Past performance is not indicative of future results.”
Markets may very well be “priced to perfection” as some say. Markets are discounting mechanisms, after all, taking into account all available information, to include future probabilities. Stock and bond markets rallied when the Fed changed course and cut rates. Stock markets were further supported by the abatement of recession warnings, the diminished uncertainty surrounding impeachment, and positive news on the US-China trade front. What if things don’t turn out as expected? What if risk is, actually, mispriced?
We do believe that stock and bond market valuations are stretched beyond what can reasonably be supported by the underlying fundamentals. For example, US stock market growth has outpaced corporate earnings growth for many years running. (In the absence of earnings growth, stocks appreciate in price via “multiple expansion,” meaning that you’re paying an inflated price for the same earnings stream, other things being equal.) High bond prices and their inverse, low yields, fail to compensate for the underlying credit and interest rate risk. (For example, does it make sense that the country of Greece can borrow money at lower rates than the US?)
On the other hand, we have learned to appreciate the power of momentum to push markets higher and for longer than we mere mortals may believe. “What is” often deviates from “what should be.” The investment environment remains constructive: the Fed remains accommodative, interest rates and inflation are low, and the economy is growing. We hope it continues.
In the meantime, here are a couple of constructive, actionable suggestions:
- Review your holdings: know what you own and why;
- Rebalance your portfolio by trimming from what has outperformed to add to what has underperformed, so long as the investment case for the underperformers remains intact.
Please call us at 318-675-0826 if you have any questions.
Jack E. Ditt, Jr. William L. McCollum