EXECUTIVE SUMMARY
Given we are in the longest economic expansion in U.S. history, a common question amongst financial professionals, economists, media pundits, and our clients is “How long will this economic growth cycle last?”. There is no economic crystal ball and no one is capable of timing the beginning or end of an economic expansion or contraction, and the same goes for a Bull or Bear Market.
The U.S. economy continues its longest running expansion in its history; and the U.S. job market remains strong, with unemployment at 50-year lows. Although many of these jobs are lower paying jobs, we have seen a slight uptick in wage inflation. The fourth quarter, and entire year of 2019, were very strong for stocks, bonds, and real estate.
There are several reasons for optimism as we begin the 2020’s. On average, the American consumer is doing very well, a trade deal between the U.S. and China (Phase 1) has been reached, and global manufacturing appears to be growing again. As detailed in our report below, several underlying economic indicators remain encouraging. Yet, some realities demand caution. For example, U.S. large cap stocks now have a valuation that is expensive as prices have moved up faster than earnings in the last quarter. However, the good news is that is that many asset classes, such as U.S. small cap stocks, international developed stocks, and emerging market stocks are trading at more attractive prices.
Now that we are in a new year and a new decade, the financial media will be barraging us with predictions about the future. Their “expert forecasts” are folly at best and can be destructive to the growth of your wealth. Warren Buffett said it best, “We have long felt that the only value of stock forecasters is to make fortune-tellers look good. Even now, Charlie (Munger) and I continue to believe that short-term market forecasts are poison and should be kept locked up in a safe place, away from children and also from grown-ups who behave in the market like children.”
Many research studies point to the inability of experts to correctly predict the future price of any asset. One of the worst forecasters is the financial media personality, Jim Cramer. For more details on the incompetence of expert financial forecasters, please see: https://www.advisorperspectives.com/articles/2020/01/06/accountability-proves-the-incompetence-of-market-forecasters
Although we, along with our professional allies, are constantly researching to ascertain whether any changes to our portfolio methodology are warranted based on empirical evidence, we remain rooted in our adherence to the principle of letting the markets work for you over the your financial plan’s time horizon in order to maximize probability of goal achievement. A diversified portfolio tied to your long-terms goals and objectives not only makes you look smart; it provides peace of mind so that you may turn your focus toward what matters most in your life.
For those who would like a deeper dive into the details that we regularly monitor, please continue reading…
World Asset Class 4th Quarter 2019 Index Returns
U.S., International Developed, and Emerging Market stocks were very strong in the fourth quarter. The Real Estate sector was up slightly and is near record levels. U.S. bonds were up slightly, and global bonds were negative. For the broad U.S. stock market, the fourth quarter return of 9.1% was well above the average of 2.1% since January 2001. International Developed Stocks returned 7.86%, which was well above the long-term average return of 1.5%. Emerging Market Stocks returned 11.84%, well above the average return of 2.9%. Global Real Estate stocks returned 0.8%, below its’s average quarterly return of 2.6%.
Here is a look at broad asset class returns over the last year and longer time periods (annualized):
U.S., International Developed, and Emerging Market stocks were all very strong in the last year (2019). The Real Estate index also had a very strong return and ended 2019 near record levels. U.S. and Global bonds were up significantly during the full year, due to an unexpected drop in interest rates across all bond maturities. Over the past 5 and 10 years, the U.S. stock market is well ahead of International Developed and Emerging Market Stocks, which means globally diversified portfolios will have returns less than the broad U.S. stock market over the past 10 years. Real Estate has also performed very well over 5- and 10-year periods.
A larger sample of asset class returns during the fourth quarter shows the strong performance of many stock asset classes, with international & U.S. small-cap and emerging market stocks leading the way during the quarter.
Taking a closer look at U.S. stocks in the fourth quarter, we can see that value took a back seat to growth in large and small cap stocks, after outperforming during the third quarter. Overall, the size factor premium was positive on a market wide basis (including small and large cap stocks), while the value factor premium was negative. Over longer time periods, growth is still well ahead of value in both large and small stocks.
International developed markets were not as strong as the U.S., but the eurozone economy has picked up off of a bottom and stock returns were more positive than an average quarter. Small cap stocks did out-perform large cap stocks. Additionally, the value premium was negative in large and small cap stocks.
For International Developed Stocks over longer time periods, the size factor premium is positive; but the value premium is negative over the past 3, 5 and 10 years.
Bond markets around the world were mixed due to the steepening of the yield curve during the fourth quarter. Yields dropped at the very short end and increased at the long end. The yield on the 5-year Treasury note increased by 14 basis points, ending the quarter at a yield of 1.69%. The yield on the 10-year Treasury note increased by 24 basis points, ending the quarter at a yield of 1.92%. And the 30-year Treasury bond yield jumped by 27 bps to 2.39%. Here is the U.S. yield curve, and you can see how yields have dropped during the quarter at maturities of 1-2 years and increased at maturities of 5 years or more (current yield curve in green, one quarter ago in blue, and one year ago in grey):
Notice below, the very strong fourth quarter return for the Bloomberg Barclays US High Yield Corporate Bond Index, up 2.61% and 14.32% for 2019 through the past year, which leads all bond returns for the quarter, 1, 3, 5 and 10-year periods. This is a sign of economic strength.
The High Yield Spread Index (see footnotes for details) has dropped back to lows of 3.5%, which we have not seen since 2018. A declining high yield spread is associated with strong expectations for the broad economy. Here is a one-year chart of the ICE BofAML US High Yield Master II Option Adjusted Spread:
The Federal Reserve will likely continue to support the current record U.S. expansion, since inflation is below their target level and data shows more disadvantaged workers entering the work force. Many of the hardest hit areas in the U.S. that have not participated in the recovery are starting to show signs of expansion. The Fed is likely to keep short term rates lower for longer than in past cycles.
One cannot time markets and typically the short term is just noise. Here is a sample of how the world stock markets responded to headline news, during the last quarter and the last year (notice the insert of the second graph that compares the last 12 months to the long term). We encourage you to tune out the financial news.
CONCLUSION
The fourth quarter was very strong for stocks, with international and U.S. small cap stocks picking up steam again, narrowing the gap compared to the excellent performance of U.S. Large Cap Growth Stocks. The Federal Reserve has signaled they will remain accommodative to growth and have made sure there are no liquidity issues with the need for dollars in the repo market. Economic data in the U.S. is showing strength again, and the probability of recession in the next year has declined. Most of the good economic news is already priced into U.S. stocks, so we will need to see increased corporate earnings and capital spending plans, along with reduced tariffs for stocks to continue the bullish trend. While the past 10-year results for growth stocks are better than value, the returns for value have still been strong. The outperformance of value during the month of September (and Q3) did not carry through to the fourth quarter; and growth finished well ahead of value for the full year. The growth trade remains crowded and we believe maintaining an investment strategy discipline of global diversification with a bias to the factor premiums and a long-term focus are critical to success.
Standardized Performance Data and Disclosures
Russell data © Russell Investment Group 1995-2017, all rights reserved. Dow Jones data provided by Dow Jones Indexes. MSCI data copyright MSCI 2018, all rights reserved. S&P data provided by Standard & Poor’s Index Services Group. The BofA Merrill Lynch Indices are used with permission; © 2018 Merrill Lynch, Pierce, Fenner & Smith Inc.; all rights reserved. Citigroup bond indices copyright 2018 by Citigroup. Barclays data provided by Barclays Bank PLC. Indices are not available for direct investment; their performance does not reflect the expenses associated with the management of an actual portfolio.
The ICE BofAML Option-Adjusted Spreads (OASs) are the calculated spreads between a computed OAS index of all bonds in a given rating category and a spot Treasury curve. An OAS index is constructed using each constituent bond’s OAS, weighted by market capitalization. The ICE BofAML High Yield Master II OAS uses an index of bonds that are below investment grade (those rated BB or below).This data represents the ICE BofAML US High Yield Master II Index value, which tracks the performance of US dollar denominated below investment grade rated corporate debt publicly issued in the US domestic market. To qualify for inclusion in the index, securities must have a below investment grade rating (based on an average of Moody’s, S&P, and Fitch) and an investment grade rated country of risk (based on an average of Moody’s, S&P, and Fitch foreign currency long term sovereign debt ratings). Each security must have greater than 1 year of remaining maturity, a fixed coupon schedule, and a minimum amount outstanding of $100 million. Original issue zero coupon bonds, “global” securities (debt issued simultaneously in the eurobond and US domestic bond markets), 144a securities and pay-in-kind securities, including toggle notes, qualify for inclusion in the Index. Callable perpetual securities qualify provided they are at least one year from the first call date. Fixed-to-floating rate securities also qualify provided they are callable within the fixed rate period and are at least one year from the last call prior to the date the bond transitions from a fixed to a floating rate security. DRD-eligible and defaulted securities are excluded from the Index.
ICE BofAML Explains the Construction Methodology of this series as: Index constituents are capitalization-weighted based on their current amount outstanding. With the exception of U.S. mortgage pass-throughs and U.S. structured products (ABS, CMBS and CMOs), accrued interest is calculated assuming next-day settlement. Accrued interest for U.S. mortgage pass-through and U.S. structured products is calculated assuming same-day settlement. Cash flows from bond payments that are received during the month are retained in the index until the end of the month and then are removed as part of the rebalancing. Cash does not earn any reinvestment income while it is held in the Index. The Index is rebalanced on the last calendar day of the month, based on information available up to and including the third business day before the last business day of the month. Issues that meet the qualifying criteria are included in the Index for the following month. Issues that no longer meet the criteria during the course of the month remain in the Index until the next month-end rebalancing at which point they are removed from the Index. ICE Benchmark Administration Limited (IBA), ICE BofAML US High Yield Master II Option-Adjusted Spread [BAMLH0A0HYM2], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/BAMLH0A0HYM2, January 10, 2019.
Past performance is no guarantee of future results. This information is provided for educational purposes only and should not be considered investment advice or a solicitation to buy or sell securities. Diversification does not guarantee investment returns and does not eliminate the risk of loss. Investing risks include loss of principal and fluctuating value. Small cap securities are subject to greater volatility than those in other asset categories. International investing involves special risks such as currency fluctuation and political instability. Investing in emerging markets may accentuate these risks. Sector-specific investments can also increase these risks. Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, liquidity, prepayments, and other factors. REIT risks include changes in real estate values and property taxes, interest rates, cash flow of underlying real estate assets, supply and demand, and the management skill and creditworthiness of the issuer.
Principal Risks: The principal risks of investing may include one or more of the following: market risk, small companies risk, risk of concentrating in the real estate industry, foreign securities risk and currencies risk, emerging markets risk, banking concentration risk, foreign government debt risk, interest rate risk, risk of investing for inflation protection, credit risk, risk of municipal securities, derivatives risk, securities lending risk, call risk, liquidity risk, income risk. Value investment risk. Investing strategy risk. To more fully understand the risks related to investment in the funds, investors should read each fund’s prospectus. Investments in foreign issuers are subject to certain considerations that are not associated with investment in US public companies. Investment in the International Equity, Emerging Markets Equity and the Global Fixed Income Portfolios and Indices will be denominated in foreign currencies. Changes in the relative value of these foreign currencies and the US dollar, therefore, will affect the value of investments in the Portfolios. However, the Global Fixed Income Portfolios and Indices may utilize forward currency contracts to attempt to protect against uncertainty in the level of future currency rates (if applicable), to hedge against fluctuations in currency exchange rates or to transfer balances from one currency to another. Foreign Securities prices may decline or fluctuate because of (a) economic or political actions of foreign governments, and/or (b) less regulated or liquid securities markets. The Real Estate Indices are each concentrated in the real estate industry. The exclusive focus by Real Estate Securities Portfolios on the real estate industry will cause the Real Estate Securities Portfolios to be exposed to the general risks of direct real estate ownership. The value of securities in the real estate industry can be affected by changes in real estate values and rental income, property taxes, and tax and regulatory requirements. Also, the value of securities in the real estate industry may decline with changes in interest rate. Investing in REITS and REIT-like entities involves certain unique risks in addition to those risks associated with investing in the real estate industry in general. REITS and REIT-like entities are dependent upon management skill, may not be diversified, and are subject to heavy cash flow dependency and self-liquidations. REITS and REIT-like entities also are subject to the possibility of failing to qualify for tax free pass through of income. Also, many foreign REIT-like entities are deemed for tax purposes as passive foreign investment companies (PFICs), which could result in the receipt of taxable dividends to shareholders at an unfavorable tax rate. Also, because REITS and REIT-like entities typically are invested in a limited number of projects or in a particular market segment, these entities are more susceptible to adverse developments affecting a single project or market segment than more broadly diversified investments. The performance of Real Estate Securities Portfolios may be materially different from the broad equity market. Fixed Income Portfolios: The net asset value of a fund that invests in fixed income securities will fluctuate when interest rates rise. An investor can lose principal value investing in a fixed income fund during a rising interest rate environment. The Portfolio may also be affected by: call risk, which is the risk that during periods of falling interest rates, a bond issuer will call or repay a higher-yielding bond before its maturity date; credit risk, which is the risk that a bond issuer will fail to pay interest and principal in a timely manner. Risk of Banking Concentration: Focus on the banking industry would link the performance of the short-term fixed income indices to changes in performance of the banking industry generally. For example, a change in the market’s perception of the riskiness of banks compared to non-banks would cause the Portfolio’s values to fluctuate.
The material is solely for informational purposes and shall not constitute an offer to sell or the solicitation to buy securities. The opinions expressed herein represent the current, good faith views of Lake Tahoe Wealth Management, Inc. (LTWM) as of the date indicated and are provided for limited purposes, are not definitive investment advice, and should not be relied on as such. The information presented in this presentation has been developed internally and/or obtained from sources believed to be reliable; however, LTWM does not guarantee the accuracy, adequacy or completeness of such information. Predictions, opinions, and other information contained in this presentation are subject to change continually and without notice of any kind and may no longer be true after the date indicated. Any forward-looking statements speak only as of the date they are made, and LTWM assumes no duty to and does not undertake to update forward-looking statements. Forward-looking statements are subject to numerous assumptions, risks and uncertainties, which change over time. Actual results could differ materially from those anticipated in forward looking statements. No investment strategy can guarantee performance results. All investments are subject to investment risk, including loss of principal invested.
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