Quarterly Letter

January 2020 – Quarterly Letter

By January 1, 2020 No Comments
February 5th, 2020

Everything worked last year. International stocks, U.S. based stocks, and fixed income all achieved substantial returns in 2019. Our clients’ stock allocations grew more than 25% last year. Fixed income allocations were up between five and ten percent.

The performance numbers from 2019 are a little misleading. Recall that we went through a 20% sell-off during the 4th quarter of 2018. If we look at returns over 2018 and 2019, the recent performance appears more modest. In 2018, the S&P 500 was down 6%. In 2019 it was up 29%. If we average the returns it comes out to 10.3% annualized over 2018 and 2019, which is basically in line with average annual returns over the last eighty years.

Stocks went up despite record investor withdrawals from stock-based investment vehicles. After the sell-off in late 2018, both individual and institutional investors reduced their exposure to stocks. As is generally the case for market timers, they did this at the worst possible time. This is just one more example of the importance of basing your portfolio on your specific long-term investment objectives. Asset allocation changes should occur only if your situation demands it, and not in reaction to market turbulence.

Regarding the near-term outlook, stock valuations are higher than they were last year. The low valuation in late 2018 was fourteen times forward earnings. Today, stocks are trading at nineteen times forward earnings. This is higher than the historic average, but not by much. Within the context of very low interest rates, current valuations are not an insurmountable obstacle to solid returns in 2020.

It doesn’t appear that a recession will occur this year. In the absence of a recession, earnings should increase. Current forecasts suggest that S&P 500 earnings will increase to $175 for 2020, but investors value stocks based on future earnings. Assuming the economy continues to grow, earnings for 2021 should increase to $195. If valuations stay the same and the market is valued at nineteen times earnings, stocks should increase to more than 3,700 for the S&P 500 benchmark. If this is the case, stock prices could appreciate 13% by the end of the year.

In my experience, stock valuations tend to increase as the economy continues to expand. Confidence builds when the economy is robust. Higher confidence is incrementally reflected in higher stock valuations. It seems reasonable to assume that in the absence of a recession in 2020, market valuations will be higher at the end of the year than they are today. If we get twenty times next year’s earnings, the S&P 500 will be worth about 3,900 which suggests a 16% return. This is probably the most optimistic scenario.

There were three main uncertainties that drove the market lower coming into 2019–Brexit, Federal Reserve policy, and trade policy with China. Great Britain finally came to a political consensus that empowered the British government to negotiate its exit from the European Union. The Federal Reserve reversed its policy to increase interest rates and lowered interest rates three times last year. China and the Trump administration have come to an agreement that doesn’t completely resolve our trade issues, but likely amounts to a near-term truce in the trade dispute.

The sell-off in late 2018 was basically a bear market. The economically sensitive sectors, like energy and industrials sold off even worse than the rest of the market. This doesn’t occur near market peaks, but more often during economic recessions and market lows. Interest rates have also been cut in half since late 2018, indicating that the global economy is operating below its potential. This economic expansion is much more complicated and diversified than previous expansions. It seems that segments of the economy are experiencing their own cycles. Exporting industries slowed down through the trade war. Energy is experiencing a massive downturn that is pretty much unprecedented in its length. Health care and pharmaceuticals fortunes depend on the swinging of the political pendulum. Consumer savings rates are the highest they have been in a generation. The only sign that the economy may be nearing full potential is the very low unemployment rate.

The mild concern over the coronavirus compares positively.  It seems that we are in a period where the market should continue to move gradually higher and downturns will likely be shallower than what we experienced in 2008-9. At some point, the market will be too expensive, but we aren’t there yet. With interest rates as low as they are, stocks are still the best option for investors looking to grow their wealth.

Eric Barden, CFA