2019 was quite the year for equity investors. U.S. Large Cap stocks, or the S&P 500 index, surged more than 28% in 2019. This was the best performance of that index since 2013, when it gained just under 30%. Technology stocks fared even better as the NASDAQ index climbed more than 35%!

Enjoy it, but be wary of repeat expectations. In fact, the evidence would suggest one should significantly temper their expectations. Looking back at the yearly performance of the S&P 500 since its inception yields an interesting point. Since 1928, the yearly average performance of the index has been about 7.7%. Not bad considering the historical context. However, in years that followed a very good year (up more than 25%) the index average return falls to about 6%. This is why it is important to keep an even head in this business and not get complacent in one’s expectations.

Where did the returns come from?

The market in 2019 was lifted primarily by the largest companies in the S&P 500. For example, Apple and Microsoft made up almost a third of the market rally in 2019. The next third was supported by the next 15 largest companies. So that means that the remaining 482 stocks provided only a third of the returns last year. This is not the sign of a “healthy” market rally. A healthy rally involves many more of the index participants.

Earnings in the S&P 500 did not grow at all in 2019. Partly due to the significant earnings growth we saw in 2018 and partly due to trade flows compressing throughout the year. The combination of these two factors brought us an environment where the only thing that drove US equity returns was a significant increase in the valuation of assets. The forward looking P/E ratio (a commonly cited valuation metric) rose from about 15x at the beginning of the year to 18x by the end of the year. Since the 25 year average P/E level is slightly over 16x, it now sits at an historically above average level.

What drove the valuation shift?

Volatility and sentiment reverted back towards a more complacent market than what we saw at the end of 2018. On the positive front we have very low unemployment, extreme fiscal stimulus around the globe and a stealth monetary stimulus here in the U.S. (more on that later). We have negative real rates everywhere and negative absolute rates in several places. However, the economic and fundamental backdrop actually deteriorated through the year. Which is why the global fiscal and monetary stimulus was needed.

Stealth Monetary Stimulus

In the U.S. the Federal Reserve is fighting a brush fire in the overnight “repo” market. To keep that market sane they have been flooding the overnight lending market with billions in short term funding. On the surface this is not considered “Quantitative Easing”, a tool often used to shore up failing markets. In fact, the Federal Reserve has even addressed this to ensure participants it wasn’t. However, the equity market doesn’t care and it is treating it exactly as such. The market has risen every week since this activity by the Fed started. Furthermore, the Fed is now in a rate cutting cycle at a time when rates are already historically low.

With the kind of fiscal and monetary stimulus we have cited it is hard not to see the markets move higher. I would be hard pressed to come up with another time in our history where so much stimulus was chasing an economy that didn’t need it. There is no recession. There is no major financial crises (barring the more minor issues in the repo market). So unless there is something we are all not seeing, we have a market that will tend to continue to go higher. That is until something changes.

Beware of the Crocs

This is exactly why one is best to make tactical moves ON THE MARGIN. As clients of SWM know, I will at times reduce allocations to specific asset classes in small incremental moves. The goal of this “tactical asset allocation” is to hedge risk while still maintaining one’s overall strategic asset class exposures. My primary goal with any client is to grow their account in line with their stated risk profile, unique circumstances and general liquidity needs. However, my secondary goal is always to preserve wealth. Anyone that has done what I do for a decent amount of time has met “Client X”. Client X is the client that comes to me because they have done serious damage to their portfolio by trying to get that last extra crumb of returns. Much like the gazelle trying to get that last sip of water when everyone knows there’s a Croc about. Nobody considers risk until it’s too late.

Predictions

As the curtain fell on 2019 we heard all of the typical “predictions for 2020” that come out this time of year. We don’t believe one of them.

This is what we know:

1. There will be a US election in 2020. It will bring increased levels of political volatility to the economic narrative. There will be a winner and there will be a loser. There may even be a legal fight to see who the winner and the loser is. Regardless, the economy (and by extension the stock market) won’t care all that much over the long term. As has been the case over the past umpteen years, the politicians in Washington don’t have as much sway over the economy as they would leave you to believe. Sure, they can enact policies that help or hurt the economy in the short to medium term. That is what we will be watching for.
2. The economy will not collapse. Will it grow? Probably. Will it slow? Maybe. Will it contract? Maybe. Many analysts are predicting sub-2% growth for the economy in 2020. That is after almost 3% in 2018 and a likely 2.3% in 2019. While the odds of a near term recession have diminished, the global outlook is weak and global trade flows have compressed.
3. Earnings will grow again. After a stellar 2018 in earnings growth on the back of the Tax Cut and Jobs Act, 2019 brought flat earnings growth. Thus, the market gains we saw were driven entirely by an increase in valuations. This makes sense since the common drivers of valuation worked in favor of higher prices. Geopolitical volatility diminished through the year and the Fed was in a rate cutting environment, amongst other things.  However, don’t expect another 2019 when it comes to stock returns. The level of earnings growth needs to catch up to the market before we can see double digits returns again.
4. Asset allocation will work, again. Clients of Shorepine Wealth Management have experienced this phenomenon. Having the right mix of stocks and bonds and being well diversified within those asset classes is paramount to your success as an investor. Do you give up some of the upside occasionally? Sure. 2019 was a perfect example. But remember, during the last bear market (Oct, 2007 – Feb, 2009) the S&P 500 was down more than 50% while 5-Year U.S. Treasury bonds were up more than 10%. Asset allocation helps you stay invested when it’s hardest to do so. And it protects your accumulated wealth. Use the tools that have been proven over time to work.

The Will of the People

As we head into this election year, remember, the real driver of our capitalist system is and always will be the will of regular people (like you and I) to improve our station in life. As long as that will survives and forces itself upon the narrative that is our common goal (life, liberty and the pursuit of happiness), everything will turn out ok.

Have a wonderful start to your new year and watch out for those crocs lurking…

If you have any questions or have experienced any changes in your financial situation please do not hesitate to Contact Me.

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