We feel investors should have an information outlet for the financial markets that is thorough, but does not require a prerequisite degree in economics. We hope this makes our commentary informative and educational for all levels of investors.
Quarter in Review
|Asset Class†||4th Quarter Return||Past 12 Months|
|U.S. Small Cap Stocks||9.9%||25.5%|
|U.S. Large Cap Stocks||9.1%||31.5%|
The 4th quarter performance in stock markets around the globe was the icing on the cake for a year where stocks returned over 20%. In addition, bonds also had a great year with broad U.S. bond returns just shy of 9%. The combined return of 40.2% for the S&P 500 stock index and the Barclays Aggregate bond index is the highest since 1997, when the combined return was 43%.
Stock returns were relatively uniform, as all sectors ended the year with at least double-digit positive returns. Information technology led all sectors, while the energy sector lagged at the end of the group of 11 sectors in the S&P 500. Stock market returns were impressive, but perhaps more impressive were the returns from the bond markets. Heading into 2019, interest rates had increased steadily over the prior three years, but a reversal of interest rates caused bond returns to swell to their best year since 2002 (Interest rates move inversely to bond returns).
For a quarter where the S&P 500 returned over 9%, the 4th quarter of 2019 was rather unremarkable in terms of news events. In early October, the U.S. and China agreed to a preliminary trade deal, which was certainly good news for the markets, but hardly the type of news that typically prompts a market surge. However, that news, along with better-than-expected inflation and employment data, proved to provide enough fuel to power the market higher.
A full-year outlook for the financial markets is always a difficult task, but given the historic stock market rise, interest rate fluctuations, and a U.S. Presidential election, 2020 could go in many directions making prognostications especially tricky. This being the case, we’ve put together a short list of factors that drive market movements, assess their current situation, and provide some concerns that may shift the markets away from their current state of historical returns achieved in 2019.
Stock Market Valuation
First off, stock market valuations are not at an alarmingly high level. This may seem hard to believe given the market’s rise, but corporate earnings have risen in near lock-step with stock prices (as was detailed in the 3rd quarter 2019 newsletter). The price/earnings ratio of the S&P 500 is hovering slightly below the average of the last 5 years and while price/book ratios* are slightly higher than their 5-year averages, they also reflect a market dominated by firms that do not require large amounts of capital to operate (i.e. technology).
Concern: Margins can no longer expand. Margins (meaning the percentage of revenue that is converted to profits) are the main variable that corporate executives can control to maximize shareholder returns. The recent tax law changes, along with a low inflation environment, have allowed companies to increase their bottom lines with relative ease in the past 2 years; positive macro events that can’t be expected to reoccur.
As mentioned in several quarterly letters in recent years, interest rates have been on a roller coaster ride, but they seem to have leveled out in the last half of 2019. The concern over an inverted yield curve (where longer term bonds yield less than shorter term bonds–see the 2nd quarter 2019 commentary for more) has abated in the last couple months of 2019. The emergence of the inverted curve was one of the biggest concerns for market watchers as that has historically been an indicator of a recession.
Concern: A return to a rising interest rate environment could hamper economic prospects. Lower yields allow corporations and consumers to access cheaper credit, greasing the wheels of spending. This reverberates across the economy, affecting home purchases, corporate expenditures, and share repurchases to name a few.
Employment indicators in the U.S. are at some of the best levels in history with unemployment at the lowest level since 1969 and average hourly earnings at the highest they have been since the 2008 financial crisis. Inflation remains at reasonable levels, allowing for accommodative monetary policy (lower interest rates). Combined, these factors have acted as a tailwind for consumer spending.
Concern: An increase in inflation, or a reversal in hourly earnings growth, could have effects that reverberate in the markets. Along with ending the spending tailwind, such increases would likely cause the Federal Reserve to reverse their more accommodative, lower-interest rate, policy.
Between Brexit in Europe, a decline in Chinese economic growth, and generally worse economic indicators (compared to the U.S.), there aren’t many positive things to point to outside of the U.S. So far, this hasn’t had a material effect on the U.S. economy and is already baked into the current economic situation.
Concern: A UK-less European Union could be messier than already predicted, causing delay in the new trade policies they will need to create with other nations. This is in addition to the trade war with China, which has hurt both the U.S. and Chinese economies.
By now, Americans know that politics in the era of the Trump presidency is anything but predictable. As of late-January, Trump is the odds-on favorite to win the election in November, but he still needs to make it through the impeachment trial and face-off against a Democratic challenger. Given the market performance during his presidency, a Trump victory would likely be positive for the markets in the short-term, but there are 10 months and thousands of Tweets to go before we get those results.
Concern: The recent intervention with Iran increased the possibility of a much larger foreign conflict in the Middle East and the trade war with China isn’t over yet, leaving the door open for some negative news for the markets. It is also uncertain how markets will react to election primary season, as the field for a Democratic nominee narrows. The nomination of one of the more progressive Democratic candidates would likely have a negative effect on the markets in the short-term, but all bets are off the table as the general election nears and democrats will need to move toward the center to appeal to a larger swath of voters.
Book Value – Value of all the assets of a company minus the liabilities. A company that requires significant amounts of machinery to operate (i.e. oil drillers) typically have greater book value than service companies where the workforce is the main value to operations (i.e. software).
† Indices used to represent asset classes:
U.S. Large Cap Stocks – S&P 500
U.S. Small Cap Stocks – Russell 2000
International Stocks – MSCI ACWI ex-U.S.
U.S. Bonds – Bloomberg Barclays Aggregate
Commodities – Bloomberg Commodity
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