A New Year, A New Outlook

No Trade Resolution, No Earnings, No Problem

In stark contrast to the investment returns of 2018, returns in 2019 flew out of the gate fast and never looked back. It was difficult to find an asset class that did not perform well last year. Baron Rothschild once said, “buy when there's blood in the streets, even if the blood is your own.” Heading into 2019 the streets looked bloody, as global investors worried about geopolitical risks, protectionism, trade wars, the aggressive Fed, and a peak in earnings. Risks abounded, without prospects of a resolution to core issues.

Many investors were frightened heading into 2019. At Noble Wealth Partners, we encouraged our clients to stay invested comparing the stock market volatility to the infamous Rope-a-dope by Mohammed Ali. In our 2018 outlook (click here to read), we state:

“2018 was a troublesome year for the market, but don’t sell your investments just yet, the stock market may be pulling a ‘rope-a-dope’ on us.”

Early in 2019, the Fed reversed its hawkish tone, loosening monetary policy with three interest rate cuts over the year. Investors stampeded back into the market, driving the S&P 500 up more than 30% over the year. Without resolution to the trade talks, and while earnings growth went negative, the only tailwind for the market was provided by an accommodative Fed, a puzzling development. Given the massive price increase in the stock market and debilitated fundamentals, we would caution readers not to expect too much from the market in 2020.

Well then, what should the stock market expect for 2020? Will the stock market contract the bat/snake pandemic? It's possible - would we then call it a stock mandemic? Who knows. Either way, let’s take a look at some of the key themes of 2020 as this year should be anything but ordinary…

Given the Backdrop, If Trump Is Not Re-Elected, It Will Be an Epic Failure

When the economy is strong the incumbent is poised for re-election. Despite the impeachment saga that is now underway this economic boost looks to be stronger for President Trump than for any other president since 1896. Without changes in the economic environment, a Trump defeat appears unlikely, nearly insurmountable from a historical perspective. In 1912, Republican President William Howard Taft was defeated with economic tailwinds this strong, but only because Theodore Roosevelt had split the Republican vote in half by running as a third-party candidate.

Fixed Income Fundamentals Remain Healthy

The good news in the credit markets: loan defaults are still dormant given the low interest environment. For 2020, expected defaults are only 3.9% and below the long-term average of 4.2% (S&P).

Bond investors have taken note: the interest rate on higher quality bonds relative to U.S. government debt has stayed low. However, bond investors are beginning to recognize the dormant risks within the more speculative areas of the market. Investors are now requiring additional compensation to hold those assets.

Business Investment Continues to Fall

Geopolitical risks and trade uncertainty create a hesitant backdrop for business owners and executives making capital expenditure decisions. This hesitation has led to a slowdown of business investment as longer-term expenditures are put on hold until executives reach clarity on the direction of the U.S. economy. This decline in investment presents one of the more serious risks as we enter the 11th year of a bull market.

Source: JP Morgan

Risks Remain Balanced

While business spending and hiring head downward, a snapshot of the leading economic indicators points to growth that is not too hot and not too cold. Compared to luminous 2018, the overall trend is less than favorable.

No Matter How You Slice It, It Has Been a Heck of a Run for the Stock Market

This prolonged bull market could affirm the fundamentals of the stock market remain intact. Or, investors have failed to recognize that the fundamentals of the market have deteriorated. We could be in the midst of a final melt-up in the stock market before an eventual downfall leading to a recession - like we have seen so many times in the past.

2019 was a special year for U.S. investors. In 2019, the total return of the S&P 500 was over 30% making it the first time this has occurred since 2013 and only the 15th time since 1937! To add to the good news - following years in which both stocks and bonds make above-average returns, the stock market has done even better. The S&P is up +14% in the next year and rises 82% of the time. Bonds averaged gains of +8% in the next year and rose 10 of 11 times. Furthermore, all sectors in the S&P 500 were up more than 11%.

Also noteworthy - unlike 2018, all asset classes were positive in 2019. In 2018, 0/8 asset classes were up 5% for the 1st time since at least 1972. In 2019, all 8 were up more than 5% with a median gain of 20%. The minimum gain of 9% was the highest since 1982 (NDR).

2019 Returns Driven by Buoyant Sentiment Instead of Fundamentals 

Stock market returns can be derived from multiple expansion (i.e. people paying too much for the same asset), earnings growth (i.e. companies growing their profits and are therefore worth more), and dividends (i.e. companies returning their cash flows to investors). The sum of those components is the total return in the stock market. Disturbingly, margin expansion responsible for 92% of the gains for the S&P 500 in 2019 (Goldman Sachs). It would be reckless for investors to assume investors will continue to overpay for stocks, driving up the multiples further, and it looks like we are not going to get help from the earnings side of the equation. As of January 22, 2019, FactSet is projecting earnings growth of negative 0.4% in the fourth quarter of last year. This adds up to lower expected returns over the next few years. At Noble Wealth Partners, we are preparing clients for mid-single digit returns in 2020 with abundant volatility.

This multiple expansion has left valuations stretched. For example, in the S&P 500, the forward P/E is now at ~18x. Well above the long-term average of 16.2x.

Multiple expansion would have to be negative in the coming years for valuations to revert to normal levels. This may weigh on future returns in the U.S. stock market. In fact, analyst exceptions for the growth rate of the S&P 500 in 2020 are the lowest they have been since 2012 (Goldman Sachs). According to their research, this implies a return of only 3% over the next 12 months.

…but That Does Not Mean You Should Sell Your Stock Positions

Historically, the rolling one-year average price return of the S&P 500 has been 10.4% after years with a 30% price gain and the returns have been positive 85% of the time (Goldman Sachs).

When Will the Us Stock Market Pass the Baton?

U.S. markets have drastically outperformed its international counterparts for the past ten years marking one of the longest periods of outperformance going back to 1900.

Source: JP Morgan

On the Rotation Theme, It May Also Be a Good Time to Take Some Profits off the Table

As long as the tax consequences are not too dire, it could be a good time to realize the gains you have earned this cycle in some popular names (think Apple, Amazon, Netflix, Microsoft, etc.). From a behavioral perspective, this is no easy feat. Evolution has taught us to continue behaviors that reward us and cease any activity that may cause us pain. For that reason, we are wired to want to hold on to the stocks that have done well. The thought of performing well may cause you excitement which amplifies a response from your amygdala reacts based on feelings and emotion and competes with your pre-frontal lobe which helps you function logically. The amygdala is a useful component of your brain in situations like being robbed but it not useful when making investment decisions. When we look at those companies that are not particularly cheap but have experienced exponential growth in recent years we see that investors are buying that growth at prices we have not seen since the Technology Bubble in the late 1990s. Since, 2015, cumulative growth returns are about 50% more than the comparable value (think “blue chip” stocks) companies. However, valuations alone are not a precondition to a market reversal. A catalyst must occur to spark this rotation amongst investors. Recent antitrust concerns could act as a catalyst for this reversal. Also, market volatility may be a catalyst as investors seek safer assets. In the 3rd quarter of last year, we began to see investors rotate into value names in the turbulent weeks of market activity. Perhaps investors are seeking the safety of the value names at the tail end of this economic cycle. Plus, value has become so cheap, how much further can it fall in a recession? Like jumping out of a window on the first floor, you may fall but you will live.

It is interesting to see the dispersion of the market capitalization (i.e. size) from the net income of the largest five companies of the S&P 500. Historically, this has been a precursor to a shift of investor preferences. Perhaps, this is the catalyst we are waiting for.

Continuing with the portfolio rotation theme - small companies are now trading at valuations as low as they have been in 20 years. Unfortunately, we do not see an immediate catalyst for this reversal as private companies are staying private longer and smaller companies tend to suffer more in recessions.

Gold Just Had Its Best Year Since 2010

Historically, an investor holding gold has only experienced returns roughly equivalent to the rate of inflation. This makes sense since gold does not pay interest or a dividend. However, after the Fed began cutting rates last year, the opportunity cost of holding precious metals fell sharply. Add in an extended period of stagnated prices, geopolitical risks, trade wars, and an upcoming election, and you have a solid backdrop for gold to continue its recent path while providing diversification to portfolios.

It’s Been a Rough Decade for Hedge Funds

The past decade has been a rough environment for diversification as central banks intervened in the markets. This led to an extended period with lackluster volatility, as measured by the VIX. The VIX measures market expectations of near term volatility conveyed by stock index option prices. Since 1990, the average level of the VIX has been 19.26. Currently, the VIX is at 23.23 but the index has spent most of its time below 15 in this expansion (CBOE). The lack of volatility has created an environment where all asset classes have risen in tandem. These are not fertile grounds for hedge fund managers that usually benefit from temporary mispricings of assets and asset classes instead of the current bull market where asset prices have synthetically been manipulated by central banks and ultra-low (and negative) interest rates.

Political Affiliations May Galvanize Your Outlook

Meet with enough clients and you will find their views on the economy and the stock market are shaped by your political affiliations and the current tenant in the White House. I’ve seen clients pull money out of the market when Obama was elected - big mistake, and clients that went to cash when Trump was elected - big mistake. If this sounds familiar, try to recognize this potential bias so you can overcome any predispositions you may have so you can continue to focus on your long-term goals.  Avoid the temptation to pull out of the market (or put money in the market) purely due to your political views, ill-timed decisions can be devastating. The chart on the right shows the potential impact moving to cash can have on your portfolio. For example, missing the 10 best days in the market shaved more than 3.5% off the total return of this hypothetical portfolio. At times, these ten best days can occur after a new president is elected.

It is true that political decisions can move the market, but to have a meaningful impact that last more than a few days, the bar is a lot higher than most people realize. Also, the market may not react as you predicted even if that threshold is reached.

Prepare for Muted Returns

Large U.S. companies have become relatively overvalued when compared to their international counterparts, smaller companies, and value oriented investments.  We would encourage clients to begin exploring assets outside the U.S. (in small doses). We would caution you not to extrapolate past returns into the future. Be prepared to see moderated returns in the equity and fixed income markets compared to what you have experienced in the past ten years. The tailwind from a secular decline in interest rates, overly accommodative central banks, and the business cycle are dissipating. The charts below provide a visual depiction of our discussion. On the left, you will see Vanguard’s projected ten-year returns for diversified portfolios with the median expected return of a 100% equity portfolio at only 6.1% (compared to historical averages of over 10%). On the right, you will see relative valuations of asset classes with growth stocks at the upper end of their range. Again, growth stocks are those with faster earnings growth being bought at higher prices with low dividend yields (e.g. Apple, Amazon, Microsoft, Netflix, etc.). JP Morgan analyzes the current price to book ratio of emerging stocks. Using a regression of historical returns, one could expect the average return of emerging equities to be about 12.5% over the next 5 years. Applying a similar regression to the price to earnings ratio of U.S. equities, one could expect a 5-year average return of only 4% (JP Morgan). Echoing the theme of reduced future returns, especially for domestic equities.

Source: FactSet, MSCI, J.P. Morgan Asset Management. Returns are 60-month annualized total returns, measured monthly, beginning December 31, 1999.

Planning Opportunities

Medical Costs Are Skyrocketing

Until this issue is addressed if at all, these costs have the potential to destroy a financial plan.

Tuition Growth Waning

That does not mean you don’t have to plan. The recent tax reform and the SECURE Act of 2019 have provided exciting new planning opportunities for families to plan for education costs.

Reach out to your financial advisor (if you have not already) to discuss potential options you may have to hedge increases in medical costs and take advantage of new legislation to help your loved ones prepare for college (or other education opportunities).

Cash-out Refinance Mortgages

It’s tempting to reach for that home equity piggy-bank. But talk to your advisor before making these decisions. in 2019, over 40% of cash-out refinances involved accepting a higher interest rate to access cash in the form of home equity. Please talk to a financial planner if you are considering refinancing options.

And Focus on Your Health

Start by Getting 8 Hours of Sleep

Getting 8 hours of sleep may help you lose weight while improving your mood, increasing your energy levels, slowing dementia, and improving your cognitive abilities.

And Don’t Forget to Exercise

Exercise has other benefits outside of what is obvious. Just one workout can alter the functionality of our brains and our motor functions. A study adds to new evidence the exercise prolongs the life of our brain and like our muscles, keeps it strong.

If you are still reading, thank you for making it this far and we hope you found this blog invigorating. At Noble Wealth Partners, we wish you the very best 2020!

Until next year!

Your team at Noble Wealth Partners