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Quarterly Review and Outlook

December 2019:
"It's the Prettiest Sight These Eyes Have Ever Seen"

By Loyd Johnson, Chief Investment Officer
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Loyd Johnson PhotoA Look Back - 4th Quarter 2019

The above title is one of my favorite lines from one of my favorite movies, the 1993 inspirational classic, Rudy. Based on a true story, it tells the tale of a woefully undersized boy from a working-class town that has a dream of not only going to Notre Dame, but playing for their prestigious football team. Through perseverance and hard work, the coach allows him to dress in the final game of his senior year. His dad comes to the game and after getting to his seat, looks out over the field and says with a tear in his eyes, "it’s the prettiest site these eyes have ever seen." It is my hunch that many had the same sentiment when they looked at their investment or 401K account at the end of 2019. It is worth remembering that the year began on the heels of a terrible December, when the S&P 500 was down over 9%, and the 4th quarter negative by 14%. The chart below illustrates what a difference a year can make. The broad-based equity index went on to make those gains back and then some. New all-time highs were made seemingly on a daily basis a month ago, and when the dust was settled, the index was up 31.5% for the calendar year.

S&P 500 Index Chart


Though large-cap domestic stocks led the way, investors enjoyed outsized returns in every equity asset class. It was good news just about everywhere. We have talked in the past about the resilience of our markets, and 2019 was a case study in why it is so important to have a thoughtful asset allocation plan, and importantly, to stick with it. With the ugly 4th quarter of 2018 already mentioned, and signs that the global economy might be slowing down; you could have searched high and low and not found any market "guru" calling for anything close to what the market actually did. The trick is…you have to be invested to benefit in a year like last year, and you have very little warning as to when the big year is going to happen. Rudy would have made for a good investor, as he would not take no for an answer, and he kept at it. He didn’t let a little adversity change his path.

As we examine the economic dashboard below, we continue to see indicators that are well outside of their historical ranges. This has been much of the source of anticipated angst. Many look at some of these important benchmarks and wonder how much longer the good times can roll. Market volatility remains stubbornly low. Only recently, in the first month of January, with the worry over the coronavirus, has the market shown some vulnerability after such a positive close to 2019. U.S. Treasuries are well below their long-term levels, and given the recent moves of the Fed to keep short term rates low, that trend could continue for the foreseeable future. Although the lower rates are great if you are borrowing money, or looking to take on debt, it is not so great for those looking to live on the income of the investments. On the positive side, unemployment remains amazingly low, with the most recent numbers stable at 3.5%. For almost a year now it has been the case that there have been more job openings than people looking for one. It may not always be the job you want, but for the most part, there is employment for those looking. That stands in stark contrast to the double digit unemployment rate seen in the middle of the 2008-2009 Great Recession.

Economic Indicators Dashboard

Inflation continues to confound many by remaining near the low end of its range, hovering around the 2% level. The Fed has stated publicly that their inflation target of 2.5% is still in place. The one area where most wouldn’t mind seeing a little inflation is on the wage side. Workers are making a little bit more on average, but the pickup is not really keeping up with even the muted overall inflation numbers. Fourth quarter GDP estimates were just recently released, and came in at +2.1%. Our economy is growing, but not at the 3.5% long-term average, or near the 5% level that many hoped for as a result of the tax cuts implemented in the first year of the Trump presidency. Other than the government itself, the consumer has been the main driver of the economy. Consumer confidence is at the very high end of its historical range, as people continue to spend. New home purchases continue to rise, and retail business enjoyed a pretty healthy holiday season.

We now look more closely at the overall investment universe with the asset class return table shown below. We love the simplicity of this table as it shows how different asset classes have performed over time. Through the use of color, it demonstrates better than any words how asset classes ebb and flow in and out of favor. Yesterday’s losers are often today’s winners. It was only two years ago in 2018, when the exciting category of Cash was the very best performer as stocks and bonds both struggled. In 2019, although returning a +2.2% return, the ultra-conservative asset was at the very bottom. In the stock world, large-cap U.S. names have been the place to be for the last two years. They outperformed International stocks by nearly 10% in 2018 and did pretty much the same last year. In fact, domestic stocks have really been the better place to be since the Great Recession. Many of the developed countries have been struggling with low, or even negative short-term rates, and just didn’t come out of the global slowdown of a decade ago nearly as well as the U.S.

Fixed Income, as measured by the Bloomberg Barclays Aggregate, fared particularly well last year, returning nearly 9% to investors. At the end of 2018, the Fed was in the middle of a rate-hiking plan, having taken short-term rates from zero to 2.5% over a two and a half year period. Further, the expectation was that there would be two to three more rate hikes in 2019, as they continued on their announced path to 3.5%. Not only did that not happen, but because of the concern of a potential slowdown, and the worry of the ongoing trade war between the U.S. and China, the Fed actually decreased rates three times in 2019, bringing the Fed Funds rate down to 1.5%. This decrease on the short end of the yield curve turned out to be a good thing for longer-dated bond holders. With the inverse relationship between prices and yield, the price of bonds was bid up as yields went down.

Asset Class Returns chart

A Look Ahead

So, now what? Depending on who you listen to, markets are somewhere between a little bit and very overvalued. It is becoming increasingly difficult to make the case that stocks, as a whole, are cheap. However, as we have seen recently and over and over again throughout history, pundits can be wrong…and markets can continue on their merry little way for quite some time before a setback. It was in 1998 that, then Fed Chairman Greenspan spoke of irrational exuberance present in the stock market. Of course, the market continued to rally for another two and a half years until the downdraft that began in 2000. January started off well with the markets making new highs, but has been tempered lately with the coronavirus concern and impeachment/election uncertainty. There are always concerns…both at home and abroad. You can’t invest, or not invest consistently trying to guess when the next significant negative period might start, or what might trigger it. We do not see the specific triggers in place today that would typically lead to a recession in 2020. The economy is still growing. Unemployment is still very low. Interest rates are low, making it cheap for investors to borrow and spend money. Corporations are making money. With less than half of companies reporting 4th quarter earnings so far, 70% are beating estimates. That is all good stuff. The worry, of course, is when that might change. It does matter where you are in the process. It has been nearly 11 years since the last recession. That is several years more than the historical average. With the Fed now in a self-induced holding pattern on rates, and even prepared to respond more if needed, it is possible that a more meandering market could exist in 2020 as we approach elections.

We end with a couple of interesting charts to consider. The first is the BCI (Business Cycle Index) which was designed to provide high probability recession forecasts based on past performances. It is made up of many of the economic indicators we have previously mentioned. It also includes the level of the S&P 500. We have been bouncing around that red warning line for the last couple of years, and went through it fairly convincingly recently. We did the same in 2006 and the recession was still a couple years away.

BCI Model

The second is a little different look at the valuation level of the S&P 500. It is a graph of the price to revenue (sales) over the last decade. It is higher than the tops made in 2000 and 2007. There are certainly other factors to consider, most notably the extreme low interest rate environment of the last 10 years. There is no doubt that part of the equity rise has happened as a result of investors seeking higher returns than those available in money markets and CD’s. We point these out because they bear watching. Like Rudy, we remain disciplined in our investment approach, staying true to client investment objectives and keeping our eye on the prize of consistent long-term performance.

S&P 500 Index Preice and Revenue chart


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