The investment markets enter 2020 with a tailwind of terrific performance. The fourth quarter ended with U.S. stocks up 6.7%, bringing the 2019 calendar year to a 31.5% return. Holy cow!

What a difference a year makes. At the end of 2018, the stock market had just suffered a steep decline, the Federal Reserve was tightening interest rates, and investors were concerned about a possible trade war with China. At the close of 2019, the U.S. stock market set record highs, the Fed had cut interest rates three times but … investor anxiety about global politics remains about the same.

Despite the global worries, investors are filled with confidence. And while the stock market is roaring into the 2020s, it’s unknown whether the recent performance trend will continue.


Cross Currents

Investors can open the newspaper to sample the mixed signals from the global economy. Protests in Paris and Hong Kong. Wildfires in California and Australia. The uncertainties of Brexit. The steadily slowing Chinese economy.

Still, both stock and bond markets are rallying. Across a broad spectrum of investment assets on Conifer Bay Capital’s radar, almost every category produced positive returns last quarter and last year.

A massive contrast remains between the federal government’s shaky financial position and the success of corporations and individuals. The U.S. and many states are running large deficits even after 10 years of economic prosperity, and the legislatures do not appear to be addressing growing pension and healthcare obligations.

In contrast, corporate earnings and profitability are high, especially because of continued low interest rates and the corporate tax reduction in 2018. For individuals, unemployment is low, home values are high, and the rising stock market has improved their financial positions.

As is evident from political rhetoric heading into the 2020 elections, not all individuals have benefitted equally from the past decade of economic prosperity. Based on the disparate policy platforms of the Republicans, moderate Democrats, and progressive Democrats, there is a huge amount of uncertainty about — and differing views about how to interact with — the economy. These crosscurrents cloud the outlook for investors in the coming year.

Stocks

Investors appear to be lining up to buy stocks these days, but one factor is certain: The stock market is more expensive than it was at the beginning of 2019. Although the largest share of last year’s gains came in Q1, the inflation of stock prices carried right through year-end.

Ending valuations are as rich – relative to the long-term averages – as the starting valuations were cheap. The best performing sectors remain those heavy with growth stocks, including the Technology and Healthcare sectors. Some top performers during Q4 included UnitedHealth Group (+35%), Netflix (+21%), and Microsoft (+14%).

As the trend has continued throughout this cycle, sectors dominated by value stocks have tended to rise less. The weaker sectors this quarter again included Utilities, Energy, Materials, and Consumer Staples.

Drivers behind the trend of growth stocks outperforming value stocks remain elusive. ETFs and index funds are the common suspects. These investment products often are weighted by market capitalization, resulting in the largest companies receiving larger proportions of the investments. Because the largest companies in the common indexes tend to be growth companies (Apple, Microsoft, Amazon, Facebook), they automatically attract a high proportion of each dollar invested.

Investors are becoming wary of recent strength because valuations on U.S. large capitalization growth stocks are at 20% above their 20-year average. Once again, investors likely will be seeking international, small cap, and value stocks, where performance has lagged.

The Outlook for Bonds

It is good news/bad news for the bond market these days.

Good news: The bond market produced a return of over 8% in 2019, even though the investment grade index started the year with only a 3% annual yield.

Bad news: The broad investment grade index yields just over 2% today, leaving little income for investors.

At these levels, bonds yield not much more than cash or money market instruments. Where are retirees, banks, and other income-oriented investors to go for a predicta-ble return on capital?

The Fed’s return to low interest rates is the cause of the shrinking bond yields. With an about-face in monetary policy in 2019 and three quarter-point rate cuts, the current rate target is 1.50%-1.75%.

For income, investors are being driven toward “high yield bonds,” which are known by many other names. Below-investment grade, junk bonds, floating rate, preferred, bank loans or hybrid bonds are all monikers for these investments. The proposition is often the same: Higher results require accepting higher risk.

While default risk has remained low, bond investors should be concerned about return correlations with the stock market. The reason bonds provide portfolio diversification is because when stock prices go down, bond prices often go up. While this is true for Treasury securities and other high-quality debt, it is not always true for high yield bonds. In 2008 when U.S. stocks declined by 38%, investment grade bonds increased by 5.2%. High yield bonds declined by 26.2%.

So while investors may sleep soundly thinking bond assets are safe, their high yield bond investments may suffer alongside equities in a decline, albeit by a lesser amount.

Updated Outlook

The end of Q4 brought a jump in portfolio rebalancing, as many investors trimmed equity allocations after the terrific year. These rebalancings moved assets toward international equities, bonds, or even cash in anticipation of 2020 IRA distributions or estimated income tax payments.

This process of trimming winners and adding to other assets is as important when stocks go up as when they decline. This year’s process is almost exactly opposite of what we did in Q4 2018.

Despite the intense media attention on U.S. elections in 2020, Conifer Bay Capital endeavors to focus on long-term client objectives. Each year brings near-term uncertainties and the coming election cycle is no different. We expect investor uncertainty and market volatility in 2020 to smooth out over time and trend toward the historical performance of the markets, with equity returns in the mid-to-high single digits.

Following a terrific performance year like 2019, we believe the chance has increased for a near-term decline. Most investment portfolios retain holdings in REITs (real estate investment trusts), large banks, and gold, all of which we believe may add stability to equity portfolios, along with bond holdings. Clients should anticipate ups and downs and remain focused on the long game.

Remember, this newsletter is educational and not intended to be an investment recommendation for you, the reader. Consult your own advisor or conduct your own research before making investment decisions.