2019 4th Quarter Update

Top Headline for Q4: Fittingly, A Big Quarter to Close a Huge Decade

Equity markets surged sharply during the 4th quarter with the S&P 500 Index up 8.5% and the Nasdaq Composite Index up a whopping 12.2%. It’s difficult to tell what sparked the positive investor sentiment as earnings for the quarter were largely flat year-over-year and only marginal tangible improvement was realized on the trade front. “Phase 1” of the trade deal between the United States and China was officially announced on December 13th. The S&P 500 Index finished the year +2.0% after the announcement. Based on a similar surge in international equities, it appears that investors are forecasting more good news on the trade front with expected positive earnings impacts globally in 2020. It is fitting that the quarter finished strong given that it closes one of the best decades ever for the US stock market. Buoyed by low interest rates, government stimulus and the lack of a recession, the S&P 500 delivered over a 190% return during the decade. This return included 6 double digit-return years and only 2 negative years with the worst year (2018) being down only 6.24%. The decade was marked by the dominance of “MegaCap” stocks such as Apple and Microsoft – each finishing the decade with a market cap that exceeded $1 trillion.

General Market Update

US Equities: In a striking reversal of course from Q3, investors moved aggressively into higher risk sectors including technology which was the top performer for the quarter. Healthcare also saw a strong surge as investors appear to see less regulatory risk on that front. It is noteworthy that investors continue to greatly favor large market-cap stocks. While the Russell 2000 small-cap index was up nearly 10% for the quarter, it has greatly underperformed the S&P 500 over the last few years and, in fact, has still failed to recover its all-time high from 2018. The third quarter brought continued degradation in year-over-year earnings for the US market with full-year 2019 projections now showing no year-over-year growth. Trade news seems to be dominating the headlines relative to earnings which is driving market sentiment and, consequently, short-term performance. We would expect this trend to continue into 2020. It is noteworthy, however, that earnings for 2019 were not good and, without signs of improvement in 2020 and beyond, the expanded price/earnings multiples could sharply contract.

International and Emerging Market Equities: As noted above, the international markets seem to be sensing positive news ahead on the trade front with strong equity-market returns in many countries. The Schwab International Equity ETF, which holds stocks of developed markets excluding the United States, was up 7.9% in Q4 and the Schwab Emerging Markets ETF was up 11.9%. Investor sentiment has risen regarding international markets despite no substantial improvement in global manufacturing data or GDP. International markets have been trading at lower multiples to the US which may imply a greater ability to expand on anticipated rather than actual earnings improvement.

Fixed Income and Credit: After a global bond price surge in Q3 that left us with $17 trillion in negative yielding bonds globally, the bond market finally slowed and reversed course a bit. Global markets were generally down slightly, the US corporate bond market posted flat returns and longer-dated US Treasuries were down in the mid-single-digit range. From an economic standpoint, one could argue that the global bond market has more room to run. Specifically, a majority of central banks are still in “easing” mode and most of the developed world is posting low and degrading GDP numbers. However, with so many central bank target rates already at, near, or below 0%, it’s reasonable to begin sensing a “top” in bond prices with asymmetric risk to the downside. In regard to the US markets, the “risk on” sentiment was seen in Q4 as corporate bonds outperformed treasuries especially on the long end of the yield curve.

A Look Ahead

Regarding the US stock market, the 4th quarter leaves one a bit perplexed. From an earnings standpoint, the data was not good and yet the market surged ahead. In fact, when looking at the full year, the price appreciation in 2019 can be attributed almost entirely to price-earnings-multiple expansion as year-over-year earnings are trending toward zero for the year. Given the lack of earnings, we’re now in well-above-average price-earnings-multiple territory. So, either the market is correct in forecasting good things to come or 2020 could prove to be a challenging year. Moreover, we continue to have “late cycle” economic signals in the US. The latest evidence is rising wages among low-wage earners which tends to threaten business margins. Still, despite all of the “late cycle” indicators, a recession does not appear imminent with few economists calling for one in 2020.

Overall, in 2020 we’re likely to see a somewhat volatile equity market driven by news headlines more than actual earnings. The market will be consumed with the upcoming US presidential election as the various candidates’ economic policies are as divergent as any time in modern history. 2020 will also be a big year for watching the Federal Reserve. The Federal Reserve’s actions relative to expectations will have a substantial impact – currently one rate drop is expected. Will we see further interest rate drops to potentially push the market higher or will we see a reversal of trend with an “allergic” market reaction like Q4 of 2018? Our guess is that the Fed will try to lay low ahead of the election. It’s tough to bet against the US equity market through November given the predicted absence of a recession, a probable drop in rates from the Federal Reserve and a likely heavy dose of positive tweets from the President leading up to the election.

In the longer-term, absent a recession, we remain bullish on the equity market. Large corporations have benefited tremendously by the near-zero interest-rate policy of the last decade and more recent corporate tax reduction. Many have used the opportunity to drop their cost-of-capital with large international companies seeing the greatest benefit. It’s also noteworthy that rates aren’t likely to climb in the short-term. Many economists think low rates in the developed world are a “new normal” related to demographic changes. If so, capital-intensive growth businesses will be one of the biggest beneficiaries. Moreover, large companies have seen substantial improvement in profit margins in recent years. The small cap market, however, is showing some danger signs. The perpetually low rates are masking the fact that there is a growing percentage of “zombie” companies in the sector (i.e., those with interest payments that exceed earnings) that will struggle to pay bills with a rise in interest rates or economic slow-down.

When looking at the bond market, it’s tough to get too excited. The last decade was characterized by an unprecedented global drop in interest rates culminating with all-time highs in certain markets in Q3 2019. In much of the developed world globally, it feels like the worst possible set-up for bonds (i.e., all-time low coupons and all-time high prices). The run could continue with further global economic weakness but the downside risk to bond prices is substantial. The bond market opportunity feels a bit more attractive in the US given that rates are higher and the fact that the Federal Reserve has a long way to get back to zero rates leaving upside to bond prices. Of course, economic conditions and central bank interest rate activity will drive the market. Stronger economic conditions are not likely to be favorable to bond prices whereas degrading conditions and rate drops could send the long US Treasury bonds substantially higher.

In summary, it’s shaping up to be a volatile year. As always, we will manage risk through diversification and strategic rebalancing to capitalize on any opportunities the market presents. We wish you great prosperity in 2020!