Returns in 2019 were strongly positive in all categories, providing most of the families that we serve with double-digit returns for the year. In fact, global stocks had their best year since 2009, and bonds had their best year since 2002. This served as a welcome contrast to 2018, where nearly every category produced negative returns. Considering this stark difference, it is ironic that most of the same economic themes were present in both 2018 and 2019, including concerns about slowing economic growth, tariffs and global trade, and geopolitics. The vastly different outcomes for each year demonstrate how incredibly unpredictable investor behavior can be from year to year, as well as how important it is to maintain a long-term perspective.
|Asset Category (index returns)||2019|
|U.S. Large Stocks||31.4%|
|U.S. Midsized Stocks||30.5%|
|U.S. Small Stocks||25.5%|
|Foreign Developed Large Stocks||22.0%|
|Foreign Small Stocks||22.4%|
|Emerging Market Stocks||18.4%|
Continuing with the theme of how irrational investor behavior can be in the short term, consider stock earnings growth vs. stock price growth for 2018 and 2019. In 2018, corporate earnings growth was strong, yet stock overall returns were negative due to investor pessimism that developed at the end of the year. In contrast, in 2019, earnings growth was much lower, yet stock prices rose sharply due to a dramatic reversal in sentiment. Over the long run, these shifts in investor sentiment tend to smooth out and play little role in market returns, giving way to the earnings that are the primary drivers of long-term stock returns. Keeping this perspective in view is a good way to avoid getting caught up in the short-term noise.
With all stock categories positive for the year, it is easy to lose sight of nuances. While small stocks tend to provide higher performance than large companies over time, they did not do so in 2019. The performance differences are even more extreme if we look at the cheapest half of small stocks, (i.e. U.S. small “value” stocks) vs. the most expensive half of large stocks (i.e., U.S. large “growth” stocks). Cheap small stocks have underperformed their larger counterparts by a significant margin over the last several years, and the last time valuation differences were this extreme was prior to the tech bubble correction.
This sort of disparity has a strong tendency to revert, and the case for owning smaller, less expensive companies as a part of a balanced portfolio has never been stronger. Within the U.S., the cheaper half of small stocks are at a significant 48% discount to the more expensive half of large stocks. More often than not, this situation has historically been followed by strong absolute and relative returns by this group of smaller cheap stocks.
Looking across the globe, foreign markets are undervalued relative to domestic markets, and emerging markets are the cheapest among them. Emerging markets have been more heavily affected than developed markets by trade concerns, so these same markets will likely benefit from any resolution of trade issues, whenever that may occur. As always, we will continue to look for opportunities to rebalance portfolios to ensure we’re in alignment with our long-range target allocations to stocks, bonds, and non-traditional investments, while also taking into consideration the potential opportunities to rebalance into U.S. small value stocks and emerging markets.
Current valuations are not a strong predictor for short-term returns, but they strongly point to probable longer-term outcomes. Along this line of thought, it is important to observe that valuation differences amongst various stock categories have been present for several years. Investing in categories that have historically provided the strongest returns (compared to U.S. large stocks) have not resulted in meaningful performance benefits over the entire decade following the financial crisis (higher growth categories include U.S. small, U.S. midsized, foreign small, and emerging markets). Like elastic being stretched, this increases the likelihood of strong benefits going forward. In fact, when performance benefits do come, they tend to come quickly and without warning, which is why maintaining exposure to these categories throughout the market cycle is so important.
Although fears of slowing growth at the end of 2018 persisted into 2019 and were intensified by escalating trade tensions, stocks seemed to shrug off the concerns and march higher. Bond markets, on the other hand, appeared less optimistic about forward prospects.
The Federal Reserve’s decision to lower short-term rates and high investor demand for corporate bonds were among the primary drivers of return in the bond markets for 2019. Fears of a weakening economy propelled interest rates lower from the beginning of the year through the summer, which caused all sectors and maturities of the bond market to increase in value. Corporate bonds outperformed Treasury and Municipal bonds, as their attractive yields generated investor demand.
|Asset Category (index returns)||2019|
|Intermediate Term Tax-Exempt Bonds||5.5%|
|Intermediate Term Taxable Bonds||8.7%|
While the strong return of bond markets is certainly a positive for 2019 portfolio growth, yields are lower now than they were a year ago, which diminishes return expectations going forward. The difference in yield between government and corporate bonds is low as well, which is a sign that the economic cycle is mature and that bond returns going forward will likely not be as high as they were in 2019. Even with relatively low forward return expectations, owning bonds is still an essential part of a balanced portfolio. Bonds serve as a ballast in times of economic weakness when stock markets can falter.
One of the big stories in the bond market for 2019 was that of longer-term rates falling below shorter-term rates, known as a yield curve inversion. As this has occurred prior to most recessions in the post-WWII era, it received quite a bit of media attention and fed into fears that economic growth could turn negative. In the past, this signal preceded a recession by up to two years, so it remains to be seen whether it will be predictive this time as well or not. However, at least for the present time, consumers and corporations appear to still be in good shape, according to most economic indicators.
|Asset Category (index returns)||2019|
|Global Hedge Fund||8.6%|
Diversifying non-traditional assets also experienced positive returns, with declining rates and rising foreign stock markets being the primary contributors to return. These themes contributed in different ways across the non-traditional categories. Foreign stocks and bonds primarily benefited dynamic allocation strategies and global hedge funds. Declining rates were the primary contributor to trend-following returns through the summer, with rising stock markets providing benefits since that time.
Closing Thoughts For The Year And Decade
In summary, 2019 was quite different than 2018, which itself was quite different than 2017. In fact, no two years ever seem to be alike and the only predictable thing is unpredictability. While 2020 is not likely to be as strong as 2019 was, there is nothing to say that it cannot be positive (in fact, historically, markets are more likely to be up than down after a strong year like 2019). All we can say for sure is that we will know in a year! Whatever the case, it is great to have a year like 2019 under our belt, which has helped all of the families that we serve move closer toward achieving their goals.
Since 2020 marks not only the turn of a new year, but the turn of a new decade, this is a good time to make a few observations about the 10 years that are now behind us. This decade will likely be remembered as one of recovery from the Great Recession and slow but steady economic growth aided by the Fed’s unprecedented quantitative easing program that helped to keep interest rates low for a very long time.
But how did investors fare in this low-growth environment? Since 10 years can certainly be considered a long-term time period, this question is worth exploring. Looking back over the past decade, a moderately allocated portfolio (i.e., 60% stocks and 40% bonds) earned returns that were about .8% below such a portfolio’s long-term average (stocks actually returned more than average, but bonds returned less than average).
|Asset Class||Trailing 10 Years.||Long Term Returns*|
|60% Stocks – 40% Bonds||7.4%||8.2%|
|*Long term start date: 1/1/1926, Source: Morningstar, see Indices for definitions|
On the face, this may seem discouraging. However, it is important to remember that one of the primary goals of investing is to increase one’s ability to sustain living expenses over time. From this perspective, the question is not simply: How high of a return did my portfolio achieve? Rather, the better question is: By what rate did my portfolio’s growth outpace inflation to increase my purchasing power? In the investment world, this concept is referred to as “real return.”
Looking at the rate of price inflation for the past decade, we see that it ran 1.1% behind its long-term historical average. With this added perspective, we are able to conclude that real returns for the decade were actually higher than they have been historically. Real returns for a moderate portfolio over the last decade have been 5.5%, which compares favorably to the long-term real return rate of 5.1%. While the moderate portfolio has provided absolute returns that are a little lower than average, inflation has run behind by even more, which means that a portfolio’s net purchasing power is further ahead.
This dynamic helps to explain why we see so many of the families that we serve making better-than-modeled progress toward achieving their goals, even in spite of a low-growth economic environment. To this point, often the best discussions come not from reviewing what happened in the investment markets, but in evaluating how these events have affected progress toward one’s own goals. As always, if you are interested in reviewing your progress, we are here to help. Email firstname.lastname@example.org or call 206.466.6200 with any questions or concerns you may have.
Paracle Personal Financial Management is an independent financial planning firm founded in 2004 with an honest desire to help people optimize their finances by providing unbiased financial planning and investment advice that puts their clients first. Paracle specializes in delivering expert, comprehensive wealth management services to busy families. Their expertise integrates financial planning with investment management to ensure their clients experience confidence in every aspect of their plan so they can focus on what matters most. To learn more about Paracle, connect with them on LinkedIn.
Indices:Global Stocks: U.S. Large Stocks—Russell 1000, U.S. Midsized Stocks—Russell Mid Cap, U.S. Small Stocks—Russell 2000, Foreign Developed Large Stocks—MSCI EAFE, Foreign Developed Small Stocks—MSCI ACWI Ex USA Small Cap, Emerging Market Stocks—MSCI Emerging Markets, US Stocks—Russell 3000, Foreign Stocks—MSCI ACWI Ex USA, U.S. Large Growth – Russell 1000 Growth, U.S. Small Value – Russell 2000 Value; Non-Traditional: Global Hedge Fund—HFRX Global Hedge Fund, Dynamic Allocation—Morningstar Tactical Allocation Category, Trend Following—SG Trend Index; Bonds: Intermediate Term Tax-Exempt Bonds—Bloomberg Barclays Municipal 5 Yr, Intermediate Term Taxable Bonds—Bloomberg Barclays U.S. Aggregate; Inflation: US BLS CPI All Urban NSA; Trailing 10 Year & Long Term Returns: Stocks – IA SBBI US Large Stock (1926 – 1988) , MSCI ACWI (1989 – 1994), MSCI ACWI IMI (1995 – Present); Bonds – IA SBBI US IT Govt (1926 -1975), Bloomberg Barclays US Aggregate Bond (1976 – Present); 60% Stocks / 40% Bonds Portfolio—rebalanced annually at calendar year end.