Hello my name is Chris Carter I’m a partner at Navalign. I’ll spend the next 10 minutes or so on a market overview and some of our thoughts going into 2020.
Well 2019 turned out to be a good year for the US economy and an excellent year for investment returns. While economic growth slowed over the course of the year it remains relatively strong. Unemployment remained close to a 50-year low, and inflation stayed slow and steady.
Declining interest rates led to surprisingly positive bond market returns, while stocks bounced back strongly from their slump at the end of 2018.
What a difference a year makes, bonds which were mostly flat to slightly down in 2018 had a great year, thanks to falling interest rates, led by double-digit returns in US corporate debt. Equity asset classes rebounded from losses in 2018 to strong gains across the board in 2019.
Large-cap US Stocks, or think of the S&P 500, or the Dow Jones, and U.S. REITs or Real Estate Investment Trust, led the way with approximately 30% returns.
Now as part of our diversified approach we invest in many of these asset classes. Developed International stocks and Emerging-market stocks posted good returns but, lagged the US market again, which has been the case for a while, I’ll talk about that more bit later. As a reminder, developed International stocks are from countries like Germany, France and the UK, whereas emerging-market stocks are from countries like India, China and Brazil.
What an amazing Bull Run it’s been. Now we’ve had five distinct volatile periods since the mid-90s, the run-up in stocks in the late 90s as we approached the peak of the “.com” boom followed by that crash, only to recover strongly right until the financial crisis, then a sharp decline of close to 60%, and since then we have had a tremendous rally in stocks. Up an astounding 378%.
It’s important to look at today’s market characteristics versus the previous two market peaks. One valuation metric to compare is the PE Ratio, or the price of the market divided by the earnings. Generally speaking, the higher this number the less attractive the market is, and when this number is lower markets, tend to be more attractive.
At the peak of the 2000 market, the PE was about 27, in 2007 it was about 16, and today it is about 18. We’ll put the current valuation into historical context a bit later, but the current dividend yield, another important metric is 2% which is the same as 2007, but higher than 2000. Finally, the 10-year treasury is significantly lower
You hear the phrase long-term investing, well this is really long-term. This is a chart of the US stock market since 1900, there are many big events listed here; wars, recessions and other economic shocks. The market is resilient and always seems to recover no matter how bad things seem to be.
If we focus on the same period we just looked at, the mid 90s to today, you see two things:
One – investors did not make money from about 2000 to 2013, so for over 12 years investors were not rewarded.
Second – the 378% run up since 2009 doesn’t look quite as dramatic when you look at it from historical perspective.
There have been dozens of other events that are not on this chart that at the time of dominate the news the market goes down under some panic selling, only to recover a short time later.
I’m going to go back to the previous chart to just briefly discuss one of these periods. In October 2014 the market dropped almost 10%, so just under where it says +378%, it’s kind of under the seven or the eight. The market dropped almost 10% due to a number of factors but the one grabbing most of the media and investor attention was the global Ebola scare.
I remember during this time so called Ebola stocks companies that either made hazmat suits, or tiny bio-techs that had an Ebola treatment in the pipeline, soared for a few weeks, only to come crashing down within a short period of time. The market rebounded and continued its ascent higher. Now remember this history lesson as we hear more news in the coming days and weeks and even maybe months regarding the coronavirus.
Since we are looking at charts, here’s a comic that shows what you might see, if you looked at a mountain range through a tennis racket. Ironically enough, this next chart actually kind of looks like that comic.
When you hear the word diversification, you probably think of your investment mix between stocks and bonds, in addition maybe you think of US and international, or large-cap and small-cap. Diversification can also be achieved by different investment styles, for example growth or value. Growth companies by definition are those that have substantial potential for growth in the foreseeable future, growth companies may currently be growing at a faster rate than the overall market, and they often devote most of their current revenue for further expansion. Think of companies like Amazon, Facebook and Google.
Value, or dividend paying stocks, may have low financial ratios, such as price-to-book or price-to-earnings, think of companies like Procter & Gamble, Verizon, JP Morgan. The stock price may also have dropped due to public perception, regarding factors that have little to do with the company’s current operations.
This shows the performance of the S&P growth index, relative to the S&P 500 value index, from 1993 until 2019. When the blue line is going up, growth has outperformed value, and when the line is going down, value outperform growth.
In the 90s, leading up to the internet and .com peak, as you’d expect growth did much better than value. As that bubble burst, value did better for the next seven years or so, but since 2007, growth has done considerably better. These two investment styles tend to go back and forth over time, and we think value has a good chance of a performing in the coming years. This is one of the reasons we are over weighting dividend-paying value stocks at this time.
This is the same chart as earlier, but now we will look at US stocks versus International stocks. International stocks have done well since 2009, but have lagged the US market significantly. In fact, overseas stocks have not fully recovered to the 2007 highs, and this is the largest disparity between US and International stocks ever.
The S&P 500 trades at about 18 times forward earnings, which is higher than the 15½ times, 20 year average. Again higher PE multiples can sometimes indicate lower returns going forward. At 2% the dividend yield on the S&P 500 is right at the 20-year historical average.
Shifting to International valuations, at 14 times forward earnings, the International market is significantly less expensive than the US, with a much higher dividend yield. International trades at about a 22% discount to the US, and has about a 70% higher yield.
This chart compares the US Stock Market performance to International, going back to 1972. The top half of the graph shows periods when International outperformed the US and the bottom shows periods when International underperformed the US.
As we saw a few slides ago, the US has done much better since around 2009, but prior to that from 2002 to 2008, it was reversed. We believe, given a cyclical pattern, that International is likely to outperform the US Stock Market in coming years. As a result we have a slight overweight to International when compared to our normal weightings.
Much of this recent under-performance is due to currency. Keep in mind International returns are always translated to the US dollar equivalent, and the Euro has been significantly weaker than the US dollar in recent history. Over the last 10 years, 45% of this performance gap is due to currency, and a strong dollar. This tends to change every 5 to 10 years, and when this happens, International returns will get a boost.
One of our favorite areas of International investing is an Emerging Markets. We are very excited about EM prospects over the next decade or so. One main reason is the growing middle class in many of these countries.
The chart on the right shows five of these countries, and the percent of the population in the middle class. In 1995, 2018, and what’s forecasted in 2030. Let’s look at India for example, in 1995 only 1% of the population was considered middle class, in 2018 it was around 14% and in 2030 it’s expected to be almost 80%. The same trend is true for the other countries listed. This middle-class explosion means more people will be able to afford goods and services, which will help emerging market economies and stocks.
To summarize, we are over weighting dividend paying stocks versus growth stocks and we are increasing exposure to overseas equities.
Now may be a good time to take profits and reduce exposure to stocks, and consider reducing risk if your financial plant supports it.
Everyone has a different time horizon and appetite for risk, so you should discuss any potential changes with your advisor. In closing, investors need to maintain balance in order to be prepared for the next downturn, whenever it occurs.
Investors should recognize that this low interest rate environment, combined with a long bull market in stocks, limits potential portfolio returns going forward. However, with both the US and global economy mostly growing, opportunities remain across the spectrum of global financial markets.
While the bull market in equities is old and has no particular expiration date, looking forward we still think the global economy and current valuations justify a diversified approach to long-term investing.