Both stocks and bonds appreciated sharply in 2019. The key driver was the Federal Reserve’s sharp U-turn towards accommodative monetary policy.
Among global equity markets, large-cap U.S. stocks were once again at the top of the leader board. Most of the S&P 500’s return came from expanding valuations; thus, the valuation risk in U.S. stocks, which we’ve highlighted for some time now, has only gotten worse.
Now may be a good time to reduce risk in your portfolio by reducing exposure to stocks if your financial plan supports it.
There are reasons to be cautiously optimistic for financial markets in 2020: Monetary policy is easing, recessions risks seem to be receding, and some geopolitical risks have abated.
Now is a good time to consider rebalancing your portfolio
Most stock investors generated strong returns in 2019, a bullish year for nearly all financial markets. The positive broad-based returns marked a dramatic (and welcome) turnaround from 2018, a year in which nearly all asset classes faltered.
This year’s surprising returns were fueled by a U-turn in monetary policy, as policymakers shifted gears to support a weakening global economy. After tightening financial conditions (raising short-term rates) four times in 2018, the Federal Reserve reversed course and began implementing a more dovish monetary policy (lowering short-term rates three times). Other major central banks also cut rates or provided additional stimulus to the markets via quantitative easing during the year, lessening global recession fears.
U.S. stocks rose in every quarter and surged an additional 9% in the fourth quarter as the United States reached a tentative “phase one” trade agreement with China. The S&P 500 Index’s 31% total return was its second-best year since 1997. (Bested only by 2013’s 32% gain.) Smaller-cap U.S. stocks rose 25.4% for the year.
Foreign markets were also strong. European stocks gained 9.9% in the fourth quarter and 24.9% for the year. After a weak third quarter, emerging-market (EM) stocks shot up nearly 12% in the fourth quarter and returned 20.8% for the year.
The 10-year Treasury yield dropped from 2.70% at the start of the year to as low as 1.45% in September, ending the year at 1.92%. Investment-grade bonds gained nearly 9%.
What’s next for the economy and stock market
After a year like 2019, the obvious question looking ahead is how much higher can equities go? For many years, assets have been flowing into U.S. stocks on the back of a strong U.S. dollar and the United States’ perceived safe-haven status relative to other global economies. The 2010s were the only decade in the last century without a U.S. recession. In this respect, 2019 was largely an exclamation point on the decade’s investment pattern.
As we look ahead to financial markets in 2020, there are reasons to be cautiously optimistic for financial markets. Just because we are in the longest economic expansion is U.S. history does not mean it has an expiration date. Accommodative central bank monetary policy and easier financial conditions should continue to support at least a modest rebound in global economic growth. Along with reduced U.S.-China trade risk, this suggests the global economy may be on the rebound. The U.S. consumer also remains in good shape as ongoing labor market strength, wage growth, and low interest rates should continue to support consumer spending and the housing market.
However, this modestly positive outlook is consistent with the consensus view, meaning that financial markets have already responded positively to these developments. The risk of an unpleasant market surprise or deterioration in the macro environment in 2020 shouldn’t be ignored.
A critical question for fundamental investors like us is always, “What’s in the price?” In this regard, we note that it wasn’t corporate profit growth that drove U.S. stocks higher in 2019. Reported earnings for the S&P 500 were actually flat over the first three quarters, and mid-single-digit percentage growth is projected for the fourth quarter. The lion’s share (roughly two-thirds) of the S&P 500’s 31% return came from a sharp expansion in valuations. We believe such stretched valuations leave U.S. stocks particularly vulnerable to disappointment or negative surprises.
Despite recent positive developments, the U.S.-China trade war could reignite or a different area of geo-economic conflict between the two countries could escalate. This would hurt a still-weak manufacturing sector and impact capital spending and business confidence (CEO confidence is already at recessionary levels).
U.S. election uncertainty, inflation surprises, and Brexit are also among the myriad risks that could impact markets over the coming months. Geopolitical risk is also, as always, a major unknown that we factor into our portfolio downside stress-testing.
Position your portfolio for success in 2020
While we watch and weigh the ramifications of short-term risks, it’s important to reiterate that we don’t invest based on 12-month market forecasts. The uncertainty is too high and the unknowns too many. More important and most relevant for our investment process is our outlook for the next several years, not months. In this respect, our assessment of the risks and opportunities remains consistent with what it’s been in recent years.
With U.S. stocks expensive, we continue to see better investment opportunities in foreign stocks and select alternative strategies. Should the positive global growth outlook for 2020 play out, we’d expect foreign stocks to outperform U.S. stocks, given their higher cyclicality and sensitivity to overall GDP growth. Receding Brexit uncertainty should also help prop up European markets. Furthermore, to the extent the U.S. dollar weakens in this environment—due to it being a counter-cyclical currency—that will help foreign stock returns (for dollar-based investors).
The Bottom Line
Currently there are few table-pounding, valuation-based opportunities in the investment markets these days. Ten-plus years of unprecedented central bank stimulus and interest rate repression have inflated the prices of most financial assets, if not the actual global economy. Therefore, if your financial plan supports it, this may be a good time to take some profits and allocate a portion of your stocks to bonds or alternative investments. Not only do these strategies provide valuable portfolio diversification, but we also expect them to deliver medium-term returns that are in line with or better than large U.S. stocks.