Executive Summary

The fourth quarter of 2018 was a perfect lesson on how emotional the stock market can be in the short term. There was no strong reason for such large losses during the quarter and we are already seeing a strong uptrend in January this year. Stocks dropped during the fourth quarter along with a significant drop in crude oil and a widening of spreads in high yield bonds. It was one of the worst Q4 for stock returns in history, which is strange since we are not in a recession or a crisis. The very negative quarter created a negative return year for stocks in 2018. On the positive side, it is quite rare for the S&P 500 to be down two years in a row without a recession. The only four times when the S&P 500 has seen consecutive annual declines were in the following time periods:

1929-1932 (The Great Depression)
1939-1941 (World War II)
1973-1974 (Collapse of the Bretton Woods system and oil crisis)
2000-2003 (The Dot.com tech bubble collapse)

Like we said in our recent blog, “The Grinch Fails Again”, https://www.laketahoewealthmanagement.org/news-notes/2018/12/24/the-grinch-fails-again, this recent market correction will fail to derail long-term financial plans as long as investors maintain a discipline and a long-term focus. We know there will be strong years and weak years for stock returns. 2018 was a weak year, and the fourth quarter was the worst for stocks since Q4 of 2008. Just one year ago broad U.S. stock indices set over 60 record highs during 2017. We also had two stock market corrections of 10% or more in 2018, in February and in December, which is rare. Experienced investors are aware of the random walk path of stocks in the short term, and since it is random, no one can time it with any consistent success. Unfortunately, stock market valuations in the U.S. are still above average on many measures. Conversely, around the globe there are low valuations in many markets. So far in January stocks are very strong and high yield bond spreads have narrowed and volatility has declined. As we brought up in the aforementioned blog post, we have maintained a higher cash target than usual and will continue to do so until valuations normalize.

For those who want to dive deeper into our market and economic commentary:

World Asset Class 4th Quarter and Full Year 2018 Index Returns

Fourth quarter index returns were very weak for U.S., international, emerging market stocks, and global real estate. U.S. and Global Bonds did well with the flight to safety. For the broad U.S. stock market, the fourth quarter return of -14.3%. International stocks lost -12.78%.

A larger sample of asset class returns during the fourth quarter shows the high negative volatility, with small cap stocks among the worst performers, in a list filled with red. Additionally, value was stronger than growth in all markets, including the U.S., which tends to happen with negative volatility. Emerging market and real estate stocks were near the top of the list (less negative).

Full year, 2018 results were weak for all equity asset classes and positive for fixed income asset classes:

U.S. stocks were the best performing broad equity asset class (down the least), followed by Global Real Estate. International Developed and Emerging Market Stocks performed much worse than U.S. stocks. However, it is the first negative return year since 2008, so longer time horizons still look pretty good. Here is a comparison of one-year index returns with five and ten-year time periods:

If we look at a larger sample of asset classes for the full year, value stocks were negative compared to growth stocks in the U.S. and international developed asset classes, but positive in emerging markets. Small cap stocks performed worse than large cap stocks in all asset classes. The Russell 2000 Value Index was down -12.86%, a bit behind the broad Russell 2000 Index return of -11.01%, during 2018. The Russell 1000 Value Index was down -8.27% in 2018, while the broad Russell 1000 Index was down -4.78%.

It was a challenging year for globally diversified portfolios with value and size tilts. However, over longer time periods, the value and size factor premiums offer significant additional return over the broad stock market premium. Every investor knows there is a significant return premium for investing in stocks over and above risk-free securities. The historical annual average for the past 91 years is an additional 8.5% (see chart below). Within the stock market, there are also significant premiums for value and size. Value stocks returned 4.82% more per year than growth stocks; and small cap stocks returned 3.24% more than large cap stocks. The stock market, size and value premiums do have large standard deviations and can be negative for long time periods. The data in the following chart is compiled from Kenneth R. French’s Data Library, http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html

It takes discipline and patience to maintain exposure to the factor premiums, in order to capture the additional return, since periods of underperformance like 2018 occur. We recently wrote a lengthy blog on Portfolio Management Discipline, https://www.laketahoewealthmanagement.org/news-notes/2018/8/20/the-importance-of-portfolio-management-discipline

How often can negative premiums exist? A recent white paper, “Volatility Lessons”, authored by Eugene Fama and Kenneth R. French, takes an in depth look at the historical volatility of stock market premiums and what it might mean for expected volatility going forward. The authors took the 642 monthly returns from July 1963 through December 2016 to bootstrap 100,000 premium returns. The probability of experiencing a negative market premium return also decreases from about 36% for a 1-year time horizon to about 7% for 30 years. The simulated probability of experiencing a negative equity premium for 10 years is about 17%, which is low, but not trivial. It is especially difficult for investors who are in the midst of a negative market due to recency bias. For the large cap value premium, the probability is a bit more at 20.5%. We are currently experiencing this “one in five” event, since for the past ten years, the large cap value premium is negative. For the small cap value premium, it is much less at 4.5% and for just the size premium, it is the highest at 23%. Small cap stock returns do have more volatility than large cap stock returns. The value and the size premiums are significant and while risky in shorter time horizons, good outcomes become more likely and more extreme (positive) relative to bad outcomes as time horizon increases.

For more details, “Volatility Lessons”, authored by Eugene F. Fama and Kenneth R. French can be downloaded at the Fama/French Forum, https://famafrench.dimensional.com/essays/volatility-lessons.aspx

Bond markets around the world were positive due to a flight to quality, which involves many investors selling stocks and buying bonds, which drives bond yields down (bond prices up). The middle of the yield curve inverted with three, four, and five-year bonds yielding less than two-year bonds. In addition to the flight to quality, non-investment grade bond spreads widened considerably, which signals a weaker economy. Notice the sharp widening of spreads at the end of 2018 and the subsequent sharp drop in January at the right-hand side of this five-year chart of the ICE BofAML US High Yield Master II Option Adjusted Spread (4.52% as of 1/9/19, more details in disclosures below):

A large contributor to the December 2018 jump in high yield spreads was the sizeable 44% drop in crude oil prices during the last half of the quarter. The energy sector relies on junk bond issuance to fund capital investment. The slight yield curve inversion and massive sell off in junk bonds created panic selling in stocks during the fourth quarter. Notice the negative fourth quarter return for the Bloomberg Barclays US High Yield Index caused a negative full year return. However, the index is still the leading all bond index returns for three years.

The Federal Reserve also had a hand in the negative volatility when Fed Chairman Powell had the opportunity to re-assure the stock market that the Fed would be flexible when faced with slowing global growth data (mostly out of China and Europe). Chairman Powell decided to reinforce the strength of the economy, three rate hikes in 2019, and the monthly selling of bonds on the Fed balance sheet at a max rate of $50 billion per month. He had to walk back his hawkish comments at the December Fed meeting during a January 2019 panel discussion with former Fed Chairs, Ben Bernanke and Janet Yellen. The Fed is in a tough position attempting to raise interest rates and reduce the size of their balance sheet in the face of a slowing global economy (when few other developed economies are doing the same). The first Friday of the month is the jobs report and the December report, released on January 4th, was much stronger than expected, which is helping the sharp turnaround in stocks and the narrowing of high yield spreads so far in 2019. However there is a seasonal effect in this report.

One cannot time markets and typically the short term is just noise. However, every now and then, the short-term noise turns into a temper tantrum, like we witnessed in December 2018. At the start of every year, major financial news outlets discuss the January effect and how the trend in January sets the tone for the year. There is no empirical evidence to support this, so just ignore the financial media’s fascination with it.

Here is a sample of how the world stock markets responded to headline news during the last quarter and the last year (notice the insert of the second graph that compares the last 12 months to the long term):

CONCLUSION

We don’t own the bottom performing years and we don’t own the best years, we own the long-term average return. The fourth quarter was a nasty temper tantrum for stocks and high yield bonds, based more on a tone-deaf Fed, poor communication from the U.S. Treasury, and global trade wars with no end in sight, than on market and economic fundamentals. So far in 2019 international stocks are doing well and the value and size premiums are positive. U.S. Small Cap Value is the best asset class so far this year, up over 8%, as of 1/12/19.

Valuations are attractive again in many areas around the globe, especially southern Europe and Emerging Markets, as an economic slowdown has been priced in. The U.S. looks fairly valued from a Price to Earnings (P/E) viewpoint but is still above historical valuations when considering Price to Book, Price to Sales, Shiller’s CAPE and Price to Cash Flow. Here is a chart of Price to Sales since 2001; and we recently peaked at 2.25 in September of 2018. The December correction moved the needle down to the current level of 2.0, but it is still well above the mean of 1.51.

The short-term path of the stock market is best described as a random walk and the high stock market premium exists because of the potential for sudden corrections that occur more often than predicted by a normal distribution. With the high stock valuations in the U.S., we knew a temper tantrum could move stocks down quite a bit (which is why we have held more cash than usual), but the economy did not justify the December correction; and a more responsive Fed, a very strong jobs report and the narrowing of bond spreads have stocks going up again. It the best January start for stocks in thirteen years. Anyone who panicked and sold out or changed strategies likely cost themselves. Maintaining discipline and a long-term focus are critical.

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Standardized Performance Data and Disclosures

Russell data © Russell Investment Group 1995-2017, all rights reserved. Dow Jones data provided by Dow Jones Indexes. MSCI data copyright MSCI 2017, all rights reserved. S&P data provided by Standard & Poor’s Index Services Group. The BofA Merrill Lynch Indices are used with permission; © 2017 Merrill Lynch, Pierce, Fenner & Smith Inc.; all rights reserved. Citigroup bond indices copyright 2017 by Citigroup. Barclays data provided by Barclays Bank PLC. Indices are not available for direct investment; their performance does not reflect the expenses associated with the management of an actual portfolio.

The ICE BofAML Option-Adjusted Spreads (OASs) are the calculated spreads between a computed OAS index of all bonds in a given rating category and a spot Treasury curve. An OAS index is constructed using each constituent bond’s OAS, weighted by market capitalization. The ICE BofAML High Yield Master II OAS uses an index of bonds that are below investment grade (those rated BB or below).This data represents the ICE BofAML US High Yield Master II Index value, which tracks the performance of US dollar denominated below investment grade rated corporate debt publically issued in the US domestic market. To qualify for inclusion in the index, securities must have a below investment grade rating (based on an average of Moody's, S&P, and Fitch) and an investment grade rated country of risk (based on an average of Moody's, S&P, and Fitch foreign currency long term sovereign debt ratings). Each security must have greater than 1 year of remaining maturity, a fixed coupon schedule, and a minimum amount outstanding of $100 million. Original issue zero coupon bonds, "global" securities (debt issued simultaneously in the eurobond and US domestic bond markets), 144a securities and pay-in-kind securities, including toggle notes, qualify for inclusion in the Index. Callable perpetual securities qualify provided they are at least one year from the first call date. Fixed-to-floating rate securities also qualify provided they are callable within the fixed rate period and are at least one year from the last call prior to the date the bond transitions from a fixed to a floating rate security. DRD-eligible and defaulted securities are excluded from the Index,

ICE BofAML Explains the Construction Methodology of this series as: Index constituents are capitalization-weighted based on their current amount outstanding. With the exception of U.S. mortgage pass-throughs and U.S. structured products (ABS, CMBS and CMOs), accrued interest is calculated assuming next-day settlement. Accrued interest for U.S. mortgage pass-through and U.S. structured products is calculated assuming same-day settlement. Cash flows from bond payments that are received during the month are retained in the index until the end of the month and then are removed as part of the rebalancing. Cash does not earn any reinvestment income while it is held in the Index. The Index is rebalanced on the last calendar day of the month, based on information available up to and including the third business day before the last business day of the month. Issues that meet the qualifying criteria are included in the Index for the following month. Issues that no longer meet the criteria during the course of the month remain in the Index until the next month-end rebalancing at which point they are removed from the Index.

ICE Benchmark Administration Limited (IBA), ICE BofAML US High Yield Master II Option-Adjusted Spread [BAMLH0A0HYM2], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/BAMLH0A0HYM2, January 10, 2019.

Past performance is no guarantee of future results. This information is provided for educational purposes only and should not be considered investment advice or a solicitation to buy or sell securities. Diversification does not guarantee investment returns and does not eliminate the risk of loss.

Investing risks include loss of principal and fluctuating value. Small cap securities are subject to greater volatility than those in other asset categories. International investing involves special risks such as currency fluctuation and political instability. Investing in emerging markets may accentuate these risks. Sector-specific investments can also increase these risks.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, liquidity, prepayments, and other factors. REIT risks include changes in real estate values and property taxes, interest rates, cash flow of underlying real estate assets, supply and demand, and the management skill and creditworthiness of the issuer.

Principal Risks:

The principal risks of investing may include one or more of the following: market risk, small companies risk, risk of concentrating in the real estate industry, foreign securities risk and currencies risk, emerging markets risk, banking concentration risk, foreign government debt risk, interest rate risk, risk of investing for inflation protection, credit risk, risk of municipal securities, derivatives risk, securities lending risk, call risk, liquidity risk, income risk. Value investment risk. Investing strategy risk. To more fully understand the risks related to investment in the funds, investors should read each fund’s prospectus.

Investments in foreign issuers are subject to certain considerations that are not associated with investment in US public companies. Investment in the International Equity, Emerging Markets Equity and the Global Fixed Income Portfolios and Indices will be denominated in foreign currencies. Changes in the relative value of these foreign currencies and the US dollar, therefore, will affect the value of investments in the Portfolios. However, the Global Fixed Income Portfolios and Indices may utilize forward currency contracts to attempt to protect against uncertainty in the level of future currency rates (if applicable), to hedge against fluctuations in currency exchange rates or to transfer balances from one currency to another. Foreign Securities prices may decline or fluctuate because of (a) economic or political actions of foreign governments, and/or (b) less regulated or liquid securities markets.

The Real Estate Indices are each concentrated in the real estate industry. The exclusive focus by Real Estate Securities Portfolios on the real estate industry will cause the Real Estate Securities Portfolios to be exposed to the general risks of direct real estate ownership. The value of securities in the real estate industry can be affected by changes in real estate values and rental income, property taxes, and tax and regulatory requirements. Also, the value of securities in the real estate industry may decline with changes in interest rate. Investing in REITS and REIT-like entities involves certain unique risks in addition to those risks associated with investing in the real estate industry in general. REITS and REIT-like entities are dependent upon management skill, may not be diversified, and are subject to heavy cash flow dependency and self-liquidations. REITS and REIT-like entities also are subject to the possibility of failing to qualify for tax free pass through of income. Also, many foreign REIT-like entities are deemed for tax purposes as passive foreign investment companies (PFICs), which could result in the receipt of taxable dividends to shareholders at an unfavorable tax rate. Also, because REITS and REIT-like entities typically are invested in a limited number of projects or in a particular market segment, these entities are more susceptible to adverse developments affecting a single project or market segment than more broadly diversified investments. The performance of Real Estate Securities Portfolios may be materially different from the broad equity market.

Fixed Income Portfolios:

The net asset value of a fund that invests in fixed income securities will fluctuate when interest rates rise. An investor can lose principal value investing in a fixed income fund during a rising interest rate environment. The Portfolio may also be affected by: call risk, which is the risk that during periods of falling interest rates, a bond issuer will call or repay a higher-yielding bond before its maturity date; credit risk, which is the risk that a bond issuer will fail to pay interest and principal in a timely manner.

Risk of Banking Concentration:

Focus on the banking industry would link the performance of the short term fixed income indices to changes in performance of the banking industry generally. For example, a change in the market’s perception of the riskiness of banks compared to non-banks would cause the Portfolio’s values to fluctuate.

The material is solely for informational purposes and shall not constitute an offer to sell or the solicitation to buy securities. The opinions expressed herein represent the current, good faith views of Lake Tahoe Wealth Management, Inc. (LTWM) as of the date indicated and are provided for limited purposes, are not definitive investment advice, and should not be relied on as such. The information presented in this presentation has been developed internally and/or obtained from sources believed to be reliable; however, LTWM does not guarantee the accuracy, adequacy or completeness of such information.

Predictions, opinions, and other information contained in this presentation are subject to change continually and without notice of any kind and may no longer be true after the date indicated. Any forward-looking statements speak only as of the date they are made, and LTWM assumes no duty to and does not undertake to update forward-looking statements. Forward-looking statements are subject to numerous assumptions, risks and uncertainties, which change over time. Actual results could differ materially from those anticipated in forward looking statements. No investment strategy can guarantee performance results. All investments are subject to investment risk, including loss of principal invested.

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