Market and Economic Commentary and Outlook Q3 2020

Executive Summary

Economies around the world continued to reopen and global markets gained ground in the third quarter.  The new bull market that started after stocks bottomed on March 23rd earlier this year charged on; however, most asset classes closed the quarter negative for the year so far. The U.S. and Emerging Market stock markets were the bright spots and lead the way for the quarter. However, it’s important to understand that the strong performance of the S&P 500 is not evenly distributed, it is concentrated in the largest U.S. stocks as noted in our previous blog: https://www.laketahoewealthmanagement.org/news-notes/2020/9/4/trhms8of4n47ivntkwefcit7czs7hs  

 Bond markets around the world were slightly positive due to the small shift down in the yield curve during the third quarter. Here in the U.S., the Federal Reserve Board of Governors (the Fed) announced a major policy shift, stating it will allow inflation to creep higher than the target of 2%, in order to support the labor market and broader economy. This shift means the Fed will be less inclined to hike interest rates when the unemployment rate falls so long as inflation does not creep above 2.5%. The indication is that low unemployment by itself does not cause inflation and the Fed will keep interest rates lower for longer, i.e. for the foreseeable future. This policy update is very supportive for stocks.

As of the writing of this summary, our elected officials in Washington are still negotiating the next round of stimulus in response to the Covid-19 pandemic.  While it is not clear what will be agreed to and implemented, it is clear the U.S. economy is not self-sustaining and will continue to need fiscal and monetary support to see Americans through the pandemic. The very high level of the U.S. stock market suggests a stimulus bill is already priced in, which warrants caution.

As we head into the final weeks of election season, increased volatility is expected.  However, there is no need to be reactive or change your portfolio solely due to the presidential race.  During our recent client appreciation event, we addressed the topic of your portfolio and elections with results from the full research team at Dimensional. Listen here: https://www.youtube.com/watch?v=HlNqMn_xTKw&t=7s   By way of example, twenty years ago, U.S. stocks lost over 7% during the disputed Bush-Gore contest in the week after the election. That contest went all the way to the Supreme Court before the election results were confirmed. In the end, markets recovered. For a more detailed look at Presidents and stock markets, here you go: https://www.laketahoewealthmanagement.org/news-notes/2020/10/12/presidents-and-markets

For those who would like a deeper dive into the details, please continue reading…

World Asset Class 3rd Quarter 2020 Index Return

U.S. and Emerging Market stocks were up significantly in the third quarter, which continues the new bull market trend that began during the second quarter. International Developed and Real Estate stocks, were up less. U.S. bonds were up 0.62% and Global Bonds were up 0.68%, as the level of interest rates continues to be very low. For the broad U.S. Stock Market, the third quarter return of 9.21% was well above the average of 2.1% since January 2001. International Developed Stocks returned 4.92%, which was well above the long-term average return of 1.4%.  Emerging Market Stocks returned 9.56%, well above the average return of 2.8%. Global Real Estate Stocks returned 2.37%, just above the asset class’s average quarterly return of 2.3%, but behind all other equity asset classes, due to continued concerns over commercial real estate vacancies. Here is a look at broad asset class returns over the past year and longer time periods (annualized):

International Developed Stocks turned positive over the past year, while Real Estate stocks are still negative, as of the end of September. Over the past five years, U.S. stocks are up double digits, while International Developed, Emerging Market and Global Real Estate stocks are much less positive. Over the past 10 years, the U.S. stock market is well ahead of International Developed and Emerging Market (EM) Stocks, which are only up 2.5% over the past 10 years. With such a low historical 10-year return, EM might be the place to be for the next 10 years.

A larger sample of global asset class returns during the third quarter shows the strength of smaller stocks, with EM small cap leading; and the International Developed (MSCI World) small cap index in second. Small-cap stocks outperformed large cap stocks in all regions, except the U.S.; and value stocks underperformed growth across all regions during the quarter.

Taking a closer look at U.S. stocks in the third quarter, we can see that value underperformed growth in the U.S. across large and small cap stocks; and small cap stocks underperformed large cap stocks. While both the size factor premium and value factor premium were negative during the last quarter, both are positive so far in October.

Over longer time periods, growth is well ahead of value in both large and small stocks. In fact, at the end of the third quarter, the relative performance of small cap value to large cap stocks is at its most extreme point in history; but is the best performing asset class over very long periods of time. If we are in a new bull market, it is probable for U.S. Small Value stocks to go from the bottom to the top of the list. So far, this is exactly what we have witnessed in October. A popular small cap value ETF, SLYV is up ~10% in October, while SPYG, a popular S&P 500 growth ETF, is only up half as much, ~5% as of market close 10/9/2020. As another history lesson, the long-term average annual performance of large cap growth stocks is ~9%, so a 10-year annual return of 17.25%, below, is more than two times the historical average. Such extreme performance is not likely to continue.

International Developed Stock Markets were positive, just not as strong as the U.S., and underperformed Emerging Market Stocks during the past quarter. In contrast to the U.S., small cap stocks outperformed large cap stocks. Additionally, the value premium was negative in large and small cap stocks during the second quarter.

For International Developed Stocks over longer time periods, the size factor premium is positive over 1, 3, 5 and 10 years; but the value premium is negative over the past 1, 3,5 and 10 years.

Bond markets around the world were slightly positive due to the small shift down in the yield curve during the third quarter. The yield on the 5-year Treasury note decreased by 3 basis points, ending the quarter at a yield of 0.29%. The yield on the 10-year Treasury note decreased by 2 basis points, ending the quarter at a yield of 0.64%. And the 30-year Treasury bond yield increased by 5 bps to 1.46%. Here is the U.S. yield curve, and you can see how yields have dropped over the past year, but are basically unchanged over the last quarter,  with the curve slightly steeper (current yield curve in green, one quarter ago in blue, and one year ago in grey):

Notice below, the very strong third quarter return for the Bloomberg Barclays U.S. High Yield Corporate Bond Index, up 4.6%. We added the asset class to client portfolios near its bottom at the end of March, when high yield spreads were very wide, at peak fear, which is usually a very good time to buy. If you wait until the clouds are clear to invest, it is always too late.

The High Yield Spread Index (see footnotes for details) spiked over 10% during the first quarter, which we have not seen since the great recession of 2009. We invested shortly after the spike in spreads and the asset class has benefited from the narrowing of the spread during the past two quarters. We sold out of the position at the end of the third quarter, realizing double digit bond returns. We made this decision since the expected return in the future was small compared to the sizeable risk of holding high yield bonds. Here is one-year chart of the ICE BofAML US High Yield Master II Option Adjusted Spread (shading represents U.S. recessions and the current one is ongoing):

Our fixed income philosophy is to maintain a stable reserve, which allows us to rebalance out of and into stocks when negative volatility spikes. We never intended to have high yield bonds as a permanent allocation to our client portfolios.

One cannot time markets and typically the short term is just noise. 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). We encourage you to tune out the financial news, since major news sources have a bias toward negative headlines.

CONCLUSION

Third quarter results were a continuation of the new bull market trend of the second quarter, which was a top ten return of all time, and another example of the importance to stay invested during the fear of a global pandemic. Anyone that sold at the end of the first quarter and did not buy back in, experienced a permanent loss of wealth. We rebalanced portfolios near the bottom by selling bonds and purchasing stocks. We also added a 4% allocation to high yield bonds, which paid off with double digit returns as we exited the position at the end of the third quarter. We know that mega cap tech stocks have extremely high valuations, while due to business closures, it is difficult to determine a fair valuation for all stocks. While we are cautious on US Large Cap growth stocks, we are optimistic about other asset classes around the globe, especially Emerging Markets. We are maintaining a higher than normal 5% cash position for the current quarter.

No one knows what corporate earnings will look like in 2021, but economic data points are strong with unemployment continuing down and leading indicators increasing rapidly to pre-pandemic levels. However, with both valuations increasing and volatility still elevated, it is likely going to be bumpy ride through the Presidential election next month if a winner is not known right away or if the results are challenged. Stocks will not like the uncertainty of a disputed election. The best course of action is to remain on track with your financial plan and focus on the decisions you can control. Please reach out to us with any concerns.

Standardized Performance Data and Disclosures

Russell data © Russell Investment Group 1995-2019, all rights reserved. Dow Jones data provided by Dow Jones Indexes. MSCI data copyright MSCI 2019, all rights reserved. S&P data provided by Standard & Poor’s Index Services Group. The BofA Merrill Lynch Indices are used with permission; © 2019 Merrill Lynch, Pierce, Fenner & Smith Inc.; all rights reserved. Citigroup bond indices copyright 2019 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.

Lake Tahoe Wealth Management, Inc.is a Registered Investment Advisory Firm with the Securities Exchange Commission.