Executive Summary
In every quarterly commentary, we ask you to tune out the financial news; and as you might have noticed and hopefully ignored, the major financial headlines during the first quarter were filled with fear, panic and doom for the future. Panic sells so much better than good news. We are in the middle of a government-imposed shutdown of the U.S. economy in order to save lives, since flattening the curve of total infections will keep our hospitals from running out of beds for those that most need them. There are many positive stories of Americans and businesses rising to the occasion and resources have made it to the most troubled areas. The Federal Government has passed a massive $2 Trillion stimulus package to help unemployed workers, small businesses, and corporations. The Treasury has merged with the Federal Reserve to make sure the cash and bond markets operate orderly. Both moves have provided reassurance to the American people and capital markets alike.
The volatility was record breaking during the first quarter. The bull market of the past 10 years ended, with a drop of more than 35% from the high; and then a new bull market began with a spike of 20% up from the bottom. We have seen four of the most volatile trading days in history with the VIX, which is an index that measures market volatility, above 80 in March; and the best percentage up day (+11%) since 1933. Right now, it is all about getting the virus under control, so the economy can be opened for business again.
Keep in mind, we don’t own the top of our portfolio value and we don’t own the bottom, we own the long-term average return. Earning the market’s attractive long-term returns requires staying invested. Downturns of 10% or more happen on average once a year and downturns of 20% or more happen on average once every 3 years. So, despite feeling uncomfortable, this downturn is a normal part of investing in the stock markets.
If you are still saving for retirement, now is a great time to increase contributions to your retirement plan and investment accounts. If you are taking distributions from your portfolio, we have made sure you had at least a year’s worth of distributions in cash prior to the correction, so that we are not forced to sell stocks near the bottom. Our active rebalancing strategy of waiting for 20% asset drift from target worked very well during the first quarter, we sold bonds and bought stocks near the bottom of the stock market during the third week of March.
For those who’d like a deeper dive into the details that we regularly monitor, please continue reading…
U.S., International Developed, and Emerging Market stocks were down significantly in the first quarter. The Real Estate sector was the worst performing asset class, due to uncertainty over tenants paying rent and if the government will step in to help. U.S. bonds were up due to the flight to safety and the Fed moving the overnight lending rate to zero. Global bonds were up slightly. For the broad U.S. stock market, the first quarter return of -20.9% was well below the average of 1.8% since January 2001. International Developed Stocks returned -23.26%, which was well below the long-term average return of 1.2%. Emerging Market Stocks returned -23.6%, well below the average return of 2.5%. Global Real Estate stocks returned -29.02%, well below its’s average quarterly return of 2.2%. Here is a look at broad asset class returns over the last year and longer time periods (annualized):
The correction in the first quarter created negative one year returns for U.S., International Developed, Emerging Market and Real Estate stocks. Over the past five years, U.S. stocks are still positive, while International Developed and Emerging Market stocks are slightly negative. All asset classes are positive over the past 10 years, and the U.S. stock market is well ahead of International Developed and Emerging Market Stocks, which means globally diversified portfolios will have returns less than the broad U.S. stock market over the past 10 years.
A larger sample of asset class returns during the first quarter shows the strength of the broad bond market, both short term T-Bills and the aggregate bond market were positive. The S&P 500 was the least negative broad equity index. U.S. small-cap stocks under performed large cap stocks; and value stocks under performed growth in all regions during the quarter.
Taking a closer look at U.S. stocks in the first quarter, we can see that value under performed growth in the U.S. across large and small cap stocks and small cap stocks under performed large cap stocks. Both the size factor premium and the value factor premium were negative during the quarter. Over longer time periods, growth is still well ahead of value in both large and small stocks. In fact, at the end of the first quarter, the relative performance of small cap to large cap stocks is more extreme than at any point in the past 20 years.
International developed markets were not as strong as the U.S., but outperformed emerging market stocks. Small cap stocks underperformed large cap stocks. Additionally, the value premium was negative in large and small cap stocks during the quarter. For International Developed Stocks over longer time periods, the size factor premium is positive; but the value premium is negative over the past 1, 3, 5 and 10 years.
Bond markets around the world were positive due to the large shift down in the yield curve during the first quarter. The yield on the 5-year Treasury note decreased by 132 basis points, ending the quarter at a yield of 0.37%. The yield on the 10-year Treasury note decreased by 122 basis points, ending the quarter at a yield of 0.7%. And the 30-year Treasury bond yield decreased by 104 bps to 1.35%. Here is the U.S. yield curve, and you can see how yields have dropped during the quarter, slightly more at maturities of 1-5 years (current yield curve in green, one quarter ago in blue, and one year ago in grey):
Notice below, the very strong first quarter return for the Bloomberg Barclays US Government Bond Index Long, up 20.63% and 32.28% for the past year, which leads all bond returns for the quarter, 1, 3, 5 and 10-year periods. Also notice the worst performing bond index, High Yield Corporate Bonds, down -12.68%, due to the significant selling of energy related bonds.
The High Yield Spread Index (see footnotes for details) has spiked over 10%, which we have not seen since the great recession of 2009. A spike in the high yield spread is associated with panic and expectations for a very weak economy, including high bond defaults. Here is ten-year chart of the ICE BofAML US High Yield Master II Option Adjusted Spread:
High Yield spreads spiked right after the price of oil crashed on the decision from OPEC and Russia to not drop production on an oversupplied global market. The goal of the oil war is to reduce the amount of shale oil production in the U.S., which has the highest cost of extraction; and is uneconomical at the current price of crude oil. The combination of the oil war and the coronavirus restrictions sent stocks down sharply. The Federal Reserve dropped the overnight lending rate to zero and then had to support the bond market with unlimited purchases (QE), since many parts of the bond market were not functioning well. Stocks still dropped, until Congress came up with a fiscal response. With massive Fed support, low interest rates and more than $2 Trillion in fiscal stimulus, we will very likely see high yield spreads decline. Since future high yield bond returns become very positive after large spikes in the high yield spread, we made the decision to allocate 4% of portfolios to high yield bonds during the quarter, reducing the 5% cash target to 1% and taking equal allocation from stocks and bonds (2% each). As the U.S. and global economy recovers, the high yield spread should decline, increasing returns of the high yield bond index.
CONCLUSION
The first quarter was very weak for stocks, with international large cap and global small cap stocks well behind the sizeable drop in U.S. Large Cap Growth Stocks. The Federal Reserve and Congress rose to the occasion with strong monetary and fiscal support and stocks jumped up from their lows on March 23rd. We rebalanced portfolios by selling bonds and purchasing stocks near the bottom, during the third week of March. We also added a small 4% allocation to high yield bonds with the belief the spike in spreads (bond selloff) was overdone. We have yet to re-test the lows and any positive news on treating the virus, with therapeutics or a vaccine will send stocks up. It is only a matter of time before we get the economy going again.
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.
