The LTWM Insider - Market and Economic Commentary Q2 2020
Executive Summary
The second quarter results for US stocks were very strong, the best quarterly return in over 20 years. A strong rebound after the record-breaking negative volatility during the first quarter. The bull market of the past 10 years ended, with a drop of more than 35%; and then a new bull market began with a sharp increase of 40% up from the bottom on March 23rd. Once again, the stock market did what was least expected in the face of a global pandemic. The consensus forecast from the experts on the news was for a retest of the lows and instead stocks climbed the wall of worry.
Right now, it is all about fully opening the global economy for business again and Asia is leading the way with Europe not far behind. Economic activity is on a positive trend for the U.S., with very strong monetary and fiscal support from the government. Jobs in the U.S. are displaying sizeable gains again and the high unemployment which resulted from the mandated shutdown, is declining rapidly.
As we consider the current state of the world and the capital markets, it’s important to remember, we don’t own the top of our portfolio value, nor do we own the bottom, we own the long-term average return. Timing the market is a fool’s game and one that is more likely to destroy wealth than increase it. We stayed invested through the mandated shutdown, actively monitored for rebalancing at 20% asset drift and purchased many asset classes when they dropped 20% from their target; and added high yield bonds as a new asset class, since the risk reward looked favorable and fixed income asset class has double digit returns.
For those who’d like a deeper dive into the details that we regularly monitor, please continue reading…
World Asset Class 2nd Quarter 2020 Index Returns
U.S., International Developed, and Emerging Market stocks were up significantly in the second quarter, so much so that it could be viewed as the start of a new bull market after the bear market decline during the first quarter. U.S. stocks led International Developed and Emerging Market stocks, while the Real Estate sector was up much less, due to uncertainty over businesses and consumers using commercial real estate at the same level as the past. U.S. bonds were up 2.9% due to a slight drop in rates; and the Fed left the overnight lending rate at zero and pledged to keep it zero for some time into the future. Global Bonds were up 1.76%. For the broad U.S. Stock Market, the first quarter return of 22.03% was well above the average of 2.1% since January 2001. International Developed Stocks returned 15.34%, which was well above the long-term average return of 1.4%, but well behind U.S. stocks. Emerging Market Stocks returned 18.08%, well above the average return of 2.7%. Global Real Estate Stocks returned 11.17%, above its’s average quarterly return of 2.3%, but behind all other equity asset classes. Here is a look at broad asset class returns over the past year and longer time periods (annualized):
While the U.S. Stock Market is positive over the past year, International Developed, Emerging Market and Real Estate stocks are still negative; and Global Real Estate is still down -15.91%, as of the end of June. Over the past five years, U.S. stocks are up double digits, while International Developed and Emerging Market 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 3.27% 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 second quarter shows the strength of smaller stocks, with EM Small cap leading; and the U.S. small cap index in second. U.S. small-cap stocks outperformed large cap stocks; and value stocks underperformed growth in all regions during the quarter.
Taking a closer look at U.S. stocks in the second quarter, we can see that value underperformed growth in the U.S. across large and small cap stocks; and small cap stocks outperformed large cap stocks. While the size factor premium was positive, the value factor premium was negative during the quarter.
Over longer time periods, growth is well ahead of value in both large and small stocks. In fact, at the end of the second quarter, the relative performance of small cap value to large cap stocks is at an extreme point; but is the best asset class to be in 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.
International Developed Stock Markets were once again, not as strong as the U.S.; and also underperformed Emerging Market Stocks during the past quarter. Like 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 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 positive due to the slight shift down in the yield curve during the second quarter. The yield on the 5-year Treasury note decreased by 8 basis points, ending the quarter at a yield of 0.29%. The yield on the 10-year Treasury note decreased by 4 basis points, ending the quarter at a yield of 0.66%. And the 30-year Treasury bond yield increased by 6 bps to 1.41%. 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 second quarter return for the Bloomberg Barclays U.S. High Yield Corporate Bond Index, up 10.18%. It is down -3.8% for the past year. However, 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. It 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 second quarter. 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):
As the U.S. and global economy continue to open, the high yield spread should continue to decline back to 4-5%, which will be a point when we evaluate exiting the position. We do not plan 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
While the first quarter of 2020 was very weak for stocks due to the global pandemic, the second quarter was very strong (a top ten return of all time), which is another example of the importance to stay invested. Anyone that sold at the end of the first quarter and did not buy back in, experienced a permanent loss of wealth. The Federal Reserve and Congress continue with strong monetary and fiscal support and stocks continue with a strong bull market trend up from the bottom on March 23rd. We rebalanced portfolios near the bottom by selling bonds and purchasing stocks. We also added a 4% allocation to high yield bonds, which is paying off with double digit returns. The global economy is opening, with Asia and Europe leading the way. China’s stock market is up 10% in the past week. The U.S. is dealing with a few areas of growing virus cases in the south, where most of the activity is indoors, but the positive cases are concentrated with the younger age groups that recover much quicker than the older age groups. As a reminder, the stock market is forward looking and while corporate earnings will be very low for 2020, the real question for fair valuation of stocks is what will earnings look like in 2021? The bull market trend is strong, from a technical viewpoint, but volatility is still elevated; and it is likely going to be bumpy ride through the next quarter. During the short-term, stocks follow a random walk. Please reach out to us if you have any questions or concerns regarding your financial plan.
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.
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