Market and Economic Commentary and Outlook Q4 2020

During the final quarter of 2020 global equity markets continued upward with a new trend emerging in early November – small and value, instead of large and growth stocks, led the way. International value stocks were also a bright spot for the quarter. The new bull market, which began after markets bottomed on March 23rd, continued through the end of the fourth quarter and into January of the current year. Better-than-expected effectiveness of the Covid19 vaccine is suggested to be the reason for the strong performance and new trends that emerged during the quarter.  The new trends are supportive of our investment strategy.

Global bonds were also positive during the fourth quarter.  Overall, 2020 was a good year for bonds, since interest rates declined substantially on the heels of the pandemic. In the U.S., the Federal Reserve Board of Governors (The Fed) announced its expectation to keep interest rates near zero for 2021 and 2022.  This policy update, along with expected continued stimulus spending, is very supportive for the current bull trend in stocks.

We are cautiously optimistic in our outlook for 2021.  “Cautiously” being the operative word due to high valuation in the US equities, market near-term headwinds, including the recent surge in COVID cases globally, higher interest rates, and the transitions in governance here at home and abroad.  However, with a longer-range view, global monetary policy remains highly accommodative, we appear to be in an early-cycle recovery, and the expectation for a full economic reopening as 2021 marches on.   

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

U.S., International Developed, Emerging Market and Global Real Estate stocks were up significantly in the fourth quarter, a continuation of the bull market trend that began during the second quarter of 2020. U.S. bonds were up 0.67% and Global Bonds were up 0.94%, as the level of interest rates remained very low and in a tight range. For the broad U.S. Stock Market, the fourth quarter return of 14.68% was well above the average of 2.3% since January 2001. International Developed Stocks returned even more, up 15.85%, which was well above the long-term average return of 1.6%.  Emerging Market Stocks led all broad asset classes and returned 19.7%, well above the average return of 3.0%. Global Real Estate Stocks returned 12.55%, also well above the asset class’s average quarterly return of 2.4%. Here is a look at broad asset class returns over the past year and longer time periods (annualized):

The U.S stock market (top 3000 stocks by market cap) led all categories with a remarkable 20.89% return during 2020. Emerging Market stocks were just behind the U.S., with a return of 18.31%, International Developed stocks were up 7.59% over the past year, while Real Estate stocks were negative, -9.09% for the year. Over the past five years, U.S. stocks were up double digits, along with Emerging Market stocks while International Developed, and Global Real Estate stocks were 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 3.63% 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. The asset class did well in the fourth quarter. We also know the relationship between the U.S. and the rest of the developed world is cyclical and given the long run of U.S. outperformance, the decade favors international outperformance.

A larger sample of global asset class returns during the fourth quarter shows the strength of smaller and value stocks, with small cap value leading (up an amazing 33.36%); followed by Emerging Market and the International Developed Large Cap Value (MSCI World ex USA). Value and small-cap stocks outperformed growth and large cap in all regions, which is quite a reversal from the previous three quarters.

During the fourth quarter, U.S. Stocks underperformed International Developed and Emerging Market stocks. Taking a closer look within U.S. stocks in the fourth quarter, we can see that value outperformed growth in the U.S. across large and small cap stocks; and small cap stocks outperformed large cap stocks. While both the size factor and value factor premiums were negative during 2020, both are positive since the end of October, a strong two-month trend that has continued into January.

Over longer time periods, growth is well ahead of value in both large and small stocks. We very likely witnessed an extreme point at the end of October, and since then, U.S. Small Cap Value has performed the best. And it is the best performing asset class over very long periods of time (last 90 years). If the new bull market trend continues, it is probable for U.S. Small Value stocks to go from the bottom to the top of the list, not just for the last quarter, but for longer time periods.

During the fourth quarter, you may have noticed, we made a slight change to our investment funds by replacing our current holding, DFA U.S. Small Cap Value (DFSVX) with Avantis U.S. Small Cap Value (AVUVX) and DFA Emerging Markets Value with Avantis Emerging Markets (AVEEX). Avantis is a new company founded by the former Co-CIO (Chief Investment Officer) at Dimensional Fund Advisors (DFA), so the new funds are based on the same factor premium research used by DFA. The primary difference is the Avantis Funds are designed using the profitability factor from the start and have more exposure to profitable stocks, less exposure to deep value stocks, compared to DFA. We were sensitive to realizing a large tax consequence, so you may still hold DFSVX if it has a large unrealized capital gain. If so, we will look for opportunities to replace the fund over time. Our expectation is the move will improve returns and reduce tracking error to the benchmark. If you would like more details, please contact us for a discussion.

International Developed Stock Markets were very strong during the past quarter. Additionally, the value premium was positive in large and small cap stocks during the fourth quarter and so was the size premium (small cap stocks outperformed large cap stocks). Notice the positive currency effect with stronger returns in US currency, which simply means the dollar weakened against the Euro and other international currencies. Our investment returns benefit from this currency effect since they receive returns in US currency.

While Value is back on top for the past quarter for International Developed Stocks; over longer time periods, the value premium is negative for the past 1, 3, 5 and 10 years. The size factor premium is positive in the past quarter and over the past 1, 3, 5 and 10 years. Plenty of room for the value factor premium to make up in the future.

Are we witnessing a new trend with value? We know from past discussions that the probability of a 10-year negative value premium is 17%, the other 83% of the time, rolling 10-year periods have a positive value premium. Now that we have just experienced a 10-year negative value premium, what does the historical data look like for the subsequent time periods that follow a decade of a negative value premium? Based on 77 historical observations, the average annual value premium is a positive 8.31% for the 10-year period:

Let us repeat, that is an extra 8.31% return per year above growth stocks for the subsequent 10 years. The 77 historical observations have a range of positive 2.86% to 13.02%. While we cannot say what the next 10 years will be like for the value premium, history supports a positive result.

Shifting the commentary to fixed income, bond markets around the world were slightly positive even through there was a small shift up in the yield curve during the fourth quarter. The yield on the 5-year Treasury note increased by 8 basis points, ending the quarter at a yield of 0.39%. The yield on the 10-year Treasury note increased by 29 basis points, ending the quarter at a yield of 0.93%. And the 30-year Treasury bond yield increased by 18 bps to 1.64%. Here is the U.S. yield curve, and you can see how yields have dropped over the past year, but are up slightly over the last quarter, with the curve slightly steeper at the short end (current yield curve in green, one quarter ago in blue, and one year ago in grey):

Notice below, the strong fourth quarter return for the Bloomberg Barclays U.S. High Yield Corporate Bond Index, up 6.45%, to lead all fixed income categories. During the full year of 2020, the U.S. Government Bond Index Long was the best performing bond index; and it returned -2.95% during the fourth quarter. You can view the drop in the yield curve at the long end (30 Yr) over the past year and the tick up during the last quarter if you view the right side of the graph above. Here are the period returns:

With the 10-year Treasury Bond just above 1.0% currently, it represents a very low level of interest rates. The rest of the developed world’s interest rates are even lower. Low interest rates are inversely related to the P/E ratio and other valuation measures. So, low rates support high valuation ratios. If interest rates start to increase and there is not a corresponding increase in corporate revenue, operating income and earnings, stock prices will adjust down. The Federal Reserve has the delicate task of balancing inflation with economic growth. We will keep a close eye on inflation over the next few quarters.

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

Strong portfolio results were achieved during the fourth quarter, as the value and size factor premiums outperformed strong broad market returns from the end of October. During the full year, we rebalanced portfolios near the stock market bottom in March, by selling bonds and purchasing stocks. We also added a 4% allocation to high yield bonds after the spike in the high yield spread (large drop in prices). We exited the position at the end of the third quarter.

As of the drafting of this report, stocks in the U.S. are at record highs. So too, are multiple valuation measures of U.S. stocks. Interest rates are increasing, which acts as a headwind to bond returns, starting with longer duration funds, which is why we target a short duration for our bond holdings. The U.S. stock market has built in expectations for a large fiscal stimulus and if the actual bill is less than expected or does not pass, stocks will correct.

It is a good time to repeat Warrant Buffet’s famous quote, “Be fearful when others are greedy, and be greedy when others are fearful”. We remain cautious and are maintaining a higher than normal 5% cash position for client portfolios. 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.