Market and Economic Commentary and Outlook

Executive Summary

What a difference a year makes. It was just one-year ago that we reported an end to the 10-year long bull market, due to a 34% decline in the S&P 500 amid the government-imposed shutdowns world-wide.  Trading volatility had increased to record breaking levels. The focus was on “flattening the curve” and remaining calm as we headed into unchartered territory.

Now, with much of the economic news about fully reopening and robust economic projections, we are experiencing positive returns in most asset classes, record breaking for some.  The Russell 3000, which is the total market index for U.S. stocks, was up a whopping 62.5% for the year ending 3/31/2021. New record highs are likely a result of improving economic data and the slowdown of coronavirus cases as effective vaccines are widely distributed. It is important to remember that the stock market is a forward-looking economic indicator and prices are a reflection of what is anticipated ahead.

It is noteworthy that the new asset class trends that emerged last October have continued.  The new trends favor value and small company stocks, instead of large company and growth stocks. Higher interest rates tend to effect growth stocks more, since their large future cash flows are worth less as they are discounted at a higher rate.  

We have found ourselves reflecting on the past year, seeking the lessons and wisdom to be garnered from living through such a historic time. In that reflection, we noticed that during such a volatile time, the desire to predict and anchor to a forecast, skyrockets.  It seems, in the face of extreme volatility, we humans seek comfort and yearning for a clear path forward. But the reality is, we just cannot predict the future and most forecasts are wrong.  There were many financial forecasts for 2020; however, essentially none of them predicted that stocks would reach new all-time highs a year later. Yet, that is exactly what happened.

Instead of clutching to predictions, the better option remains to rely on our continual study and navigation skill. Sticking to the disciplines of sound financial planning and investment management (the study) and to proceed with prudence (navigation skill), works.  If there is anything, we have learned during the past twelve months, its an affirmation of staying vigilant and minding our discipline to portfolio management and controlling what you can.

As we look forward, old concerns are replaced with new ones.  In the decade long battle between deflation and inflation, inflation has moved to the centerstage of future concerns and is a result of stimulus packages and Central Bank support in the U.S. and abroad. 

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

World Asset Class 1st Quarter 2021 Index Returns

U.S., International Developed, Emerging Market and Global Real Estate stocks were all positive in the first quarter, a continuation of the bull market trend that began during the end of the first quarter of 2020. U.S. Bonds were down -3.37% and Global Bonds were down -1.9%, as the level of interest rates increased across all maturities, except for the very shortest, which are anchored to zero by the Fed. For the broad U.S. Stock Market, the first quarter return of 6.35% was well above the average of 2.4% since January 2001. International Developed Stocks returned 4.04%, which was well above the long-term average return of 1.6%.  Emerging Market Stocks returned 2.29%, slightly below the average return of 3.0%. Global Real Estate Stocks returned 6.22%, also well above the asset class’s average quarterly return of 2.5%. Here is a look at broad asset class returns over the past year and longer time periods (annualized):

The U.S stock market (as defined by the Russell 3000 Index) led all categories with a remarkable 62.53% return in the last year. Emerging Market stocks were just behind the U.S., with a return of 58.39%, International Developed stocks were up 45.86% over the past year, while Real Estate stocks were more challenged, but still up 36.05%. It is still unclear how many digital workers will remain working at home and how many will return to office buildings. 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 3.65% 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. 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 next decade favors international outperformance. During the first quarter, after extensive research, we increased our target allocation for emerging market stocks by decreasing the targets for international developed stocks. Please let us know if you have any questions about this change.

A larger sample of global asset class returns during the first quarter shows the strength of smaller and value stocks, with small cap value leading (up an additional 21.17%, after an amazing 33.36% return during the 4th quarter of last year); followed by the Russell 1000 Value Index (large cap value), up 11.26% and the International Developed Large Cap Value (MSCI World ex USA) up 8.33%. Value and small-cap stocks outperformed growth and large cap in all regions, which is a continuation of the strong trend starting on November 2nd, 2020.

During the first quarter, U.S. Stocks outperformed International Developed and Emerging Market stocks. Taking a closer look within U.S. stocks in the first 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 2019 and most of 2020, both are positive since the end of October, a strong five-month trend that is likely to continue. As an example, if you look at Small Cap Value below, it returned 21.17% during the quarter, while Small Cap growth only returned 4.88%. The difference of +16.29% is the size factor premium for the first quarter. Our portfolio models have a higher allocation to value than growth to capture the positive value and size factor premiums.

While large growth is at the bottom of the list for the past quarter, over longer time periods, it is well ahead of value in both large and small stocks. The air is slowly hissing out of the growth stock bubble from an extreme point at the end of October last year, 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 and last year, but for longer time periods.

International Developed Stock Markets were positive during the past quarter, outperforming Emerging Market Stocks, but underperforming U.S. stocks. 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 negative currency effect with stronger returns in local currency, which simply means the dollar strengthened against the Euro and other international currencies. This served as a headwind to international stock returns in our funds during the first quarter, which are priced in U.S. dollars.

While Value is back on top for the past two quarters and one year for International Developed Stocks; over longer time periods, the value premium is negative for the past 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. There is still plenty of room for value to catch growth over longer time periods in the future.

We are witnessing a new trend with value and size factor premiums and we discussed this potential trend continuation in our last quarter commentary, viewable here:  https://www.laketahoewealthmanagement.org/news-notes/2021/1/15/market-and-economic-commentary-and-outlook-q4-2020

History points to an extra 8.31% return per year for value above growth stocks for the next 10 years. The 77 historical observations have a range of positive 2.86% to 13.02%. While we can’t 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 market returns around the world were negative due to a sizeable shift up in the yield curve during the first quarter. The yield on the 5-year Treasury note increased by 56 basis points, ending the quarter at a yield of 0.95%. The yield on the 10-year Treasury note increased by 81 basis points, ending the quarter at a yield of 1.74%. And the 30-year Treasury bond yield increased by 75 bps to 2.39%. Here is the U.S. yield curve, and you can see how yields have jumped over the past quarter and year (current yield curve in green, one quarter ago in blue, and one year ago in grey):

Notice below, the best first quarter bond return still belongs to the Bloomberg Barclays U.S. High Yield Corporate Bond Index, up 0.85%, which is a testament for the perceived strength of the economy and large stimulus dollars chasing risker bonds. Also notice, the U.S. Government Bond Index Long is the worst performing bond index, due its long duration, down -13.39% during the first quarter. Here are the period returns:

With the 10-year Treasury Bond up at 1.74%, it is a sizeable increase from the end of last year. In our last quarterly commentary, we predicted that if interest rates increased, growth stock prices will decline, all else equal. 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 (price control) with economic growth to make sure interest rates don’t rise too quickly, given all the proposed government stimulus. Any intervention by the Fed to increase short term rates may send stock prices down. We will keep a close eye on inflation and Fed policy 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 first quarter, as the double-digit value and size factor premiums have led to outperformance of broad stock market returns since the end of October. If the world economy continues to reflate and open, we expect the current trend of value and small cap stock outperformance to continue.

Right now, in April, stocks in the U.S. are at record highs. So too, are multiple valuation measures of U.S. stocks. We do see more reasonable value across the globe and took action to increase our target allocation to emerging market stocks during the first quarter.

Interest rates are at higher levels; and if the uptrend continues, it acts as a headwind to bond returns, especially longer duration bond funds, which is why we target a short duration for our bond holdings.

While we remain cautiously optimistic about the economic future, the best course of action is to focus on the decisions you can control to achieve the success of your financial plan. Please reach out to us with any questions or concerns. We are watching the potential tax changes closely and will be ready with recommendations.

Standardized Performance Data and Disclosures

Russell data © Russell Investment Group 1995-2020, all rights reserved. Dow Jones data provided by Dow Jones Indexes. MSCI data copyright MSCI 2020, all rights reserved. S&P data provided by Standard & Poor’s Index Services Group. The BofA Merrill Lynch Indices are used with permission; © 2020 Merrill Lynch, Pierce, Fenner & Smith Inc.; all rights reserved. Citigroup bond indices copyright 2020 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.