The LTWM Insider - Market and Economic Commentary Q2 2019

Executive Summary

The U.S. economy and stock markets ended the second quarter of 2019 on a high note, as did bonds.  This is unusual because they typically move in opposite directions, but periods where stocks and bonds move in tandem do occur. However, over longer time periods, when one is up, the other, typically, is down. This is why they act as great diversifiers in a portfolio with each other. As discussed below, the current conditions provide insight about why this has happened, and evidence makes a strong case for a well-diversified portfolio that includes plenty of exposure to investments outside the US economy and large cap stocks.   This is an important point, because while the media touts “record highs for the market”, the reality is that it is US Large Cap stocks that are reaching record highs.  There are many other asset classes that should be included in a well-diversified portfolio, and they are not all at record highs.  Our portfolios have captured the run up in US Large Cap stock values in our US Large Cap stock holdings.  It is important to recall periods like the Great Recession and the Dot-Com crash of the early 2000s and remember that portfolio management is about managing return AND risk, and that it is unwise to allow a portfolio to retain too much risk, like the risk of level of the S&P 500.  By its very nature, a diversified portfolio will contain some investments that are doing better than others in any given time period. It is critical for success to maintain a long-term outlook and focus on increasing probability of long-term goal achievement (what the money is invested for).

 The S&P 500, Dow Jones Industrial Average, and Nasdaq indices all closed at record highs, and have continued on that trajectory, and much of that trajectory has been fueled by monetary policy of the Federal Reserve Bank.  Our economy is on track to reach longest economic expansion in recorded history, beginning at the end of the Great Recession in June of 2009.  The job market is on its longest run ever with 105 straight months of job growth. The Federal Reserve Bank would like to see greater wage increases that will eventually drive inflation to their target of 2%, thus allowing them to “normalize” the Fed funds rate to a higher level.  However, the Federal Reserve Bank is realizing that in order to stoke inflation they likely have to cut the Federal Funds Rate first.  Due to this circumstance, the aggregate bond market has had a rally to high valuation levels in anticipation of that rate cut.  

 The bond futures market is expecting two quarter point rate cuts by the Fed, half a percent in total, by the end of 2019.  This level of rate cut has been supported by Federal Reserve Bank Governors this year. However, the stronger than expected jobs report for June, released on July 5th, may cause the Fed to reconsider such a steep rate cut.  If this occurred, bond prices could take a step back to more reasonable levels. Additionally, the Fed is considering new research that shows the most economically challenged areas of the country, which have not participated in the current expansion, are showing signs of economic strength; and that is a strong reason for the Fed to keep the current expansion going by keeping rates low. So far, current wage growth of 3% is not creating inflation and if the U.S. can finish the on-again trade negotiations with China, we may be further away from the end of the longest expansion in U.S. history anyone reasonably expected.

 Of obvious concern: how long can the U.S. sustain this strong economic performance? The reality is economic recessions don’t die from old age, rather, they die from economic missteps and/or other unanticipated events.  Unsustainable levels of debt are a common driver of recession. 

 In the U.S., auto loans are reaching the high levels of delinquent payments, mostly by sub-prime borrowers.  Credit card, student loan, and direct consumer loan debt has expanded, as has global debt in general. The largest consumer debt market, mortgages, appears to be in pretty good shape, since low interest rates are driving home prices up slowly in most regions.

Will stocks and bonds at record highs in the U.S. coexist or is one of the asset classes going to correct?  How long can global central bank policies be sustained? The S&P 500 appears to be overbought, while U.S. small cap stocks, international developed and emerging market stocks are below all-time highs (and much lower in valuation).  A globally diversified portfolio continues to be essential for solid long-term investment results.  This is important because no one can time markets, anticipate global central bank decisions, or predict the future.  Managing risk in conjunction with expected return is as prudent today as it has always been, irrespective of sensationalized headlines in the news. 

 For those who want to dive deeper into our market and economic commentary:

World Asset Class 2nd Quarter 2019 Index Returns

Second quarter index returns were strong for U.S. and international developed stocks. U.S. and Global Bonds did well with the drop in the yield curve, which is near low yields for the year. For the broad U.S. stock market, the first quarter return of 4.10% was slightly more than twice the average since January 2001. International Developed Stocks gained 3.79%, which was well above the long-term average return of 1.5%.  Emerging Market Stock returns were 0.61%, below the average return of 2.9%. The Global Real Estate stocks returned 1.29% for the second quarter, below its’s average quarterly return of 2.6%. Both the U.S. and Global Bond markets returned close to 3%, well above their average quarterly return since January 2001 of 1.1%.

 A larger sample of asset class returns during the second quarter shows the strong U.S large cap asset class returns, which were above international and emerging market stocks. The value factor premium was negative in the U.S. and International developed markets but positive in emerging markets. Additionally, the size factor premium was weaker in all regions.

Here is a closer look at the second quarter 2019 U.S. stock returns and longer-term annualized returns, where you can see that small cap stocks are behind large cap stocks for the past 1,3,5 and 10-year periods. Value stocks are behind growth stocks in the large cap and small cap asset classes for the past 1,3,5 and 10-year periods.  This is highly unusual and suggests that central bank policy has caused distortion in markets and that we are likely to say a leadership change in the relatively near term. 

We wrote about the probability of the size and value factor premiums being negative for a 10 year period in our last  two quarterly commentaries, https://www.laketahoewealthmanagement.org/news-notes/2019/4/19/the-ltwm-insider-market-and-economic-commentary-q1-2019 and https://www.laketahoewealthmanagement.org/news-notes/2019/1/14/the-ltwm-insider-market-and-economic-commentary-q4-2018. The average annual size factor premium is 3.24% and the average value factor premium is 4.82% from 1927-2017, which is sizeable over the long term. The probability of a 10-year negative large value premium is 20.5%, a 10-year negative small value premium is lower at 4.5% and a 10-year negative size premium is a bit higher at 23%. While large and small growth have better results than large and small value, the returns for value over the past 10 years are still excellent at 13.19% annually for large and 12.4% annually for small, We don’t know when the growth outperformance will end, but we do know that growth stock valuations are very rich. We also are witnessing the tech unicorns go public (start-up company worth more than $1 billion) at new levels of valuation. While LYFT, and UBER, fizzled during their IPOs, a handful of new tech growth IPOs, including BYND, CRWD, ZM and WORK have significantly pushed the limits of valuation with price to sales ratios above 20 At one point, BYND was trading at over 90x trailing sales. As a reference point, the P/S ratio of the S&P 500 is just above 2. We are only able to use the P/S ratio as valuation measure, since none of the companies are profitable and the balance sheets are very small. The sky-high valuations can continue if interest rates remain extremely low, but the slightest sign of trouble could send the asset class tumbling.

The same asset class data for international developed stocks shows the value factor premium is also negative for the 1,3,5 and 10-year periods. However, the size premium is positive over 5 and 10 years for international developed stocks. Also notice during the second quarter that local currency returns were lower than returns translated back to the U.S. dollar. This was due to the strengthening of the local currency against the U.S. dollar during the quarter.

;�

Bond markets around the world were positive due to yields dropping from weakness in Europe and strong language from the ECB on keeping rates low, which means moving more negative. The German 10-year Bund yield is -0.37%, while the U.S. 10-year Treasury is 2.05%. Once the German Bund started to drop in yield, many international bond investors started buying higher yielding U.S. Treasuries, pulling its yield down about 50 basis points. The Fed has now moved its stance from not raising rates at all in 2019 to signaling a rate cut as the next move. This swift change happened as the yield curve quickly dropped rates across all maturities. This was a not a traditional flight to quality, which would normally send high yield bond spreads up. It was a direct result of the ECB announcing its willingness to move rates even more negative. Almost all outstanding government bonds in Sweden, Switzerland and Germany have a negative yield. If in a flight to quality, high yield spreads would widen. However, spreads are near the same level as the end of the first quarter, after widening during the stock sell-off in May and narrowing in June. Here is the one-year chart of the ICE BofAML US High Yield Master II Option Adjusted Spread (3.98% as of 7/5/19, more details in disclosures below):

Notice the very strong second quarter 2019 return for the Bloomberg Barclays US Government Bond Index Long at 6.0% and 10.92% for 2019 through two quarters, which leads all bond returns for the quarter and year to date. This is a direct result of the drop in yields at the longer end of the yield curve.

The Federal Reserve is closely watching what is happening with low wage workers, who are seeing employment opportunities from the current expansion, including longer hours. Economic research shows that the bottom 20% of worker’s work hours are negatively correlated with unemployment, while the top 10% is not, which means those working the most are not affected by recessions, while those working the least see economic hardship. On the positive side, adding labor hours by extending an expansion, increases the labor supply, which provides more room to run with non-inflationary growth. The Fed can now point to increased opportunities in low wage areas, which narrows the wealth gap, as a reason to keep rates lower than models predict for longer. For more details, see https://www.vox.com/2019/6/26/18759628/federal-reserve-interest-rates-jobs-inflation-workers

 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.

CONCLUSION

 The second quarter was a bumpy ride with stocks correcting during the entire month of May, but the full quarter added to the strong first quarter results of 2019. U.S. large cap stock indices have reached record highs, with very high valuations in the growth sector, especially the recent unicorn IPOs. The Federal Reserve has signaled they may remain more accommodative with lower rates than previously expected. Economic data in the U.S. is strong, inflation is low, but some forms of debt levels are at record highs, especially non-investment grade debt, and the trade tariffs are causing an international slowdown. While the past 10-year results for growth stocks are better than value, the returns for value have still been strong. We don’t know when a shift to value will occur, but if history and behavioral finance are used as a guide, the frenzy of chasing overvalued growth stocks will end badly. Maintaining an investment strategy discipline and a long-term focus are critical to success in the management of investment portfolios.

We also wanted to share some relevant research from our friends at Dimensional, who are pointing out that the average stock market return is hardly ever experienced in any given year.

 The Uncommon Average:

The US stock market has delivered an average annual return of around 10% since 1926.  But short-term results may vary, and in any given period stock returns can be positive, negative, or flat. When setting expectations, it’s helpful to see the range of outcomes experienced by investors historically. For example, how often have the stock market’s annual returns actually aligned with its long-term average?

 Exhibit 1 shows calendar year returns for the S&P 500 Index since 1926. The shaded band marks the historical average of 10%, plus or minus 2 percentage points. The S&P 500 Index had a return within this range in only six of the past 93 calendar years. In most years, the index’s return was outside of the range—often above or below by a wide margin—with no obvious pattern. For investors, the data highlight the importance of looking beyond average returns and being aware of the range of potential outcomes.

Tuning In To Different Frequencies

Despite the year-to-year volatility, investors can potentially increase their chances of having a positive outcome by maintaining a long-term focus. Exhibit 2 documents the historical frequency of positive returns over rolling periods of one, five, and 10 years in the US market. The data show that, while positive performance is never assured, investors’ odds improve over longer time horizons.

Conclusion

While some investors might find it easy to stay the course in years with above average returns, periods of disappointing results may test an investor’s faith in equity markets. Being aware of the range of potential outcomes can help investors remain disciplined, which in the long term can increase the odds of a successful investment experience. What can help investors endure the ups and downs? While there is no silver bullet, understanding how markets work and trusting market prices are good starting points. An asset allocation that aligns with personal risk tolerances and investment goals is also valuable. By thoughtfully considering these and other issues, investors may be better prepared to stay focused on their long-term goals during different market environments.  

Standardized Performance Data and Disclosures

Russell data © Russell Investment Group 1995-2017, all rights reserved. Dow Jones data provided by Dow Jones Indexes. MSCI data copyright MSCI 2017, all rights reserved. S&P data provided by Standard & Poor’s Index Services Group. The BofA Merrill Lynch Indices are used with permission; © 2017 Merrill Lynch, Pierce, Fenner & Smith Inc.; all rights reserved. Citigroup bond indices copyright 2017 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.