Executive Summary

It is with high hope for a return to normalcy and deep gratitude that we say Happy New Year! The fourth quarter of 2021 was strong for stocks and now we know that the flat third quarter was just a bull market pause, as we discussed in our previous market commentary. The S&P 500 finished the year with 68 record highs, the last on December 29th. The index hit a fresh record high on January 3rd, then the Federal Reserve Board December meeting minutes were released on the 5th and the much more hawkish board discussion sent interest rates higher and stocks down sharply, with growth stocks leading the decline.

With higher inflation and an increase in bond yields, investors have moved funds to the reflation trade in January, and value stocks globally in large cap and small cap asset classes have outperformed. LTWM globally diversified portfolios are tilted toward the value and size factor premiums to capture the higher expected return. We expect this trend to continue well into the future given the current economic fundamentals.

All eyes will be on the Fed during 2022 since its monetary policy will move from supporting to restricting economic growth. Current market expectations are for Fed bond purchases to taper to zero by the end of March, which is also when the first interest rate hike is expected. Any acceleration of Fed policy action will likely send stocks down and any delay will likely send stocks to new record highs. Stocks can continue up in the face of increasing interest rates, if inflation is not too high, or growth does not slow. The economic business cycle appears healthy with low unemployment and strong job growth; but with valuations in the U.S. high, we remain cautiously optimistic.

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

World Asset Class 4th Quarter 2021 Index Returns

U.S., International Developed, and Global Real Estate stocks were strong in the fourth quarter, a continuation of the bull market trend that began on March 23rd of 2020 (the Covid bottom). U.S. Bonds were up 0.01%, while Global Bonds were up 0.07%, (basically flat) as the level of interest rates increased on short maturities and decreased across longer maturities, while the overnight lending rate is still anchored to zero by the Fed. For the broad U.S. Stock Market, the first quarter return of 9.28% was well above the average of 2.5% since January 2001. International Developed Stocks returned 3.14%, which was above the long-term average quarterly return of 1.7%. Global Real Estate Stocks returned 12.35%, well above the asset class’s average quarterly return of 2.7%. Emerging Market Stocks returned -1.31%, below the average quarterly return of 2.9%. While emerging markets continue to have Covid, supply chain and inflation issues, overall, stocks were very strong for the quarter. Here is a look at broad asset class returns over the past year and longer time periods (annualized):

Global Real Estate stocks (as defined by the S&P Global REIT Index) led all categories with a strong 31.38% return in the last year. The U.S stock market (as defined by the Russell 3000 Index) gained 25.66%, while International Developed stocks were up 12.62% over the past year. Emerging Market stocks lagged with a one year return of -2.54%. Over the past five years, U.S. stocks were up 17.97% annually, while International Developed stocks were up 9.63% annually, Emerging Market stocks were up 9.87% annually, and Global Real Estate stocks were up 8.25% annually. Over the past 10 years, the U.S. stock market (up 16.3% annually) is well ahead of International Developed (up 7.84% annually) and Emerging Market (EM) stocks, which are up 5.49% annually over the past 10 years. We continue to believe EM might be the place to be for the next 10 years, due to much lower valuations and higher growth as the pandemic ends. We are seeing early signs that supply chain disruptions are decreasing.

Taking a closer look within U.S. stocks in the fourth quarter, we can see that market wide results were up 9.28%, value underperformed growth across large cap stocks but value outperformed growth across small cap stocks; and small cap stocks underperformed large cap stocks during the last quarter of 2021.

If we extend our analysis of U.S. stock over longer time periods, U.S. Small Cap Value continues to perform the best for the past one-year return (up 28.27% below). Investors are still debating the return of inflation or reflation, which improves the attractiveness of the trade for value stocks over growth stocks. However, the continuing pandemic supported mega cap growth stocks, which still represent the highest concentration since 2000, and led the S&P 500 to outperform in the fourth quarter. We discussed the difficulty of the largest stocks driving the index in our 2020 blog, “Will Tech Giants Continue to Dominate”, https://www.laketahoewealthmanagement.org/news-notes/2020/9/4/trhms8of4n47ivntkwefcit7czs7hs

International Developed Stocks were positive during the fourth quarter (and stronger in local currency), outperforming Emerging Market Stocks, but underperforming U.S. stocks. Looking closer, the value premium (value-growth) and the size premium were negative (small cap stocks underperformed large cap stocks). The currency effect served as a headwind to international stock returns during the quarter, as US currency returns were lower than local currency returns. Our investment funds are priced in U.S. dollars and the dollar was strong during the fourth quarter.

While Value was behind in the last quarter, it is better than Growth over the last one-year period (13.26% vs. 11.57%) for International Developed Stocks; over longer time periods, the value premium (value-growth) is negative for the past 3, 5 and 10 years. The size factor premium (small cap-large cap) is now negative in the past quarter and year, it is positive over the past 3, 5 and 10 years. There is still plenty of room for value to catch growth over longer time periods in the future.

The U.S. economy is still in the early stages of a new business cycle, adding significant jobs each month with a declining unemployment rate and increasing employment wages, although we are past peak growth or rather, in a period of slower growth. The Conference Board’s Economic Index of leading indicators has been positive for the past year, signaling expectations of continued strength in the business cycle. Consumer demand is strong for long term purchases, including appliances, autos and residential homes, however, supply chain issues continue to dampen growth and fuel inflation. Although, recent data suggest supplier prices and delivery times have improved globally during December. The December jobs report, released on January 7th, 2022, had new jobs at 199,000, less than half of what was expected (455,000), while the unemployment rate declined below 4% for the first time (3.9%). With wage increases above 4% annualized, it is clear the Fed is behind the curve in addressing inflation and will likely have to take action quicker than expected with tapering (reducing bonds purchases), raising the overnight lending rate and reducing the size of their balance sheet by selling bonds. Treasury yields have jumped across all maturities so far in January. The new covid variant, Omicron is highly transmissive and caused a short pullback in stocks, but investors have mostly looked past the ability of it to have a negative economic impact. Stocks are very much following the news from central banks around the world, watching for the removal of stimulus.

The ECB and the Bank of Japan are both in the same boat as the Federal Reserve, doing the best it can to keep monetary support accommodative by pushing interest rate increases out as far as possible to achieve economic growth, while not stoking inflation and hurting real growth. The euro area is still struggling to achieve a strong consumption rebound, but stocks are doing well in January as most of the new omicron cases are not having an economic impact. The Bank of England increased interest rates from zero to 0.25%, which allowed the British Pound to strengthen against the Euro and the Dollar. Norway also raised its benchmark rate by 50 bps over the past year. The Japanese government raised GDP expectations for 2022, while reducing them for 2021, effectively pushing growth out another year due to the pandemic and supply chain constraints. Emerging markets had a more challenging quarter, due to several China real estate holding companies cutting the pace of investments and multiple interest rate hikes in Latin America. We will be watching international economic developments closely since it appears Asia and Europe will be out of the pandemic prior to the U.S. economy and inflation is more of an issue domestically.

Shifting the commentary to fixed income, bond market returns around the world were slightly positive during the fourth quarter but negative for the full year. The yield on the 5-year Treasury note increased by 28 basis points, ending the quarter at a yield of 1.26%. The yield on the 10-year Treasury note decreased by 2 basis points, ending the quarter at a yield of 1.52%. And the 30-year Treasury bond yield decreased by 18 bps to 1.9%. Here is the U.S. yield curve, and you can see how yields are barely up at the short end (1-5 years) and down at the long end (30Y) over the past quarter (current yield curve in grey, one quarter ago in blue, and one year ago in green):

Notice below, the highest fourth quarter bond return is for the US Government Bond Index Long (up 3.05%), while TIPS, inflation protected bonds, were up 5.96% for the past year. The Bloomberg Barclays U.S. High Yield Corporate Bond Index was up 0.71% for the quarter and 5.28% for the past year, which means investors are not concerned about economic weakness yet. With high yield spreads down around 3%, which is the lowest level since 2007, expectations for an expanding economy are high. High-Yield spreads should reverse and start to widen when investors expect economic weakness. Here are the period returns:

The Federal Reserve has a very delicate task of balancing higher than expected inflation (price control) with economic growth to support full employment in the face of the continuing pandemic. The latest Fed meeting minutes released on January 5th contained a discussion about the need to increase short term rates earlier than expected and possibly reduce bond holdings, sent stocks, gold and even bitcoin down sharply. At the same time, the 10-year Treasury yield jumped to a nine-month high. It could be troublesome for crypto investors that the coins are behaving like risky assets and not currencies. It is likely the Fed will reduce bond purchases by the end of March and may raise the benchmark rate at the same time, which is what investors expect. Any acceleration of the timeline will send risk assets down further, while any extension of rate hikes could continue the bull market to new record highs. We do know that high valuations reduce expected returns but we expect value to perform much better than growth in an interest rate rising environment.

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; and often the headlines of the day have very little to do with the direction of stocks.

CONCLUSION

Thanks to a strong fourth quarter, higher than average portfolio results were achieved during 2021. For 2022, we know the Fed will be less supportive for the strong stock results to continue, but it is unknown when the more restrictive policy may hit stocks, if at all. The Fed is in a very difficult situation, with fighting higher-than-expected inflation and a strong job market heating up the economy (the role they were designed to contain) while supporting American citizens and businesses in a continuing pandemic. Europe and Asia are emerging from the pandemic, and it appears supply chains are reducing bottlenecks. All eyes will be on the global central banks’ monetary policy decisions during the first half of the year.

While we remain cautiously optimistic about the economic future, we know that 2022 is the year the Federal Reserve changes from accommodative to restrictive policy. We also know the stock market is unpredictable in the short term. The best course of action is to focus on the decisions you can control to achieve the success of your financial plan. We are here in your support and would be happy to answer any questions or concerns.

Also, please enjoy this timely piece on dealing with all-time high anxiety from our friends at Dimensional, Weston Willington, VP:

Investors are often conflicted about record-high stock prices. They are pleased to see their existing equity holdings gain in value but apprehensive that higher prices somehow foreshadow a dramatic downturn in the future. And they may be reluctant to make new purchases since the traditional “buy low, sell high” mantra suggests committing funds to stocks at an all-time high is a surefire recipe for disappointment.

Financial journalists periodically stoke investors’ record-high anxiety by suggesting the laws of physics apply to financial markets—that what goes up must come down. “Stocks Head Back to Earth,” read a headline in the Wall Street Journal in 2012.1 “Weird Science: Wall Street Repeals Law of Gravity,” Barron’s put it in 2017.2 And a Los Angeles Times reporter had a similar take last year, noting that low interest rates have “helped stock and bond markets defy gravity.”3

Those who find such observations alarming will likely shy away from purchasing stocks at record highs. But shares are not heavy objects kept aloft through strenuous effort. They are perpetual claim tickets on companies’ earnings and dividends. Thousands of business managers go to work every day seeking projects that appear to offer profitable returns on capital while providing goods and services people desire. Although some new ideas and the firms behind them end in failure, history offers abundant evidence that investors around the world can be rewarded for the capital they provide.

Whether at a new high or a new low, today’s share price reflects investors’ collective judgment of what tomorrow’s earnings and dividends are likely to be—and those of all the tomorrows to come. And every day, stocks must be priced to deliver a positive expected return for the buyer. Otherwise, no trade would take place. It’s difficult to imagine a scenario where investors freely invest in stocks with the expectation of losing money.

Investors should treat record high prices with neither excitement nor alarm, but rather indifference. If stocks have a positive expected return, reaching record highs with some frequency is exactly the outcome we would expect. Using month-end data over the 94-year period ending in 2020, the S&P 500 Index produced a new high in ending wealth in more than 30% of those monthly observations. Moreover, purchasing shares at all-time records has, on average, generated similar returns over subsequent one-, three-, and five-year periods to those of a strategy that purchases stocks following a sharp decline, as Exhibit 1 shows.

Humans are conditioned to think that after the rise must come the fall, tempting us to fiddle with our portfolios. But the data suggest such signals only exist in our imagination and that our efforts to improve results will just as likely penalize them.

Investors should take comfort knowing that share prices are not fighting the forces of gravity when they move higher and have confidence that record highs only tell us the system is working just as we would expect—nothing more.

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.

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.