What difference a year can make. At the end of 2018 we were licking our wounds after a brush with a bear market. The only investment that had a positive rate of return in 2018 was holding cash. Fast forward 12 months and the picture is entirely different. Stocks had their best annual performance since 2013 and bonds had their strongest year since 2003. This was the 7th best year for the S&P 500 since 1950. The rally in all asset classes can be attributed to a bounce back from the tough fourth quarter of 2018 as well as improving economic conditions, progress on the US-China trade front, and three cuts by the Federal Reserve (Fed).

All 11 sectors of the S&P 500 posted positive market returns this year. 90% of the stocks in the S&P 500 were up in 2019. The standout sectors were technology, communication services, and financials. Tech gained an amazing 47.9% this year with Apple and Microsoft largely driving these returns. These two stocks account for nearly 40% of this sector and Apple surged 88.9% while Microsoft rallied 57.5%. Communication services increased by 32.6%. This sector is a mashup of telecom companies, consumer technology, and media companies like Google, Facebook, and Netflix. The technology leaning components in this sector rallied nicely this year. Financials added 32.1% this year. This group was helped by the Fed cutting rates. This helped steepen the yield curve which improves their profit margins. The laggard this year was the energy sector. Energy rose 11.8% but the group continues to struggle with a glut of crude and natural gas production. Additionally, energy companies have high debt levels which complicates their financial picture.

Decade in Review

The 2010s were an impressive decade for investors. The S&P 500 averaged an annual return of 13.8% and bonds returned about 4.4% during the past ten years. Not too shabby for the most hated rally in market history. S&P 500’s returns were driven largely by earnings growth. Corporate earnings grew by 10% on average each year during this decade. This was also the first decade in history where the US did not experience a recession. The US is in its 126th month of economic growth which is the longest on record. Stock returns were much better in the 2010s than the 2000s which was largely a lost decade for stocks. Returns for the S&P 500 during the 2000s were an average annual loss of 0.7%. The 1990s and 1980s saw returns of 17.3% and 18.0%.

As we head into 2020, we are optimistic that stocks will have a positive year. We do not expect to see a repeat performance of 2019’s returns. The presidential election has everyone’s attention and rightful so. We anticipate there will be periods of increased market volatility around the primaries in the first quarter and then more volatility as we get closer to election day in November. The time in between will likely see investors waiting around without a lot of movement. We wrote about market performance during election years in December on our website. The data shows that returns are slightly lower than average in election years, but markets tend to have a positive performance more often in an election year than non-election years. More importantly, stocks tend to have less volatility in election years than non-election years. We will see if this holds in 2020.

We have had some people comment to us that they were cautious about putting new money to work because of the terrific market performance this year. We have written in the past that all-time highs usually are followed by new all-time highs. Looking at data on how stocks performance after years of 20% or better return years, it shows that investors should not worry. Returns three months, six months, one year and three years after a 20% or better return year see higher returns than an average market returns.

The list of data points to be positive on as we head into a new decade is long. This is why we are optimistic about stocks heading into the year. The US consumer is confident and in excellent shape financially. This bodes well for the economy since the consumer is close to 70% of economic activity. Economic growth is expected to be about 2% in 2020. This by no means robust but the economy is not overheated either. At this time risks of a recession are low in the next 12 months. This will likely allow the Fed to keep rates steady for most of the upcoming year. The Fed typically likes to remain on the sidelines during an election year and given the board of governors’ recent comments; they are not looking to raise rates anytime soon. Trade is probably the biggest wild card for the economy. It appears that the US and China will sign a Phase 1 trade deal in early 2020 but this situation is fluid. If there continues to be progress on trade talks globally, it should be a catalyst for stocks. If things regress, this could be a source of volatility.

There are a few things that we are monitoring which have us slightly cautious. Investor confidence has surged this year as markets have rallied. We started 2019 with a tremendous amount of fear in the market, and now we are seeing a lot more optimism bordering on greed. This can sometimes lead to swings in the market as people rush in and out of stocks. Corporate balance sheets are the most leveraged they have been since the financial crisis. 50% of the corporate bond market sits at a BBB credit rating. This is still considered investment grade and good quality. However, if an economic slowdown or another unforeseen issue occurs many companies are one step away from being downgraded to junk bond status. This would see an increase in borrowing costs that could have an impact on earnings. Corporate earnings expectations for 2020 are optimistic. They are factoring in further profit margin expansion which could be difficult to achieve given we are near record margins. If earnings growth rates drop stocks could see a pullback. Lastly, the pace of stock buybacks is expected to slow down. This has been a catalyst for stock prices and a significant slowdown in buybacks could remove a larger buyer from the markets.

The market valuation stands at an elevated level but not so high that is has us significantly concerned. The market started the year selling for 15.4x and is now 18.2x using forward earnings estimates. Given the low interest and low inflation environment, seeing a higher than average P/E is not unusual. Further expansion in multiples is likely to be limited so earnings are going to have to carry the market higher.

The upcoming election is going to be contentious. Your political views do impact your perspective on the economy and financial markets. This bias is something you’ll likely hear us discuss with you as we meet this year. We are not making significant changes to our allocations or investment strategies because of the upcoming election. We are watching corporate and economic data as we head into 2020 and are trying to remove politics from our decision making.

Please contact me at 913-871-7980 or by email to discuss your financial planning and investment management needs.

Disclaimer: The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results.

US Market Viewpoints: Q4 2019