State of the Markets
The fourth quarter was strong and 2019 turned out to be a fantastic year for investments. Concerns of geopolitics, trade wars, and pending recessions were all placed on hold as markets reached new highs, several U.S. companies achieved trillion-dollar valuations, and most asset classes ended the year with positive double-digit returns.
As of the end of December, the U.S. stock market (Russell 3000) was up 9.1% for the quarter and 31% for the year. International developed markets (MSCI World ex USA IMI) were up 8.4% for the quarter and 22.9% for the year. Emerging markets (MSCI Emerging Markets IMI) had a positive return of 11.6% for the quarter, which brought 2019 performance to 17.7%. Publicly traded real estate (S&P Global REIT), while up only 0.8% for the fourth quarter, delivered returns of 23.1% for the year. The U.S. bond market (Bloomberg Barclays U.S. Aggregate Bond Index) had a modest return of 0.2% for the quarter but delivered 8.7% for 2019.
The total returns for major asset classes are below.
As an investor, you might find it helpful to step back from these impressive stock market numbers and look at the drivers of returns.
How Valuations Impact Performance
Stock market returns always come from a combination of three things – dividends, earnings growth, and changes in valuations. (Foreign markets are impacted by changes in currencies as well.) Looking at the first illustration in the chart below (courtesy of JP Morgan), you will see that over the last 15 years, the S&P 500 delivered total returns of 9%, which came from a 2.5% dividend yield, 6% earnings growth, and a 0.5% change in valuation. (These numbers are approximations.)
Historically, dividends are very consistent. Earnings may fluctuate from year to year, but actual long-term earnings growth is consistent as well. Valuations are the biggest variable and can rise and fall dramatically. However, valuations are mean reverting, which means that low valuations trend up over time and high valuations trend down. Said differently, high valuations often lead to lower future returns, while low valuations often lead to higher future returns.
The next set of data in the chart shows that in 2018, dividends were stable, earnings were very positive, but as the U.S. and International markets declined for the year, there was a significant decrease in valuations. It is no surprise that after the concerns that led to the 2018 decline dissipated, stock markets recovered significantly.
What is surprising is that 2019 was not a good earnings year. According to Barron’s, total 2019 earning for S&P 500 companies, are projected to increase by only 0.6% over 2018. Earnings outside the U.S. were slightly negative. Despite that significant lack of earnings growth, stock markets did extremely well, and you can see in the third set of data in the chart above, that the vast majority of returns in 2019 were driven by the recovery of valuations.
Understanding how changes in valuations impact overall market performance can also help investors understand how valuations within market segments and strategies can impact past and future performance.
Over the past few years, some segments of the stock market have done extremely well, while others have done just OK. The main reason for this gap in performance is that the large cap and growth categories have seen increases in valuation, hence better performance, while small cap and value categories have seen decreases in valuation, hence lagging performance. The Morningstar chart below illustrates current valuations of market segments broken down by size and style and confirms significant disparity between the cheap and expensive segments of the markets.
Just as cheap valuations at the end of 2018 set the stage for great performance in 2019, the relatively cheap valuations of small cap and value compared to large cap and growth, may set the stage for outperformance in the future.
Schwab and TD Ameritrade
There has been some big news in our industry over the last few months. We recently wrote about the trend of custodians like Schwab and TD Ameritrade moving to zero commission trades. This news ultimately led to declines in stock prices for both companies, which then led to Schwab making an offer to buy TD Ameritrade.
The deal was accepted and is slated to close at some point in 2020. It is estimated that it will take up to three years to fully integrate the firms. While this is a significant consolidation of market share within the discount brokerage world, this merger is likely to have minimal impact on our relationship with Schwab, but of course we will pay close attention as the transaction proceeds.
In late December, the SECURE Act (Setting Every Community Up for Retirement Enhancement) was passed as part of a Federal budget deal. The new law makes significant changes to IRA accounts, 401k plans, and 529 plans. Here is a bullet point summary of some of the changes that might affect individual investors:
- Required Minimum Distributions (RMD) age increases from 70 ½ to 72 for anyone who had not reached 70 ½ by the end of 2019
- IRA’s inherited by non-spousal beneficiaries can no longer take distributions based on their own life expectancy, but instead must take all distributions within 10 years after inheritance (with some exceptions)
- Parents can take penalty-free withdrawals up to $5,000 from retirement accounts upon the birth or adoption of a child
- 529 plans can be used to pay off up to $10,000 of student debt