Databank

4th Quarter 2019


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The Standard & Poor's 500stock index posted a +9.1% gain in the fourth quarter of 2019.

That's nearly as much as much as the average return historically earned in a full one-year period!


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Before getting into the numbers, I want to start by saying that we examine stock returns over a one-quarter period,not so much to inform our long-term investment strategy as to confirm our outlook.

To be clear, you don't make decisions about strategic investment policy decisions based on three months of data! If you did, based on this past quarter's returns you see right here, you'd just put all your money in tech and health care stocks, or maybe in the Chinese stock market! No! Obviously,a prudent professional would not base a strategic investment plan on three months of recent performance.

It's nonetheless wise to analyze quarterly returns on broad indexes to confirm your investment view, your understanding of the economy.

This quarterly report gives you a snapshot of financial history in the making. If you look back at previous quarterly reports in this series, they tell the full story about economic trends,as well as investment returns,here in the U.S. and across the globe.


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Let's cut to the chase. This is what happened in U.S. stocks in the last 20 quarters.

There are a lot of numbers in this table. So, just in case you're having any trouble recognizing it, this is what a roaring bull market looks like!

This is the quarterly total return on stocks —including dividends as well as price appreciation —as measured by the Standard & Poor's 500, over the past 60 months of the 126-month-plus bull market.

Instinctually, you may think the longest bull market in history —by six months and running —is overdue to end, but economic fundamentals are strong.

Let's look at the current status of key fundamentals that have driven these outstanding returns.


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The non-farm economy needs to create about 100,000 new jobs to keep with population growth and historic immigration trends. According to new figures released by the Bureau of Labor Statistics on January 10, unemployment is at a 50-year low and the economy created 145,000 new jobs in December. The job-creation figure was slightly lower than expected, but nonetheless fairly strong.


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In addition, the Institute of Supply Management reported in early January that the 89% of the economy outside of the manufacturing sector wasperforming slightly better than expected. The monthly index of purchasing managers at non-manufacturing companies surveyed by ISM corresponds with an expected rate of U.S. economic growth of 2.2%. That's slightly stronger than the recent consensus forecast of 60 economists surveyed by The Wall Street Journal, as well as the Fed's projections.


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According to the Federal Reserve's most recent projections, the U.S. economy is expected to grow 2% after inflation in 2020.

A 2% long-term growth rate is low compared to the 1980s and 1990s, but current conditions are sustainable, according to the Fed's pronouncements and recent speeches by key members of the Federal Open Market Committee.


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Here's a timeline of developments in the two major financial economic issues affecting investors in 2019—the trade war with China and Fed interest rate policy —versus the price of the S&P 500 index, an index of the 500 largest U.S.public companies and, speaking more broadly, a measure of the progress of civilization.

Although trade with China actually haslittle effect on U.S. economic growth, the clash of the world's two largest economies is a dramatic showdown and gets a lot of press attention. Fear of the trade war rattled the stock market occasionally and created uncertainty all through 2019,butwas estimated by JP Morgan to have shaved 2019 growth by only about two tenths of 1%. In contrast, Fed policy had a real impact on U.S. interest rates and wasmuch more influential in the markets in 2019.


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Just to give you some of the backstory of what happened in 2019, this was the timeline we published here a year ago, in our report from 4Q 2018.

Just before 2019 started, in the first three weeks of December 2018, to be precise, the S&P 500 plunged 19.8% from an all-time high in September 2018.

Stocks were volatile in October and November. Then, the Fed hiked lending rates on December 19, 2018, triggering the frightful selloff.

The Fed raised rates in the face of the trade war fears and some evidence that the long expansion had cooled more than the Fed expected.

Stock investors surmised correctly that the rate hike would invert the yield curve, a financial signal that has preceded every recession in modern history.

Stocksposted a vicious -13.5% loss in the fourth quarter of 2018. It was the worst quarterly performance for stocks since 2011, and it was widely attributed to fear of the yield-curve inversion.


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An inversion is when long-term bonds yield less than short-term bonds.

When short term bonds pay more than long-term bonds, investors are not rewarded for "term risk," the risk of owning longer-term bonds. That's a condition that makes no financial sense. You should, of course, get paid more for the risk of owning longer-term bonds than risking your money for months.


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While it is true that, over the last several decades, every recession was preceded by the inversion of the yield curve, not every yield curve inversion has been followed by a recession, and this appears to be one of those times.

In 1995 and 1998, for example, the Fed changed course, cutting the fed funds rate after the yield curve inverted, and the Fed's quick action averted a recession.

After the December rate hike by the Fed, when the stock market plunged, the Fed realized it made a mistake and acted swiftly.


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This picture from our quarterly report for the fourth quarter of 2018 a year ago was a key turning point.

As we said at the time, the Fed did a complete reversal on January 4, 2019, just three weeks after hiking rates.

Mr. Powell, in front of an audience of economists in Atlanta, with his three predecessors on stage with him, essentially acknowledged that theFed had made a mistake.


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Mr. Powell said the Fed was listening to the market reaction to the rate cut and it was a signal that the Fed would reverse policy and lower rates, if needed, to keep the expansion from losing momentum.


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On May 13, 2019, after months of worry, the yield curve did indeed invert.

And, as Mr. Powell had signaled, the Fed cut rates on July 31.

But the stock market uncertainty persisted anyway,because it was unclear if the Fed had acted quickly enough.


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However, the psychological damage to the market was done. Recession predictions throughout the year spread gloom on financial TV and print.

These headlines from August show how the yield curve inversion spread fears that a recession was inevitable.


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The Fed would cut rates again on September 18, and that was followed byyet a third quarter-point cut on October 30, 2019.

By the end of the year, the yield curve un-inverted. Worry over Fed policy melted away when economic data continued to show that a recession was unlikelyand that the Fed indeed had acted in time to prevent a recession.A major cloud hanging over the economy had passed.

On December 13, with the U.S. announcement of the first phase of an agreement to end the trade war with China, the second worry dogging investors also subsided.

Instead of being remembered as the cause of a recession, the Fed's pronouncements and actions will be remembered as a anexample of the Fed's improved ability to respond to economic and market events, a sign of progress in the way central banks manage economic challenges facing major economies.


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Against that economic backdrop, value and growth stocks in 2019 performed about the same, but large caps returned much more than small companies.

This way of analyzing modern investments —classifying equity securities by characteristics, such as market-capitalization (the value of all their shares) and price-earnings ratio —was first articulated publicly in 1952 by Harry Markowitz, who was awarded the Nobel Memorial Prize for Economic Sciences in 1990.

Let's be sure you understand what Modern Portfolio Theory —MPT—is.


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MPT is a large body of financial knowledge based on academic research done over the last 70 years.

This framework for investing is now taught in the world's best business schools and embraced by institutional investors.


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The world which markets revolve around is dynamic, and not enough statistical history exists to make predictions with certainty.

MPT is a framework for managing that risk.

It's based on financial, economic,and statistical facts. It's history, which means it's looking though a rear viewmirror, but it's helpful in understanding the future and coming up with an investment outlook.

In addition to classifying investments based on their distinct statistical characteristics, MPT imposes a quantitative discipline for managing assets based on history and fundamental facts about finance.

MPT does not guarantee success,but its logic is embraced by pension funds and other institutional investors,and it has become the basis of the study of investing at colleges and universities.


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Okay, back to the overview of 2019.

Large value and growth returns of 31% in 2019 represent a roaring bull market run for blue chip stocks.


While your eye may be drawn to the 50.3% return on tech stocks, the bigger story for diversified investors is that the poorest return among the 10 S&P industry indexes was the 11.8% on energy industry shares. All of the other industry sectors returned more than 20%!


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Here's the U.S. stock market return in 2019 compared with major world regional stock market total returns.

The U.S. economy led the world out of the financial crisis and Great Recession. For the past 126 months, the U.S. stock market has consistently outperformed the world's other major stock markets.

U.S equities, represented by the S&P 500 2019, returned 31.5%, besting Europe's return by a 30% margin, but Europe's bourses showed a 25.5% total return in 2019, an absolutely great year for the region's equities markets.


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Notable in this bar chart of 2019 returns of a diverse group of 13 assets is that there was only one loser —agriculture commodities, which suffered a fractional loss of one-third of 1% for the year.

Apart from agriculture, the other 12 asset classes showed positive returns. That's unusual. Even asset classes that are not highly correlated with U.S. stocks performed strongly. Commodities, muni bonds, and gold showed gains.


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The S&P 500 traded sideways in 2015 and most of 2016, hitting two downdrafts along the way. After the November 2016 election, stocks broke out and rose steadily to an all-time peak on September 20th, 2018.

Over the next three months, the S&P 500 declined on growing fears of an economic slowdown, yet the Fed announced that it would stick to its plan to hike the rate at which it lends to banks to 3%, and hiked rates a quarter point on December 19th, which triggered a sharp selloff.

Selling of stocks accelerated in mid-December, and by Christmas Eve stocks had plunged -19.8% from their peak, technically qualifying as a bear market.

On January 4th, 2019, the Fed signaled rates were on hold, whereupon stocks rallied for seven months, putting in a new record high on July 26th, 2019.

In addition to the worries created by the Fed's hiking rates throughout 2018, the trade war with China added to volatility.
After the President's statement on March 1st, 2018 that "trade wars are good and easy to win," stocks often were whipsawed after the President's tweets about the details and timeline for tariffs on Chinese imports.

Over the last five years, including dividends, the S&P 500 total return index gained +73.9%.

The five yearaverage annual of 14.8% is nearly 50% over the stock market's average annual total return of approximately +10% going back 200 years, as described by Wharton professor Jeremy Siegel in his seminal book, Stocks for the Long Run.


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Growth was the dominant propellant in this five-year stretch of the bull market.Whether a company classified as small, large,or mid-cap was not so important. Stocks with the best expected earnings growth were favored. Value returns over the five years were in line with their historical norm.


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Riskier stocks with high growth rates were favored in the five years ended December 31, 2019. As a result, the technology industry sector returns, dominated by Facebook, Amazon, Apple, Netflix, and Google, towered over all other sectors.


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The dominance of the U.S. stock market in this 60-month run shows up clearly in this chart. The S&P 500 gained 73.9%, more than double returns on European stocks.


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Across a wide range of 13 asset classes, U.S. stocks showed a 73.9% total return in the five years ended December 31, 2019. That's more than twice the returns of any other investment across this diverse group of indexes representing different asset classes.

U.S. stocks are the key growth component in a diversified portfolio. They are the risk asset in a growth portfolio, a key part of a basket of investments that must be designed strategically to help an investor stay with a long-term portfolio through bad times, since no one can know if the next five years will be as good to stocks as the last five year.


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1st Quarter 2020
3rd Quarter 2019
2nd Quarter 2019
1st Quarter 2019
4th Quarter 2018

This article was written by a professional financial journalist for Pacific Financial Strategies Inc and is not intended as legal or investment advice.
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