Looking Back: Key Drivers of Our 2019 Portfolio Performance
What a difference a year makes. Just about every major asset class lost money in 2018. In 2019, that was turned on its head. Pretty much everything went up. A lot. Below we’ve reproduced the chart we included in our year-end 2018 commentary, updated with 2019 returns, to show the welcome turnaround.
It’s fair to say that most investors were surprised by the financial markets in 2019. At the end of 2018, as far as we can tell, not a single Wall Street strategist predicted the 10-year Treasury yield would drop below 2% or that stocks would soar 20% to 30% or more, let alone that both would happen simultaneously.
We don’t make—and our investment process isn’t based on—12-month market predictions. Instead, we incorporate a range of potential outcomes, typically looking out over a medium- to longer-term time frame (five to 10-plus years). We then use a short-term (12-month) time frame to stress-test our portfolios against potentially severe downside scenarios and to ensure their risk exposures are consistent with each portfolio’s investment objective.
Our portfolios reaped the benefits of our multi-scenario, long-term, diversified investment approach in 2019. We also experienced some of the inherent tradeoffs that come with it in any given year or shorter-term period.
First and foremost, the benefits. Simply put, our portfolios meaningfully participated in the surprising global equity market rally. While our balanced portfolios maintained a somewhat defensive tilt, our overall exposure to equities was (and is) still significant.
Similarly, we’ve maintained meaningful strategic exposure to core bonds in our more conservative portfolios as ballast in the event of a recession or an unexpected external shock, such as a geopolitical event that leads to a flight-to-safety.
So, the very strong stock and bond market rallies were a tailwind for our globally diversified portfolio returns in 2019.
… and Tradeoffs
Now for the tradeoffs. In 2019, most of our tactical portfolio positions were headwinds to performance.
As a reminder, our tactical positions are asset classes or investment strategies that look compelling on an “expected return versus risk” basis compared to U.S. stocks and core bonds, analyzed across the range of scenarios we think are reasonably likely to play out over the medium term (a market cycle). If/when we identify such opportunities, we tactically tilt our portfolios to them. Potential opportunities have a high hurdle to qualify as a tactical allocation (a “fat pitch”). And the extent of our tactical exposure depends on our assessment of the probability and magnitude of the tactical opportunity. Finally, even when we have tactical positions, we maintain strategic (long-term) exposure to U.S. stocks and core bonds for diversification purposes—implicit acknowledgement of the inherent uncertainty about the path of future investment outcomes.
Our current tactical positions are as follows: (1) a modest overweight to European and emerging-market (EM) stocks; (2) allocations to lower-risk and/or diversifying alternative strategies (such as our multistrategy alternatives fund and trend-following managed futures funds); and (3) allocations to flexible, actively managed, fixed-income funds and floating-rate loan funds. (We discuss these positions later in this commentary.)
These tactical positions all made money in 2019. But in aggregate they didn’t gain as much as the mix of U.S. stocks and core bonds from which they were funded.
In a nutshell, 2019 was a year in which the benefits of global equity diversification and a longer-term, valuation-driven, tactical allocation approach were not apparent.
Overvalued U.S. stocks became even more expensive while outperforming other global markets (continuing a multiyear trend). And within the U.S. market, growth stocks again trounced value stocks, extending a multiyear winning streak. This has been a headwind to many of our active U.S. equity managers compared to the S&P 500.
In addition, the diversification and risk management benefits of alternative strategies within a traditional balanced portfolio were mostly irrelevant given the very strong performance of core bonds and U.S. stocks. (A traditional 60%/40% U.S. stock/bond portfolio had its highest total return since 1997, and its fourth-highest risk-adjusted return over the past 40 years.)
Finally, our active bond fund managers, broadly speaking, believed it prudent to not take on much interest rate risk or credit risk in their funds in 2019. As a result, most of them trailed the red-hot core bond index, after having meaningfully outperformed it over the prior several years. (All our active bond funds are ahead of the core bond index over the trailing five years.)
At year-end, based on our analysis, we continue to believe these tactical positions improve our portfolios’ risk-return profile and will add value relative to U.S. stocks and bonds looking ahead over the next several years as this extended market/economic cycle plays out.
Looking Ahead: 2020 … and Beyond
As investors (and humans), we think it is helpful to maintain a balanced mindset—to be financially and emotionally prepared for whatever the markets may throw our way in the coming year. (Related to this, it’s critical to be invested in a portfolio whose investment policy and risk profile are aligned with your personal financial objectives and attitudes toward risk.)
In our year-end 2018 investment commentary, we described two very different potential scenarios for the global economy and financial markets in 2019. One was bullish for stocks and bearish for bonds, and the other forecasted stock market losses and bond market gains. We said we thought either type of scenario had a reasonable chance of playing out (as well as other variations) and that our portfolios were positioned and prepared for either one, with a mix of offensive, defensive, and diversifying investments. As it turned out, both stocks and bonds rallied, and by much more than either scenario predicted.
As we look ahead to the financial markets in 2020, there are again reasons for shorter-term optimism—cautious optimism—for stocks. There are also notable risks that could lead to a volatile and challenging year. We list several of the pros and cons below. Suffice it to say, economic and geopolitical uncertainty remain elevated and the range of market outcomes wide.
Some Reasons for Market Optimism in 2020
Some Key Market Risks in 2020
Overall, the economic and global macro backdrop appears to be turning to a modestly positive—or at least benign—trajectory for 2020. However, this is the consensus view as well. Financial markets have already responded very positively to these developments and the improving outlook. The risk of an unpleasant market surprise or deterioration in the macro environment in 2020 shouldn’t be ignored.
Opportunities and Risks Over the Medium Term
Looking beyond the next 12 months, over a medium-term (5–10 year) time horizon, the range of outcomes is still wide, but our confidence around our base case is higher. We see significant headwinds to the performance of both U.S. stocks and core bonds. The downside risk relative to their potential return is high. Hence, as noted above, we are tactically underweighted to both asset classes.
U.S. stocks sport the unappealing combination (from a forward-looking, return-on-investment perspective) of high valuations, in conjunction with high profit margins, and above-normal earnings. History, economic logic, and our scenario analysis strongly suggest this isn’t a sustainable state of affairs. The business cycle and the market cycle haven’t been repealed.
However, we also know momentum and sentiment (driven by central bank liquidity) can extend the current trend still further. Many investors seem to be of the mindset that, “as long as the music is playing, you’ve got to get up and dance,” as Citigroup’s ex-CEO infamously said in July 2007. (Presumably, they also believe they will be able to slip out the emergency exit ahead of the crowd just before the party gets shut down.)
Said differently, valuation is worthless as a short-term market-timing indicator. Overvalued markets can get even more overvalued in the short-term due to investor optimism, greed, and euphoria. The 1999–2000 tech stock bubble is an extreme example.
But valuation—the price you pay for an expected future stream of cash flows—is a hugely important driver of investment returns over the medium to longer term. For example, the Nasdaq index had an annualized loss of 6.3% in the 10 years following its March 2000 peak. And it didn’t reclaim that peak level until mid-2015, more than 15 years later.
Valuation is not 100% determinative of future returns. Nothing is. But it’s a very strong indicator, as shown in the chart. (Note: The chart uses the Shiller price-to-earnings ratio, where earnings are a 10-year average adjusted for inflation. Our internal valuation analysis is not based on the Shiller P/E or any single valuation metric. But the Shiller P/E is well-known and captures the longer-term relationship between starting valuation and future return reasonably well.)
With U.S. stocks expensive and high risk, we continue to see better investment opportunities elsewhere: in foreign stocks, flexible bond funds, and selected alternative strategies.
European and EM stocks are a kind of mirror image of the U.S. market. They’ve been out of favor for several years and look relatively cheap on still-depressed (below normal) earnings. Our base-case five-year return outlook for both markets is several percentage points higher than for U.S. stocks (see the Asset Class Return table below).
In the shorter term, should the positive global growth outlook for 2020 play out, we’d expect international and EM stocks to outperform U.S. stocks, given their higher cyclicality and sensitivity to overall GDP growth. To the extent the U.S. dollar weakens in this environment—due to it being a counter-cyclical currency—that will further help foreign stock returns (for dollar-based investors).
Core bonds’ very low starting yield implies very low expected returns over the next five years. Nevertheless, in our conservative portfolios we still maintain meaningful exposure for risk management purposes.
However, flexible bond funds and alternative strategies run by skilled managers are particularly attractive in this low-return/high-risk environment. We own funds run by investors with the expertise to actively manage their portfolio risk exposures (e.g., dialing down risk when the reward is not commensurate) and the ability to take advantage of market inefficiencies and opportunities when they appear. Not only do these strategies provide valuable portfolio diversification, but we also expect them to deliver better medium-term returns than a traditional mix of U.S. stocks and core bonds.
These tactical opportunities are relatively attractive, but none of them are without their own risks. There are few table-pounding, valuation-based fat pitches in the investment markets these days. Ten-plus years of unprecedented central bank stimulus and interest rate repression have inflated the prices of most financial assets … if not the actual global economy.
Given this backdrop—weighing the shorter- and medium-term risks and return opportunities and considering the economic fundamentals against market valuations—we think the wisest course for balanced investors continues to be a broadly diversified, moderately defensive posture.
The economic consensus seems to be for decent global growth in 2020 and accommodative central bank policy. This would be a supportive environment for stocks and other financial assets. However, to some extent this outlook is already reflected in current market prices—at least for U.S. stocks—especially after the sharp year-end rally. Just look at the 180-degree swing from Fear to Greed, as tracked by CNN, at the end of 2019 compared to a year earlier. A famous Warren Buffett quote comes to mind …
High valuations and excessive optimism make asset prices more susceptible to negative surprises. The U.S. election and evolving or unexpected geopolitical risks may be the key drivers of market volatility in 2020.
As we said earlier, we don’t make 12-month market forecasts. The uncertainty is too high and the unknowns too many. Market history shows the range of outcomes over such a short time frame is extremely wide.
In our 2018 year-end commentary, we wrote, “No one knows what next year will bring. We may see some continuation of recent market trends or a stabilization or reversal in some of them. The market consensus will undoubtedly be surprised again. The only certainty is the lack of certainty.”
That turned out to be a pretty good forecast for 2019. We’ll stick with it again for 2020.
More important—and most relevant for our investment process—is our outlook for the next several years not months. In this respect, our assessment of the risks and opportunities remains consistent with what it’s been in recent years.
Our portfolios are built to be resilient across a range of macroeconomic scenarios. They are positioned to withstand a severe market downturn (consistent with each portfolio’s specific risk objective). Yet they also provide tactical exposure to asset classes, strategies, and managers we believe currently offer attractive total-return potential over the medium-term (and longer) horizon.
We also remain ready to shift from a relatively defensive to a more offensive posture when market volatility (e.g., a bear market) provides us the opportunity to add to U.S. stocks at much lower prices and much better expected returns. We may or may not get that opportunity in 2020. It may come in 2021. Or 2022. We don’t have to predict when. We follow our investment discipline. We’re confident it will serve us and our clients well, as it has over the past 32 years.
As always, we appreciate your confidence and trust in Litman Gregory. We wish everyone a happy, healthy, and peaceful New Year.
—Litman Gregory Investment Team (1/7/2020)
Commentary from Our CIO—Second Quarter 2021
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Research Update: Increased Return Expectations for U.S. Stocks
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