The LTWM Insider - Market and Economic Commentary Q1 2019
The first quarter of 2019 has proven to be a retracement of the sharp negative volatility of stocks during the fourth quarter of 2018, and it turned out to be the best quarter for U.S. stocks in a decade. It was an impressive turnaround in a short period of time; and another reminder that we don’t change investment strategies when faced with short-term negative volatility in stocks.
The Federal Reserve Board has issued guidance that is much more accommodative to stocks since economic data out of Europe and China was below expectations. Once again it appears the force of deflation is stronger than the force of inflation, which leaves plenty of time for the Fed to keep interest rates low. In addition, the news flow out of the trade talks between the U.S. and China continues to be positive with the two parties moving on from the trade agreement details to enforcement of the treaty. We could see the completion of the trade treaty during the second quarter.
Economic data for the U.S. continues to be positive with very low unemployment, continued job creation and low interest rates. The probability of recession in the next 12 months is low.
For those who want to dive deeper into our market and economic commentary:
World Asset Class 1st Quarter 2019 Index Returns
First quarter index returns were very strong for U.S., international developed, emerging market stocks, and global real estate stocks. U.S. and Global Bonds did well with the significant change of hawkish tone from the Fed and the corresponding drop in the yield curve. For the broad U.S. stock market, the first quarter return of 14.04% essentially matched the -14.3% return experienced during Q4 of 2018. International developed stocks gained 10.45% vs. a 2018 Q4 loss of -12.78%. All of the broad equity asset returns were well above the average quarterly returns since January 2001. Even the Real Estate return of 14.07% for Q1, was more than double digits above its average quarterly return of 2.6%. Both the U.S. and Global Bond markets returned close to 3%, well above their average quarterly returns of 1.1%.
A larger sample of asset class returns during the first quarter shows the strong double digit returns, with U.S. real estate stocks among the top performers, followed by the U.S. small cap index and the U.S. large cap index. The size factor premium was positive in the U.S. and International developed markets, but negative in Emerging markets. Additionally, value was weaker than growth in all regions.
Here is a closer look at the 2019 first quarter U.S. stock returns and longer-term annualized returns, where you can clearly see that while small cap stocks outperformed large cap stocks for the quarter, small cap stocks are behind large cap stocks for the past 1,3,5 and 10-year periods, which is unusual. Value stocks are behind growth stocks in the large cap and small cap asset classes for the past 1,3,5 and 10-year periods, which is also unusual. Over time we expect both of those long-term trends to reverse.
We wrote about the probability of the size and value factor premiums being negative for a 10-year period in our last quarterly commentary, https://www.laketahoewealthmanagement.org/news-notes/2019/1/14/the-ltwm-insider-market-and-economic-commentary-q4-2018. The average annual size factor premium is 3.24% and the average value factor premium is 4.82% from 1927-2017, which is sizeable over the long term. The probability of a 10-year negative large value premium is 20.5%, a 10-year negative small value premium is lower at 4.5% and a 10-year negative size premium is a bit higher at 23%. We also know that growth stocks had record inflows for the first quarter of 2019. The SPDR Portfolio S&P 500 Growth ETF (symbol SPYG), which has assets of $4.5 billion, had inflows of $630 million in March, the largest monthly inflow on record for the fund. The fund has a history close to 19 years. While we don’t know when the growth outperformance will cease, we do know that it is a very crowded trade with too many investors chasing recent strong results. We also just witnessed the first of the unicorns to go public (start-up company worth more than $1 billion). LYFT, the ride sharing competitor to UBER, price their IPO at $72 a share and opened trading on March 29 at $87.33. Since then, it has dropped to $71.77, below the pricing of the IPO, as of April 4th, which is not a great sign for other tech start-up unicorns getting ready to go public; and there are well over 100 of them.
The same asset class data for international developed stocks shows the value factor premium is also negative for the 1,3,5 and 10-year periods. However, the size premium is positive over 5 and 10 years for international developed stocks. Also notice during the first quarter that local currency returns were higher than returns translated back to the U.S. dollar. This was due to the weakening of the local currency against a strong dollar during the quarter.
Bond markets around the world were positive due to a sharp reversal from the Fed, moving from a hawkish forecast of raising rates twice in 2019 to a more dovish forecast of not raising rates at all in 2019. The Federal Reserve also signaled ending the balance sheet runoff (not purchasing new bonds to replace maturing bonds), known as quantitative tightening at the end of this summer. This swift change in stance caused a slight inversion in the yield curve and a quick drop in rates in almost all maturities. This was a not a traditional flight to quality, which would normally send high yield bond spreads up, while Treasury bond yields go down. Notice the sharp drop in spreads in January at the right-hand side of this five-year chart of the ICE BofAML US High Yield Master II Option Adjusted Spread (3.90% as of 4/3/19, more details in disclosures below):
Notice the very strong first quarter 2019 return for the Bloomberg Barclays US High Yield Corporate Bond Index at 7.26%, which leads all bond returns for the quarter. Such tight high yield bond spreads is a leading indicator of a strong economy.
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):
While, the fourth quarter of 2018 was a nasty temper tantrum for stocks and high yield bonds, the first quarter of 2019, was almost a complete reversal. U.S. large cap stock indices are now within a couple of percentage point of record highs. The short-term path of the stock market is best described as a random walk and the high stock market premium exists because of the extreme difficulty of timing the market and the potential for sudden corrections that occur more often than we all would like. Anyone who panicked and sold out, or changed strategies, likely cost themselves from achieving a higher rate of return. Maintaining discipline and a long-term focus are critical to success in the management of investment portfolios.
Standardized Performance Data and Disclosures
Russell data © Russell Investment Group 1995-2017, all rights reserved. Dow Jones data provided by Dow Jones Indexes. MSCI data copyright MSCI 2017, all rights reserved. S&P data provided by Standard & Poor’s Index Services Group. The BofA Merrill Lynch Indices are used with permission; © 2017 Merrill Lynch, Pierce, Fenner & Smith Inc.; all rights reserved. Citigroup bond indices copyright 2017 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.
The ICE BofAML Option-Adjusted Spreads (OASs) are the calculated spreads between a computed OAS index of all bonds in a given rating category and a spot Treasury curve. An OAS index is constructed using each constituent bond’s OAS, weighted by market capitalization. The ICE BofAML High Yield Master II OAS uses an index of bonds that are below investment grade (those rated BB or below).This data represents the ICE BofAML US High Yield Master II Index value, which tracks the performance of US dollar denominated below investment grade rated corporate debt publically issued in the US domestic market. To qualify for inclusion in the index, securities must have a below investment grade rating (based on an average of Moody's, S&P, and Fitch) and an investment grade rated country of risk (based on an average of Moody's, S&P, and Fitch foreign currency long term sovereign debt ratings). Each security must have greater than 1 year of remaining maturity, a fixed coupon schedule, and a minimum amount outstanding of $100 million. Original issue zero coupon bonds, "global" securities (debt issued simultaneously in the eurobond and US domestic bond markets), 144a securities and pay-in-kind securities, including toggle notes, qualify for inclusion in the Index. Callable perpetual securities qualify provided they are at least one year from the first call date. Fixed-to-floating rate securities also qualify provided they are callable within the fixed rate period and are at least one year from the last call prior to the date the bond transitions from a fixed to a floating rate security. DRD-eligible and defaulted securities are excluded from the Index,
ICE BofAML Explains the Construction Methodology of this series as:Index constituents are capitalization-weighted based on their current amount outstanding. With the exception of U.S. mortgage pass-throughs and U.S. structured products (ABS, CMBS and CMOs), accrued interest is calculated assuming next-day settlement. Accrued interest for U.S. mortgage pass-through and U.S. structured products is calculated assuming same-day settlement. Cash flows from bond payments that are received during the month are retained in the index until the end of the month and then are removed as part of the rebalancing. Cash does not earn any reinvestment income while it is held in the Index. The Index is rebalanced on the last calendar day of the month, based on information available up to and including the third business day before the last business day of the month. Issues that meet the qualifying criteria are included in the Index for the following month. Issues that no longer meet the criteria during the course of the month remain in the Index until the next month-end rebalancing at which point they are removed from the Index.
ICE Benchmark Administration Limited (IBA), ICE BofAML US High Yield Master II Option-Adjusted Spread [BAMLH0A0HYM2], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/BAMLH0A0HYM2, January 10, 2019.
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.
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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.
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