In this edition of Chartology, Chris Maxey of the Investments Team discusses an exceptional 2019, some of the market trends at play throughout the year, and the importance of reframing expectations going forward.
We thought that the start of the new decade and the start of a new calendar year was a good time for us to reflect back on a couple of things that we’ve seen happening in the market and provide a bit of perspective as we move forward.
One of the things that we have spoken about in the past and that we’ll bring up again is the percent of eight major indices that have a return greater than 1%. Why do we ultimately care about this? Well one of the reasons is that as we build portfolios, as we introduce asset classes into our portfolios, the hope is that we’ll have some things working, some things not working, and that the blend of all of those things will ultimately result in a good experience for clients and for investors. What we saw in 2018 was frankly, that was not the case. In 2018 there was nothing that really made money, no matter where you were investing across stocks, bonds, commodities, REITs, none of those asset classes were particularly beneficial.
In 2019, we’ve actually had the opposite case. Every one of those asset classes was up, and in some cases, rather significantly. So, 2019 was a very good year and 2018, not so much. Where does that leave us though as investors? If we reflect on what the experience was like for a balanced portfolio, so someone that might be invested in this case, 50% in equities and 50% in bonds, 2019 was an outstanding year. We see that a portfolio that doesn’t include trading or fees or any other expenses, would’ve been up about 20% in that construct, which was as good as we’ve seen going back to the mid to late 90s. In fact, it was as good as we’ve seen since 1997, and so we don’t necessarily want to say that we’ll never repeat this experience again, but we do want people to understand that 2019 was exceptional.
The other thing that we’re having to remind ourselves of – we run into this problem, we see that clients struggle with this sometimes – is that losses will occur even for diversified portfolios. As you look at the blue dot, what that represents is the maximum drawdown in any calendar year for that 50/50 portfolio, and while outcomes of down 20%, or down 30% are incredibly unusual and not likely based on historical experience, drawdowns of 5, 10, 15% are certainly common and should be expected. We’ve been the beneficiary of not having to go through that in 2019. Same thing in 2017 – we didn’t have to go through that. 2018 was somewhat of a different story. But we do want people to reassess and think about “Am I comfortable, based on my current situation, with the possibility that I could lose 5, 6, 7, 8, 9, 10, 15%?” If you’re not, now is the time to rethink your portfolio allocation and to have a conversation with your advisor as to what you are comfortable with.
As we turn the clock forward and talk about where stocks are, where bonds are, this is where the story is certainly going to get a little bit tricky. As we look at U.S. equity market valuations, we have two charts here. One is the price-to-earnings ratio for the S&P 500, the other is the price-to-cashflow ratio, and then we also show the 20-year averages for both of those metrics. We look at this data across small cap stocks, mid cap, U.S., international, across any number of sectors. We really want to focus on the S&P 500 today, for the benefit of brevity. What you will see is that on these valuation metrics, on other valuation metrics, the market is above its long-term average.
Now that really shouldn’t be surprising after we had such a good year in 2019, but what I would also point out is that, while we might be above average, that doesn’t necessarily mean the market can’t go higher. There is past precedent for the market continuing to move higher despite valuations being already high, but what it also suggests is that as we look over longer time frames, whether we look at 3-, 5-, 10-, 15-year time frames, right now is a good time to reassess our return expectations. Whereas in the past we could have maybe assumed that because valuations were low, we would get a higher return. Now we’re going to have to operate with the mentality that valuations have moved above their long-term averages, so maybe there is still some upside participation left, but the reality is that as we look over longer time frames, return expectations are going to be down from where they have been in the recent past.
The other area that’s also going to be a little bit tricky is within the fixed income space. What we show is something that we’ve talked about in the past, which is using the starting yield as a gauge for future returns. What this tells us is that your starting yield tends to be what your return experience is as you move forward. You see the two lines, the shaded area, and then the 10-year period starting yield line graph itself. You’ll notice there is a very strong relationship between those two. Right now, because of where we’re at, the return expectation on the bond market is certainly lower than what we would have seen last year. So, coming into last year yields were higher, and by extension, return expectations had actually begun to increase. Now as yields have fallen, it’s certainly good if you’re trying to refinance your mortgage or if you’re trying to borrow money, but it’s not necessarily so good if you’re a saver, you’re an investor, and you’re trying to find a place to house your existing cash or fixed income assets.
We know that 2019 was an exceptionally good year. We’re certainly happy to have that outcome, but does it come at the expense of what’s to come in 2020 and beyond? We don’t know yet, but we certainly think that now is a good time to reframe our expectations and rethink the way that we’re building our portfolios. This is a great time to have a conversation with your advisor about how we’re thinking about portfolio construction and how we’re thinking about investing right now.