What a difference a year makes. During the fourth quarter of 2018 stock markets were incredibly bad as most major indices were down an average of 15% (with the S&P 500 briefly losing more than 20% intra-quarter). By comparison, the fourth quarter of 2019 was exceptional as average stock market returns exceeded 9%. This was a well-above average quarterly return that capped a strong stock market for the entire year. The NASDAQ was the best forming index (both quarterly and annually) as the most recent three-month return was 12.49% and the twelve-month return was 36.74%. This index was overwhelmingly supported by the excess valuation developing in the top five holdings of the index (Apple, Microsoft, Facebook, Alphabet, and Amazon). This group of stocks commonly referred to as FANG stocks account for a 29% weighting of the entire NASAQ and about 50% of the annual return of the NASDAQ Index. Although 2019 was dominated by the large cap companies listed above, the fourth quarter was characterized as a more “normal” market as other asset classes also performed well. In the fourth quarter the Russell 2000 Small Cap Index was up 9.93%, the Russell 1000 Large Cap Index was up 9.03%, and the MSCI EAFE (international) Index was up 8.23%.
However; many investors failed to fully participate in the major rebound of 2019. Two significant developments scared investors (i.e. sold stocks and held cash) into underperformance. First, the dramatic decline in the fourth quarter of the previous year shook many investors out of the market at precisely the wrong time as they sold in a panic. D’Arcy Capital was committed to a full investment strategy entering 2019 as we correctly identified the intra-quarter (4th quarter 2018) decline by the S&P 500 of 20% as the healthy correction the equity markets needed (see D’Arcy Capital Q2 Economic Perspective). Second, as the summer of 2019 was coming to an end, the yield curve briefly inverted (short-term government rates were yielding more than long-term government rates). Many stock market participants, economists, and investment firms interpreted this event as an imminent precursor to recession and again sold stocks at the wrong time. And again, D’Arcy Capital established a contrarian opinion that the inversion was an anomaly and would not lead to a recession (see D’Arcy Capital’s Inverts, Kinks, and Humps September 20, 2019). Although 2019 was an exceptionally strong year for stocks, it might have benefited the smallest amount of investors. It took committed analysis to “wade” through all the contradicting inputs.
For 2020 it is vital that investors do not view the stock market as a singular entity. There is a minority portion of the stock market that presents above average risk and below average potential returns (large cap growth technology stocks) and the majority of the market that presents below average risk and above average potential returns (almost everything other than large cap growth technology stocks). Unfortunately, the narrowing of high performing stocks and the proliferation of passive index investing has pulled many investors unwittingly into the stocks and indices with the most risk. Investors have been “lulled to sleep” by a handful of popular stocks. D’Arcy Capital encourages investors to wake up and reconnect with diversification, risk management, and historical asset class returns. D’Arcy Capital will be focused on exploiting high potential asset classes and defending against high risk asset classes.
D’Arcy Capital has distilled the most important concepts for 2020 into the bullet points below:
- Stay active and cease being passive. Stay active in fund, sector, and individual stock selection. Stay active in risk management and asset allocation. Stay active in your thought process and avoid group think.
- Invest in small and manage large. Small cap stocks have underperformed large cap stocks for the last 10 years. This is historically abnormal. Include small caps in current allocation.
- Look to foreign investments relative to domestic investments. Both developed international and emerging market sectors are much less (price-to-earnings) expensive than U.S. based stocks
- Focus more on risk and less on return during good times. During high performing markets investors tend to focus on returns and in declining markets investors tend to focus on risk. It is the other way around.
- Look forward 10 years not backward 10 years. What provided excess investment returns the previous 10 year probably won’t be same sources of return in the future. The S&P 500 (passive investment) provided substantial returns from 2009 to 2019 (13.54% annualized). Investors forget that the previous 10 years was known as the zero return decade from 1999 to 2009 (-.95% annualized)
- Favor value stocks and reduce exposure to growth stocks. The Russell 1000 Large Cap Value Index has an average price-to-earnings ratio of 16.93 times and a yield of 2.50%. The same measures for the Russell 1000 Large Cap Growth Index are 28.35 times and 1.10%
- Stay short not long. Use short duration bonds and avoid long duration bonds. Underweight U.S. Treasury bonds.
- Don’t overlook municipal bonds. Tax-free municipal bonds still provided a very competitive return for fixed income investors. With tax minimization techniques continuing to disappear, municipal bonds over an excellent alternative. Should also perform better during climbing interest rates.
- Manage for inflation and not for a recession. Investors are still concerned with recession probabilities (because that was the most recent major market disruption) and are underappreciating inflation potential. The Federal Reserve is actively targeting a higher inflation rate. Don’t fight the Fed.
It is very difficult for humans to perceive the “good times” while they are in them. Did Americans know the roaring 1920s were roaring while they were experiencing them or only after the Great Depression began? Don’t know. It would serve investors well to understand we are currently in some pretty great times economically (high market returns, solid corporate earnings, low unemployment, low interest rates, low energy prices, and stable prices). Although pockets of risk do exist in the stock market the overall economy is very positive. The old expression “make hay while the sun is shining” comes to mind. It might be a good time to plant some hay seeds and listen for a roar in the 2020s.