As we celebrated America's independence on July 4, we also cheered the sizable rebound that the financial markets have enjoyed in 2019. It's been a pretty amazing run, to be sure, with the S&P500 up 19% year-to-date.
At the same time, we can't help but question why our account balances aren't dramatically larger. We need to remember back to the end of 2018. Stocks had been on the decline for more than three months, including a 4000 point drop in the Dow Jones Industrial Average in December alone. At that time, the Fed was undertaking a steady program of interest rate increases, Trade wars were accelerating, and corporate profits appeared to be peaking. The stimulative effects of tax cuts had begun to wear off. The bond market was signalling recession with an inverted yield curve.
It added up to a pretty ugly package, and investors headed to the exits... We reminded our clients to keep a long term perspective, and since that time, we've retraced those declines and added a bit more.
By January, the Fed had begun to change its tune, sending a signal to investors that they weren't so hardheaded as to raise rates in an already slowing economy. More recently, expectations have been more focused on a rate cut. While recently strong labor market statistics call into question when the next cut might be, the bottom line is that the Fed is being accommodative. And that's a good thing for stocks.
With this backdrop, the glass is half full again. Corporate profits don't look that bad and the trade wars just might get settled. Large cap stock indexes are making new highs again.
But is it really "all clear"? We have some concerns that we'll describe below, and a way that investors can address them.
Indicators are mixed: The yield curve is still inverted, with the yield on a one-month T-Bill yielding more than a 5-year Treasury Note. This indicator has correctly signaled each of the past six recessions. It says nothing about timing of that recession, but the yield curve is in an unusual state at the present, essentially signalling low inflation expectations in the future -- which investors translate into indications of slowing economic growth. Corporate profits are also indeed slowing, as are home and auto sales. Again, these are not recession indicators. But they are clear signs of a loss of momentum.
Trade is still a wild card: Nearly every one of America's major trading relationships is in flux. China... Europe... The hot spot moves around. But our largest trading partners are in our own hemisphere, too. And the NAFTA replacement (USMCA) still needs to be ratified by the US, Mexico and Canada's legislatures. There is both economic and market risk inherent in trade wars, owing to their unpredictability. The markets are sanguine about this at the moment. But with valuations at the high end of their historic range, the market could be vulnerable to bad news on the trade front.
Bull market underpinnings have some holes: Recessions aren't necessarily bad for stocks. But there's reason to believe that this one might be. Thanks to the corporate tax cuts, companies have been huge buyers of their own shares. But if corporate profitability declines due to a recession, so too will the cash flow available for share repurchases. Company stock buying has been a bigger underpinning of the bull market than most investors believe.
Companies have added a lot of debt in recent years, too. Those debt service costs stay the same when sales decline, possibly exacerbating the decrease in cash available for share repurchases. The good news is that the recession indicators are still few, and investor flows in to funds and ETFs have accelerated of late. And while investors are recognizing that 2019 corporate profits are showing some weakness, they are already looking out to fiscal 2020 earnings.
We're surely not suggesting that long-term investors exit their stock positions. But our muted expectations for US equity returns are colored by high valuations and the lateness of the economic cycle. We're modeling 5-7% returns per annum over the coming decade. (The short term is anybody's guess.)
For portfolios with oversized equity positions versus long-term strategic targets, it makes sense to bring those allocations back in line -- especially in light of recent performance and possible risks we've described above. We also believe that investors should open their eyes to private investments. Whenever possible, investors should seize the opportunity for equity-like returns (8-10% per annum) when it's not connected to equity market risk. That's Portfolio Management 101 -- find investments whose returns aren't totally correlated to the same factors.
For those investors who can tolerate the illiquidity of such investments for part of their portfolio, we believe that private investments in renewable energy, private equity and multifamily real estate (specifically in affordable housing) are attractive long term holds for impact-oriented and traditional investors alike.
We welcome questions and comments.