On Christmas Eve of 2018 the S&P 500 was down close to 20% from its market peak. With corporations continuing to report strong earnings throughout the sell-off, many analysts thought the market was starting to look reasonable – practically a bargain. Ever since then, the S&P 500 has done very well. In fact, the 31.49% S&P 500 2019 return represented the best year for the that index since 2013 when it was up 32.39%. As I write this letter, the S&P 500 Price-to-Earnings Forward (next 12 months of estimated corporate earnings) ratio is 19.65 while one year ago we were at 15.15, which is the long-term average P/E for the S&P 500. Obviously, investors feel more comfortable with P/E multiples near the historical average of 15 last year, but let’s hope corporate earnings - the denominator in our P/E ratio - stay strong and possibly increase over this next year. Strong earnings would force the P/E ratio lower…potentially back to the long-term average. Should earnings surprise us to the downside, we could see stock prices fall as the P/E ratio would look even more inflated.
The stock market was off to the races in January and seemed to never look back. Some of this price increase was attributable to the Federal Reserve telegraphing that they would be more accommodative due to the trade disputes with China and they followed through by cutting their rates by 0.25% three different times throughout the year. You will recall that they were increasing rates back in December of 2018 (some viewed the last one or two increases in 2018 as a mistake). As the lower Federal Funds rate did its thing and the demand for bonds increased throughout the year, intermediate and longer-term bond yields decreased. Thus, to get any kind of yield out of securities, one would need to take more risk and invest in the stock market.
The other tailwind for the stock market was progress on the China vs. the US trade war. Phase one of this deal was just signed yesterday and helps partially resolve the 18-month dispute. However, many believe the low hanging fruit was picked in phase-one and the more difficult disputes like intellectual property rights, cyber-protections, subsidies and state-owned enterprises will be more difficult and take longer to resolve. I wouldn’t be surprised to see the second phase take place after the election.
Let’s take a detailed look at how your portfolio performed in 2019. Depending upon your portfolio’s size, most of you will own the securities mentioned below.
Fixed Income: Anyone with fixed income in their portfolio did well in 2019. Overall the intermediate bond funds we hold averaged a total return of 7-8% while our short-term bond funds/ETF’s had average returns of 6%. The ultra-short PIMCO Short-Term returned 2.73%. Even the Schwab Value Advantage returned a little more than 2% last year; currently it is yielding 1.52%. Anytime we earn more than 3-5% with our bonds, it is a good year. I would expect to see the 3-5% average returns for bonds in 2020.
Large-Cap Domestic Equities: At least 34% of your equity exposure is in the Schwab Total Stock Market or S&P 500 index. 2019 proved to be the best year since 2013 with the Schwab Total Stock Market index up 30.88% and the Schwab S&P 500 up 31.44%. Vanguard Dividend Growth tried to keep up with the large-cap indexes as it was up 30.95%. Warren Buffett’s Berkshire Hathaway was only up 10.93%, but Morningstar considers it to be 10% undervalued as I write this. Last but not least, PRIMECAP Odyssey Growth, underperformed the index as it was only up 23.97% with their health care taking a toll on the fund. I’m willing to ride these same securities into 2020. I believe Vanguard Dividend Growth and Berkshire Hathaway are equity backstops should the market drop and there is some upside potential left in the PRIMECAP Odyssey Growth as healthcare makes up 30% of this fund.
Mid and Small-Cap Equities: Our mid-cap exposure performed as I would have hoped this year. For those of you with Vanguard Selected Value, you saw this fund return 29.54% in 2019 and beat the underlying mid-cap value index by close 2.5%. The Schwab US Mid-Cap ETF was up 27.47% to meet the mid-cap index benchmark. Our Small-Cap stock funds, Vanguard Tax-Managed Small-Cap and Schwab U.S. Small-Cap ETF were up 23.28% and 26.49% respectively. These two holdings follow different indexes, so I wasn’t too surprised with these results.
Foreign Equities: Our largest holding in the international space is First Eagle Overseas. This fund trailed their benchmark in 2019 as well as over the past three years - I will continue to watch First Eagle in 2020. That said, we must be careful of selling something just because it is trailing the benchmark over a shorter time period. If a fund is trailing their respective benchmark over the past 10 years, it may be time to part with that fund. Ever since the start of the bull market in 2009, value stocks have underperformed. First Eagle (up 17.91%) and Oakmark International’s (up 24.43%) holdings define value, or deeply discounted stocks. Until value comes back – and some day it will – value will most likely underperform. Vanguard Global Wellington exceeded my expectations in 2019. The one-year old, 65% global stock portfolio was up 22.15% in 2019.
Outlook: I believe we started 2019 at an artificially low point and some of the gain we received in 2019 brought us back to more reasonable valuations when one accounts for corporate earnings. Looking forward, I could see more volatility occur as the negotiations on phase two of the China vs. US trade deal play out within our Twitter accounts. As everyone knows, we have a presidential election in November of this year. While the market could react to certain candidate proposals in the short-term, I would ask that you look at the long-term time horizon as we approach the election (if you have not read my third quarter 2019 letter, I would suggest you pull it out of recycle bin and take a look). This economy may have more room to run or we may hit an icy patch and end up in a recession. Many analysts I follow suggest a high single-digit US stock market return in 2020. If that proves to be the case – I’ll gladly take it. The foreign equity market is supposed to be better valued, but we have been hearing that for the past 10+ years. I will believe it when I see it. Regardless, our equities continue to be predominantly centered in the US with about 20% of our holdings in deeply discounted international equities.