KCS Quarterly Market Review for Q4 2019
January 31, 2020
2019 was a year of unusually strong returns for both stocks and bonds, with the MSCI All Country World index and Barclays Global Aggregate bond index returning +26.6% and +6.8%, respectively. While most pundits expected bonds to do well as the global economy slowed, virtually no forecaster expected equities to shine as they did. KCS was in the minority early in 2019 when we said that “…a continued stock market “melt-up” is not out of the question.” Fortunately, KCS portfolios were positioned to benefit from rising equity markets.
For 2020, virtually all forecasters see a year of decent, but below average, returns for both equities and bonds. KCS believes that 2020 could again surprise on the upside with solid double-digit returns for global equities (though not as strong as 2019), owing to accommodative central banks, gradually accelerating global economic growth and at least a temporary truce in the trade war. Meanwhile, we think individuals invested in longer-term government bonds are likely to be disappointed; for this reason, KCS fixed income portfolios are mostly avoiding these types of investments. (Note that the recent stock market decline related to the coronavirus from China has not altered our view as of this time. We will write a separate update on this shortly.)
We continue to favor international equities over their US counterparts, owing to both more attractive valuations and the likelihood that the US dollar declines in value relative to other major currencies. On the fixed income side, we are emphasizing shorter-term bonds and those poorly represented in the broader indices in order to weather the increase in interest rates that we expect. Overall, while a recession and bear market are no doubt in our future, we think that they won’t occur until after 2020.
A Brief Update on KCS
2019 was also a year of significant growth and evolution at KCS. We added two more talented employees to our ranks; our clients’ accounts performed strongly, both relative to their benchmarks and against our long-term return assumptions; and our business grew briskly, with assets under management increasing approximately 38% during the year. This large increase resulted both from strong market returns and a number of additional clients. We welcome these new members to the KCS family.
For KCS, 2019 was also significant given the number of valuable service enhancements we were able to bring to our clients. We are thrilled to now be able to trade most securities with zero transaction charges. This enables us to reduce costs to clients, improve returns, and unlock several new opportunities, such as the ability to invest in individual stocks at a lower account size. We’re also pleased with client reception of our short-term fixed income strategy, which enables our clients to invest their idle cash in a portfolio of shorter-term bonds that pays a higher yield than money market funds. Finally, we’re pleased with new software we added this year, such as eMoney for financial planning, and with our improved processes, including a new year-round tax loss harvesting program. We are confident that these new systems and services will all help drive better client outcomes in the years to come.
The 4th Quarter in Review
2019’s robust equity performance continued unabated during the fourth quarter, with global equities experiencing their second strongest quarterly return since 2013. Stocks were lifted particularly by the resolution of several key concerns that had been hanging over the markets last year. We mentioned two of them last quarter:
Either a signed US-China trade deal or a Brexit conclusion could move global stock markets several percentage points higher, as worst-case scenarios are replaced by more positive outcomes. All sides in the various negotiations surely know this by now, and both problems are completely manmade and solvable with the right motivations. Hopefully, the recent positive market reactions to minor victories have encouraged the parties involved to reach amenable outcomes.
Ultimately, both of these issues were resolved in a manner that reassured investors. In the UK, December elections gave a resounding victory to Prime Minister Boris Johnson, solidifying Brexit but also eliminating the risk of a no-deal crash out of the EU (which the markets dearly wish to avoid). In the week following, British stocks rallied +6%. Meanwhile, here at home, US trade negotiators secured a truce with their Chinese counterparts, delaying further tariffs and opening the door for some tariff rollbacks contingent on achieving certain milestones.
The resolution of these worries led the MSCI ACWI (All Country World index of equities) sharply higher, finishing Q4 with an +8.9% gain. This performance trounced returns on global bonds (as measured by the Barclays Global Aggregate index), which rose by just +0.5% during this same period. For the full year, these indexes of stocks and bonds returned +26.6% and +6.8%, respectively—recouping the losses they experienced during the latter part of 2018 and then some.
We noted at the beginning of 2019:
Perhaps most significantly, some of the best market gains in a cycle occur during its final year or two, meaning that a continued stock market “melt-up” is not out of the question.
While it doesn’t feel like we’re in “melt-up” territory just yet, there are certainly pockets of irrational exuberance today. (A market melt-up occurs when prices surge broadly for a meaningful period of time, such as we saw in 1999 – 2000 at the end of the dot-com era.) We are keeping a watchful eye this year for excessive speculation and other signs that the 11-year-old bull market is nearing its conclusion. While the secular uptrend that began in 2009 is likely far from over, a bear-market pause (meaning a drop of at least 20% in the major equity indexes) may occur in the next year or two as valuations become progressively richer.
During the 4th quarter and throughout the year, KCS’ portfolios were positioned to benefit from a rising equity market and higher interest rates. Our equity performance was aided by our individual stock selection, only partly offset by the drag from our greater international exposure relative to the benchmark. In fixed income, we benefitted from owning bonds with higher yields than the Barclays Global Aggregate benchmark and the tightening of credit spreads, while our positioning in shorter duration bonds weighed somewhat on performance as interest rates fell.
Looking forward to 2020 and beyond
We started last year with three assumptions:
- Many sectors of the market are already pricing in a near-term recession, making them attractive even if we experience an economic dip.
- Markets rarely fall for two years or more in a row.
- This expansion (and bull market) may still have room to run.
We’re pleased that 2019 worked out on all three counts. Equity markets were strong last year, with US markets performing especially well, closing out a decade during which the S&P 500 outperformed its historical averages (see chart below). Notably, the S&P 500 still lags its 20-year average by a considerable margin, owing largely to very high initial valuations during the tech bubble. Yet even investing in equities just 2 months before their all-time peak valuation in March 2000 resulted in a respectable 20-year return of +6.1% per year. To us, this illustrates the long-term attractiveness of equities, even when the starting point isn’t ideal. Another point to note is that future returns, while likely to be below those of the past decade (as we argue below), may yet be quite reasonable, as US equities still have a lot of catching up to do from the poor returns of the 2000-2010 decade.
Source: Standard and Poors
Fortunately, today we’re nowhere near the extremes of 2000, yet US valuations are nevertheless becoming rather frothy. The table below shows this succinctly, ranking the S&P 500’s valuation today relative to its own history. On almost every metric, the S&P 500 is trading near the top of its historical valuation range. This leads us to say with some confidence that future US stock returns are unlikely to be as strong as they have been over the past decade.
Source: Goldman Sachs
On the other hand, international markets continue to be more reasonably priced, with valuations on average about 35% cheaper than the US, and economies that are in many cases at a much earlier stage of economic expansion. We see a tremendous opportunity for a catch-up as international equity valuations start to converge with their US counterparts. On top of this, we foresee an additional tailwind for non-US equities as the US dollar weakens vis a vis other major currencies.
The table below shows just how far behind US equities foreign market performance has been over the past decade. The first 4 bars show the annual returns of various US stock market indices. The fifth bar represents developed non-US markets, while the one on the far right shows emerging market equities. Returns for the latter two are shown both in local currency and in US dollars.
Note two things: First, these international equity markets have lagged the US by anywhere from 4% to 11% per year since 2010. Second, a strengthening US dollar subtracted around 2% per year from their performance for a US-based investor. Clearly, non-US markets lagged the US over the past decade, and the stronger dollar magnified this underperformance for the US investor. This contrasts sharply with the recovery from the dot-com bust during 2002 – 2007, during which non-US stocks, both emerging and developed, significantly outperformed the US equity market.
There is one constant in market trends—they always end. It’s not unusual for one sector of the market to underperform or outperform for one to several years, only to suddenly “revert to the mean” in subsequent years, becoming a star or taking back some or all of its stellar performance.
The table below illustrates this, showing annual performance of various asset classes since 2000, with the best performers on top and the worst at the bottom. We know you can’t read the words unless you can enlarge the chart—look instead at the colors and note that there are stretches of one color (for example, light green or light grey) at or near the top for several years, which in later years disappeared into the middle or even dropped to the bottom.
Source: Fidelity Investments
We anticipate a similar fate for the top performers of the past several years (most notably, US technology). Yes, the trend is your friend—until it isn’t. We believe in hedging our bets, not putting all our eggs in just one or a few baskets, and looking for undervalued areas of the markets that we believe are likely to be future stars. Successful investing means aiming toward the future rather than making decisions by looking in a rear-view mirror.
What does KCS expect from the equity markets during the next 12 months? We find it interesting that virtually every forecaster expects stock prices to increase between 5% and 10% this year, a much greater clustering than we usually see. As forecasters are rarely correct (how many foresaw a nearly 30% rise in equities back in January 2019?), we think there’s a high likelihood that the stock market does something completely different in 2020, either falling modestly (less than 10%), or rising well into the double digits. For a number of reasons, including the history of secular bull markets, the favorable interest rate environment, and recent economic data hinting at accelerating growth, we believe that a strongly rising market in 2020 is more likely than a single-digit percentage move in either direction.
Moving on to fixed income, we opined six months ago on the apparent lunacy occurring in some parts of the global bond market. We showed the 2-year government bond yields of several countries in comparison to the US and pointed out that some of these countries were being paid to borrow money for up to ten years. Things have corrected somewhat since then, with US yields falling and interest rates mostly rising elsewhere (see the table below).
During 2020, we expect interest rates to gradually rise, both in the US and overseas, especially in longer-term bonds, even as central banks stand pat on short-term rates. This will result in a “steeper” yield curve (longer-term rates meaningfully higher than short-term rates), which is beneficial to equities but harmful to long-term, low-yielding bonds. Almost every country on the list below remains in negative territory, which is not sustainable in the long run. As interest rates rise, we expect a lot of carnage in the low yielding, long-duration assets held by many passive products such as ETFs. KCS’s fixed income positioning currently emphasizes higher-yielding and shorter-duration bonds that should weather the coming interest rate increases far better than most longer-duration bonds, funds and ETFs.
Sometime last year, a clever investor said to us, “The world is upside down—people are buying stocks for income and bonds for capital appreciation.” While only partially true, it does reflect the effects of extremely low bond yields and the feeling among many investors that they would go even lower. (As the table above illustrates, last year that sentiment only proved true in the US). Yet interest rates remain historically low in most countries, causing us to avoid large areas of the fixed income market while we await further interest rate increases.
Among equities, the overvaluation of US stocks relative to the rest of the world continues to both concern and intrigue us. As the next 10 years are unlikely to be a repeat of the previous decade, we remain overweight in non-US opportunities and in sectors and individual stocks that appear undervalued. We believe that our international overweighting, rigorous stock and fixed income selection, and our interest rate positioning will serve as potential sources of outperformance in the years to come.
While we don’t expect the next decade to deliver the gangbuster returns of the past 10 years, we do believe that the 2020s will be rewarding to persistent and patient investors. We enter the new decade excited about the opportunities in front of us in both the financial markets and in our ability to deliver greater client value. We thank you for entrusting us in your journey through life as we strive to provide the exceptional service and peace of mind that each of you deserves.
The KCS Wealth Investment Management Team
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