September 30, 2019 Market ReviewSubmitted by Karstens Investments on October 30th, 2019
by Michael D.Karstens, CFP ®, AIFA ®
Pressured by the ongoing U.S. - China trade war and fears of slowing global economic growth, stock returns generally moved sideways in the third quarter. U.S. stocks, as measured by the S&P 500, eked out a small gain of 1.7%, while the EAFE (Europe, Asia, Far East) fell about 1%. Developing markets suffered a bit more and were down 4.3% for the quarter. Year-to-date numbers through the end of September looked much more impressive with most major indexes sporting double-digit gains. For the year-to-date, the U.S. was once again the leader, posting a gain of 20.55%. The EAFE has also posted solid returns and is up 12.8%. Developing markets have been hurt by the slowdown in China and soft commodity prices but still managed to gain 5.4% for the year through September. All is great, right? We would say that the past 12 months or so is a perfect example of why putting too much emphasis on short-term performance is a waste of time. While the year-to-date numbers look very respectable, they certainly don’t reflect the massive selloffs that occurred in the fourth quarter of 2018. If you look at one-year numbers, as shown on page six, small U.S. stocks have actually posted single-digit losses, international stocks are down slightly, the NASDAQ is flat and the S&P 500 is up very slightly. We have always felt it is best for investors to look at results over longer periods of time, which helps to weather short-term market swings.
As we look ahead, there’s obviously a great deal of uncertainty that investors face. As a matter of fact, based on what investors are relaying to me in meetings, there is more uncertainty than at any time that I can remember. Common themes of these worries are really based on four critical areas. The first is that the economic expansion is in the tenth year, and people believe we may be ready for a recession. Secondly, a lot of people are concerned about the trade talks and ongoing tariffs and some of the uncertainty that those cause. Third, excessive debt levels both at the government level and the corporate level continue to cause concern especially if the economy would fall into recession. And finally, not only the U.S. political environment but also the international political environment seems to be as caustic as one can remember. The chart above is a graphic illustration of how elevated levels of uncertainty are today. It seems like the media is filled with these stories and I probably don’t need to go into too much detail as we are bombarded on a constant basis at least in regard to each of these issues.
From an investment standpoint the combination of these concerns makes for a very interesting mix. Historically there have been a few ways to protect from potential recession, market downturn, or worse. Cash, CDs, treasury bills and high-quality short-term bonds all have been reasonable ways to insulate portfolios in bad economic times. These “safe” assets have given investors some peace of mind and downside protection during market declines and may very well do so in the future. The biggest downside to these investments is that they currently pay very low interest rates (2%) and may not maintain purchasing power should the Fed get its wish of higher inflation. Over very long periods of time, stocks and real estate have generally outperformed CDs, T-bills, etc. and often by a wide margin. If I had to bet, I would say that this will again be the case over the next 25+ years however there are likely to be some pretty rough patches along that journey.
We must acknowledge that both U.S. stocks and U.S. real estate are trading at historically high levels today. Although this does not mean they will move downward in the near term, it often has led to lower than average returns over the following five to ten years when we start from such high levels. This can be seen in the below chart which shows historical five-year returns based upn starting Price-to-Earnings Ratios. Clearly starting at lower P/E ratios offers the opportunity for outsized returns while starting at higher levels has resulted in more modest returns. This would be in line with our expectations of a lower return environment for U.S. stocks in the foreseeable future, but we would certainly be okay with some surprises to the upside. International stocks are a slightly different story. Most international stocks have lagged the U.S. by a significant margin over the past ten years and by most measures, international stocks trade at much lower valuations than their U.S. counterparts. In some cases, these disparities are close to all-time highs. With that said, there are some good reasons for this under-performance as the economic recovery in Europe has been much less robust than in the U.S. and they certainly have their own economic problems.
Negative interest rates, Brexit, questions regarding the stability of the European Union, Greece, etc., all come to mind. Oftentimes, buying stocks when they are cheap pays off with better long-term results, and we would not be at all surprised if these international stocks, especially developing markets, do better than U.S. counterparts over the next 10 to 15 years.
Lastly, gold is often an under-owned, under-discussed investment, and as a portfolio holding it is often considered insurance against the declining dollar or increasing inflation. Gold has actually had a very substantial run-up in the past several months due to rising concerns of government money printing, government deficits, and geopolitical concerns. Gold often times does well when the U.S. dollar is falling and it is somewhat surprising that gold is up with the dollar remaining so strong. We continue to think a small investment in gold may make sense as an insurance policy against some of the concerns people have regarding Fed policy and money printing around the globe. It certainly is an interesting world out there today and it often reminds me of John Templeton and his wealth of wisdom. He always used to say that there was never a period in his lifetime when there was an absence of great worries, yet during his lifetime the standard of living rose by enormous amounts. This has certainly been the case for my generation as well and we can hope this continues for future generations.