January 8, 2020

2019 was a good year for investors, with extraordinarily strong domestic markets. As measured by the S&P 500 Index, stocks returned 31%. The Bloomberg Barclays U.S. Aggregate Total Return index, a proxy for the domestic fixed income market, was up 9% in 2019.

In many ways, last year’s record performance is a tale of two years. While a year is a popular timeframe for measuring performance, it is an arbitrary measuring stick. If we lengthen our perspective to the past two years, stocks returned 12% and bonds 4%. While still above long-term average returns, these two-year returns point to 2019 performance being a combination of a bounce back from 2018 (when stocks returned -4% and bonds were flat) and strong performance in 2019.

As you may recall, after reaching a market high in September of 2018, stocks tumbled nearly 20% in the last three months of 2018, nearing bear market levels. Heading into 2019, such a strong year was not on the horizon for most investors. While the U.S. economy was growing, investor sentiment was pessimistic due to geopolitical and trade tensions, combined with stress imposed on the market by the Federal Reserve implementing four interest rate increases in 2018.

Given this backdrop, why were returns so strong in 2019? While the underlying financial strength and profitability of companies determine long-term stock market performance, short-term performance in the stock market is often inscrutable. Nonetheless, a significant portion of 2019’s domestic stock performance was simply a recalibration of investor sentiment.

Strong 2019 returns in the bond market were partly due to a reversal in Federal Reserve policy from tightening to easing. In the face of slower global growth and trade uncertainty, the Fed cut interest rates three times in 2019 to support domestic growth, a continued strong job market, and to nudge inflation towards the Fed’s 2% target level. Central bank easing caused interest rates to fall and bond prices to increase (bond yield and price are inversely related). We expect the Fed will now pause on further cuts.

The economic recovery continued in 2019, with GDP growing at a rate of 2.1% in the third quarter. We expect the U.S. economy to continue growing steadily, although at a slower pace in the expansion’s eleventh year. Economic indicators are strong, especially consumer data. This should bolster personal consumption, which accounts for roughly 70% of U.S. GDP.  

While we do not anticipate a repeat of 2019’s phenomenal performance in 2020, mounting evidence supports positive stock market returns. Over the last 18 months, trade wars suppressed global manufacturing. As trade tensions appear to be easing, many economies may now benefit from a reversal on this trend. The services side of the economy remains quite strong. And, as mentioned earlier, the U.S. consumer remains in solid shape. These positive factors should lead to a renewal of corporate earnings growth ahead driving business values higher.

Further, stock market valuations are high by historical standards, but not stretched, or even close to the levels reached in the late 1990’s. Overall investor sentiment appears to be reserved, which resulted in significant movements of money from stock funds into bond funds in 2019. This contrarian direction of fund flows is not indicative of a market top.

The trend in lower bond yields over the last year may also reverse, as general price inflation increases with improving economic activity. Under these conditions, the yields on longer-dated bonds should increase somewhat, leading to a steeper yield curve (a sign of economic health). The current low level of interest rates is quite accommodative for financial markets and business in general, and the Fed will be reluctant to raise short-term interest rates until after the presidential election late this year.

Volatility in the financial markets was muted in 2019; with the upcoming election, price volatility could increase. We encourage our clients to maintain a long-term discipline and have patience in the face of potentially active markets.

The above information is for educational purposes and should not be considered a recommendation or investment advice. Investing in securities can result in loss of capital. Past performance is no guarantee of future performance.

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