Markets Soar in an Imperfect Economy

January 2020

The stock market reminded us again this past year that a perfect economy is not required to push stock prices higher. Rather, prices climb on signs of incremental improvements. One by one the concerns that dominated the headlines at the start of the year—Federal Reserve interest-rate increases, recession risk, and trade disputes—reversed, faded, or improved. And as that occurred, investors became, if not optimistic, at least less pessimistic.

The end result was a U.S. stock market that produced a generous 31.5% total return in 2019.¹ We don’t wish to diminish that achievement, but it should be mentioned that most of 2019’s gain was simply a retracement of the market’s late 2018 decline. Nonetheless, the stock market ended the year 10.3% above its 2018 high and the annualized total return for the two-year period was a rewarding 12.1%.

Some investors may fear that the past year’s large stock-price gains foretell an imminent decline. A study of market history, however, leads to no such conclusion. Since 1926, the stock market rose in 12 of the 19 calendar years that followed a 30% or better totalreturn year. The average return for all of the 19 years was 10.2% and the median return was 12.0%. These figures require some caution, though, due to the wide range of returns—the worst year being -34.7% and the best 37.9%.

Our 10-Year Return Projections

While large stock-price gains in a given year have been poor indicators of the following year’s returns, sharply higher stock prices along with lower interest rates do consistently result in lower 10year return forecasts from our proprietary models. As of year-end, our 10-year forecast for the S&P 500 ® Index is 3.1% to 5.2%, down from 5.6% to 7.8% one year ago. Our 10-year forecast for a portfolio of U.S. government and corporate bonds with 1-to-10-year maturities is 2.3% to 2.7%, down from 3.2%.

Many of you will no doubt be disappointed by the low returns that our models are forecasting. But, with the S&P 500 ® Index trading at 18.2 times 2020 forecasted earnings and the 10-year U.S. Treasury bond yielding just 1.9%, our models simply reflect that both stock and bond prices are elevated due in part to low interest-rate policies set by the world’s central banks.

Using Volatility to Achieve Better Returns

Fortunately investors will have opportunities to earn better returns than what our models project. Some of those opportunities will come from other asset classes, making it important to maintain a diversified portfolio. Other opportunities, ironically, will come from the same market volatility that many investors despise. How investors respond to market volatility will meaningfully affect the returns they achieve.

One simple approach to making market volatility work to your advantage is to rebalance your portfolio following large price changes in one or more asset classes. To illustrate this point, let’s assume that investors A and B each begin with $10,000 invested 60% in a stock portfolio and 40% in a savings account. Over the next three years, the stock portfolio provides annual returns of -15%, +8%, and +20%. The savings account provides annual returns of 2% each year.

At the end of the first year, investor A realizes the stock portfolio’s negative results have caused its allocation to fall well below her predetermined 60% target. She also views the decline as an opportunity to buy at a lower price. Investor A decides to move $400 from the savings account to the stock portfolio, bringing her overall portfolio back to her initial allocation targets for both. Investor B chooses to make no changes at the end of the first year, and neither investor makes changes during the final two years of our example period.

The results for our two investors are shown in the chart below. Investor A, by rebalancing her portfolio after the first year’s significant drop in the stock portfolio, was able to achieve a higher three-year cumulative return of 9.6% versus investor B’s 8.5% return. Investor A’s simple rebalancing strategy worked to her advantage because it put more money in the stock portfolio ahead of the positive returns it produced in the final two years.

This approach should not be confused with market timing, which is a tactic by which investors try to predict the overall stock market’s short-term direction. We do not recommend market timing due to the extreme difficulty of accurately predicting the markets’ short-term moves with high enough consistency. By contrast, rebalancing relies on what has already occurred in the markets to determine which allocation adjustments to make.

Now, it is possible that the stock portfolio in our example could have continued to decline in years two and three. In that case, moving additional monies from cash savings to the stock portfolio to maintain the target allocations would have been the correct strategy. This assumes that the stock market eventually recovers as it has throughout U.S. history.

Of course, buying stocks when prices have fallen can be emotionally challenging. That is why having a disciplined plan is so important. By setting a target allocation and actively managing to it, investors can remove some of the harmful emotion from investing, thereby providing opportunity for higher long-term returns. And by combining that discipline with an understanding that buying low is better than buying high, investors can position themselves to benefit from the markets’ inevitable volatility—regardless of whether market returns are forecasted to be high or low.

1_{All returns for stocks or the stock market are based upon the Standard & Poor’s 90 Index for the period of 1926 through 1956, and the Standard & Poor’s 500 ® Index for the period of 1957 through 2019.}

_{*The information provided in this material should not be considered as a recommendation to buy, sell or hold any particular security. This report includes candid statements and observations regarding investment strategies, individual securities, and economic and market conditions; however, there is no guarantee that these statements, opinions or forecasts will prove to be correct. Actual results may differ materially from those we anticipate. The views and strategies described in the piece may not be suitable to all readers and are subject to change without notice. You should not place undue reliance on forward-looking statements, which are current as of the date of this report. The information is not intended to provide and should not be relied on for accounting, legal, and tax advice or investment recommendations. Investing in stocks involves risk, including loss of principal. Past performance is not a guarantee of future results.*}