Winter 2020 Market Perspectives

David S. Lynch, CFA

David S. Lynch, CFA

January 16, 2020

Market Perspectives

Global equity markets returned approximately 10% in the fourth quarter, pushing returns for the year to over 30% in the US and nearly 20% internationally. Bonds had a relatively quiet quarter in terms of returns, but the primary bond indexes still returned a solid 6-10% for the year. Nearly all markets we track had returns in positive territory for the year as central banks maintained stimulative policies and low interest rates. Technology was the leading sector of the S&P 500 at an astounding +50% for the year. Energy was the weakest sector but still up a respectable 12%.


Volatility dropped in the fourth quarter as sentiment stabilized after the volatility and sharp internal market rotation of Q3. The market finished the year more optimistic since the world had muddled through to a better growth outlook, or at least avoided the imminent recession that worried the stock market and inverted the yield curve during the middle of the year. Q3 earnings, combined with progress on trade negotiations with China, were well received. After the market punished momentum names in Q3 and safer haven sectors rallied, the market was back on growth with technology again in Q4.

S&P 500 Index -- Price & Volatility

For 2019, the positioning of our equity holdings worked well: growth outperformed value (although this was not as dominant as in prior years) and large cap outperformed small cap; the technology sector was the top sector and US markets outperformed international markets. Throughout the year, we diligently trimmed and rebalanced these successes back toward our neutral weightings. While we still prefer quality growth companies, we did reduce our growth overweight during 2019. Also, we have been adding back some international exposure recently. 


Market Outlook and Q4 Summary


Overall Asset Allocation


Our baseline advice remains essentially the same as last quarter. We are comfortable with our long-term holdings but recommend prudent rebalancing and trimming equities back closer to policy targets if needed. We are comfortable holding bonds for ballast, diversification, and risk management. A modest cash position is appropriate as dry powder for opportunistic reinvestment.


We expect GDP and earnings to keep growing but not at stellar levels. Considering the lofty starting point of most markets, we have modest return expectations for the coming years. There is less margin of safety this far into the cycle and some of the unique structural supports are not as robust as they once were. For example, the downfalls of WeWork and some of the other struggling IPOs pose a risk to the entire technology food chain and ecosystem, which includes the public tech companies that had been benefitting from the unwavering support granted to these venture capital darlings.


US Equities


US equities continue to achieve new all-time highs. The strong returns of 2019 were largely the result of “multiple expansion” in which the market price-to-earnings (P/E) multiple expanded as optimism and risk appetite outpaced earnings growth, at least in the short term. As a result, there are several macro metrics pointing toward the market looking rather expensive on a historical basis. However, there are valuation metrics to justify either side of the buy/sell argument (see table below).  It is notable that many of the best metrics in favor of equities are those measured in reference to low bond yields.

S&P 500 valuation metric Current Historical percentile
US market cap / GDP 199% 99th
Enterprise value / Sales 2.5x 99th
Enterprise value / EBITDA 12.7x 93rd
Price / Book 3.6x 90th
Cyclically adjusted P/E 27.8x 89th
Forward P/E 18.4x 88th
Cash flow yield 7.2% 85th
Free cash flow yield 4.1% 53rd
S&P earnings yield - 10Y UST 362 bps 28th
Median metric   89th

Source: Goldman Sachs Investment Research, EBITDA - Earnings before interest, tax, depreciation, and amortization. December 16, 2019.

Another factor facing markets is the 2020 US election. Though we prefer to look through the political noise, there are times when the political climate, particularly regarding how it spills over into the tax and regulatory environments, needs to be factored in to our thinking to a greater degree than average. We expect 2020 will be one of those times.  Sectors such as energy (environmental policy), health care (single payer system), and technology (privacy and anti-trust) have all priced in some of these financial uncertainties, but there are also cross-sector policy issues that could pressure the entire market. For example, if stock buybacks by corporations are curtailed by a dramatic (although unlikely) policy shift, one of the major market supports from 2019 would be taken away. There was negative net issuance of stock in the US in 2019 as the tailwind of buybacks was strong. Should this be removed from the equation, sectors such as financials could lose a critical leg of support.


Similarly, the tax cuts that boosted earnings in 2018 (and coincidentally made for harder year-over-year earnings comparisons in 2019) would have to be factored into earnings projections if they were reversed back to pre-2018 levels. However, even if a material change such as this took place, there would also be likely beneficiaries such as government bonds that would have better long-term fiscal footing if tax revenues were increased. These dynamics are another reason for sound diversification of portfolios and not hyper-concentration in any one thesis, sector, or asset class.


We are neutral weighted across asset classes and remain confident about finding individual ideas within the market.  We find some wit and wisdom from the famous Peter Lynch[1] in a December Barron’s Q&A profile (emphasis added): “Best trade you ever made{?} I never did a good trade. Best investment you’ve made[?] Taco Bell”. He is reminding us to avoid excessive market timing (“trades”) and instead keep the focus on long-term opportunities (“investments”) that can be held through volatility.


International Equities


International markets continued to lag the US in 2019. We have been selectively adding to positions, expecting an improvement in relative performance going forward. A resumption of more normalized global trade should start to benefit Asia and emerging markets, especially China and other exporters. The strength of the dollar has muted returns for US-based portfolios invested in overseas markets, but the relatively strong valuation of the dollar should eventually see a weakening, which will enhance international returns for US-based investors.


Emerging markets have opportunities for active management, and we particularly favor stocks set up to benefit from a growing middle class and more consumer demand in those regions. Developed international markets also have opportunity, but the stock market composition of these developed international economies tends to contain fewer growth companies and a smaller technology sector. Having fewer dynamic constituents, as compared to US indexes, leads to a lower relative valuation multiple and lower growth rate over the long term. However, we still like these markets for diversification opportunities and global exposure.


Core Fixed Income


In fixed income, we are at a market weight and recommend maintaining an appropriate amount of core fixed income, consistent with staying the course toward long-term investment goals. In Q4, we saw a tentative re-steepening of the curve as fears of recession receded. Long-dated US Treasury bond prices were down 4% for the quarter, yet still returned 16% for the year. The more commonly held intermediate parts of the Treasury and muni bond curves were up 6-9% for the year.


In 2019, we rebalanced back to neutral on duration (interest rate sensitivity) and expect to hold that stance for the early part of 2020. Our portfolios have room to add on weakness if investment grade credit experiences any spread widening.


Opportunistic Fixed Income


Our holdings in opportunistic fixed income remain modest. We maintain small exposures to dollar-denominated emerging market debt and high yield corporate debt. These positions were strong performers in 2019; the high yield bond index returned 14% and emerging market bonds were up 15%. Excellent returns but with the consequence that these sectors are now trading at spreads that have less room for the same magnitude of upside going forward.


The two primary factors facing fixed income markets are: 1) the absolute level of debt, and 2) the debt service burden attached to that debt. While the level of debt is unfavorably high for many corporations and countries (including the US), the burden to service that debt is not onerous in this low interest rate world.  Interest payments are relatively small and manageable (incidentally, this is the same favorable dynamic keeping the US consumer healthy). The ability to roll and extend maturing bonds out the fiscal calendar is quite easy and welcoming for the time being. Should either of these conditions change, we would expect problems in the bond market, especially the BBB (triple B) and high yield markets. We are skeptical of corporate credit markets being able to adapt to higher rates or an economic slowdown without some painful spread widening. At more material levels of dislocation, the equity valuations of these companies could also take a negative hit.  This is a further reason why we typically avoid the stock and the bonds of highly indebted issuers.




Our overall allocation preference is to remain diversified across stocks, bonds, sectors, and countries. We seek stocks and bonds that are resilient across political regimes, geopolitics, and trading noise. We strive to find stocks that we can hold for three to five years, and ideally even longer. We seek high quality bonds that can confidently be held to maturity. This strategy is core to preserving multi-generational wealth and sustaining institutional portfolios. We complement this core with growth opportunities created by market disruptions. In the current moment, we are closer to home and concentrated in our strategic core while remaining patient for market dislocations that offer fresh opportunities.


If you have any questions or feedback, please do not hesitate to reach out to us.

[1] Peter Lynch is not related to David Lynch, although Dave wishes that he were.