Markets, Values, and Expectations Are in a Much Different Place Now
On this day one year ago, the S&P 500 closed at 2,237. 1 Investor pessimism about the ramifications of a global pandemic were at a peak, and it was becoming clearer that this health crisis was going to turn into a severe economic downturn. The S&P 500 closed that day down 33.9% from its all-time high of 3,386, set just a few weeks earlier on February 19. 2 The intensity of this market selloff was matched by only two prior historical periods; the Great Depression and the stock market panic of 1987.
A Closer Look at March 2020–March 2021
The events that would unfold over the following year were nothing short of incredible. The initial market reaction was followed quickly by the economic consequences of shutting down an entire economy. Weekly unemployment claims, which had never exceeded the October 1982 record of 695,000, quickly rose to above 6,000,000 for the week ending March 28, 2020. 3 In response, the Federal Reserve dusted off the global financial crisis playbook and quickly injected $3 trillion of liquidity into the financial system to prevent the health and economic crisis from cascading into a financial crisis as well. Federal and state governments responded swiftly, creating new assistance programs, enacting foreclosure and eviction moratoriums, and issuing multiple rounds of direct stimulus checks, among other activities. Just this month, another round of stimulus checks was approved, along with a number of additional expansionary measures. Of course, this says nothing of the herculean efforts by our health care workers and those who rapidly developed and tested the life-saving vaccines which are being deployed today.
As policy responses were announced, digested, and monitored, it became increasingly clear throughout the following 12 months that this global pandemic would not have the anticipated negative impact on corporate America. A new economic phrase was needed to explain what was happening, which resulted in the term "K-shaped recovery," meaning that we were simultaneously experiencing strong economic growth in some segments of the economy, while a severe recession in others. Although the economic effects of the pandemic were highly unique for every company, it quickly became clear that corporate profits would not suffer as dramatically as once feared. Over the course of the year, as CEOs announced increasingly optimistic earnings results and forecasts, share prices recovered strongly. The table below displays the returns for the U.S. stock market, shown by company size and value orientation. Small value companies, the top performer, have delivered returns of 126% since the lows of March, 2020.
Data represents past performance. Past performance is no guarantee of future results. Chart is for illustrative purposes only. Returns are based on data for the time period of March 23, 2020- March 22, 2021. Source: Morningstar Direct. Specific indexes: (All Morningstar) US Large Growth TR USD; US Large Core TR USD; US Large Value TR USD; US Mid Growth TR USD; US Mid Core TR USD; US Mid Val TR USD; US Small Growth TR USD; US Small Core TR USD; US Small Val TR USD.
Another way of measuring the incredible returns over this time period is to show the growth of $10,000 over this full calendar year. In the graph below, we see that $10,000 invested in large U.S. companies has grown to about $18,000 over this time period, while that same investment in small U.S. companies has appreciated to just under $24,000.
Data represents past performance. Past performance is no guarantee of future results. Chart is for illustrative purposes only. Returns are based on data for the time period of March 23, 2020- March 22, 2021. Source: Morningstar U.S. Small Value Index and Russell 100 Index TR.
Markets are in a much different place now.
Portfolio values are in a much different place now.
Expectations are in a much different place now.
Disciplined Investors Will Be Rewarded
In late March 2020, we felt it was important to counter the overwhelming market pessimism with a note of optimism. We outlined that while nobody knew the path moving forward, markets were being priced to deliver tremendous future returns. In this analysis, we compared the expected returns of U.S. equities to the yield of U.S. Treasury bonds and noted that this premium was significantly above historical averages. We concluded by saying, “Volatility may be unnerving, but we believe investors will be well rewarded for this disciplined approach over the coming years."
We certainly didn’t anticipate all of those strong returns occurring over just the next 12 months. However, portfolios have benefited tremendously from remaining fully invested over this time period, and maintaining an overweight to those small value stocks that have performed so well. In addition, portfolios benefited from our disciplined rebalancing process, which proactively rebalanced accounts during the market decline in March 2020, selling appreciated fixed-income positions to purchase stocks and capturing tax losses, as appropriate. Unfortunately, there are consequences to strong bull markets; just as future return expectations rose as valuations grew more attractive in March 2020, now we face the opposite dilemma; strong returns have produced less attractive valuations today.
We recently received the latest Market Perspectives from Vanguard highlighting their asset class return outlooks for the next 10 years. Using the latest projections from Vanguard, we see they anticipate 10-year U.S. equity returns to average about 4% per year, with inflation of 1.8%. 4 The difference of 2.2% is the real expected return for a diversified U.S. stock portfolio, which is well below historical averages. We do want to highlight that these are only estimates, which can be revised higher if corporate earnings exceed expectations. In addition, a closer evaluation of Vanguard’s expectations show that they expect higher returns from value stocks, small company stocks, and international stocks. Our investment philosophy is well-positioned to capture these higher expected returns.
On the heels of what may end up being the single best 12-month period of investment returns in our lifetimes, we want to intentionally pause and reflect on where this positions us moving forward. Portfolios have grown significantly over this time period, and that’s certainly worth celebrating. Just as our Investment Team was proactively purchasing stocks one year ago as part of our disciplined rebalancing approach, we have recently been doing the opposite; selling stocks to purchase fixed income to ensure portfolio alignment with targeted allocations. And, our job as integrated wealth advisors is to understand how this market rally impacts each client's financial plan and wealth goals, and to account for the reality that returns moving forward will likely be far less exciting than the previous 12 months.
... our job as integrated wealth advisors is to understand how this market rally impacts each client's financial plan and wealth goals, and to account for the reality that returns moving forward will likely be far less exciting than the previous 12 months.
Setting proper expectations is a key component of the financial planning process. Portfolios have appreciated significantly in the past year, and now we must understand that it would be inappropriate to anticipate above-average returns with the current data that is available. Establishing future return expectations is a mixture of both art and science, and is far from precise. For example, while we may anticipate lower future returns over the coming decade, we have no idea how these returns will be achieved. We might experience a strong market rally in 2021 or a market correction. Rather than trying to predict what we should do next, we continue to believe that a diversified investment approach positions your portfolio to succeed, regardless of what the markets do in the coming weeks, months and years. Additionally, we know that the appropriate action to take lies in each individual, customized financial plan, adjusting future expected returns and modeling the impact on each client's financial goals.
One pearl of wisdom that we have acquired since our practice began in the late 1980s is to be mindful that change is constant. Markets are constantly in flux. They are always presenting new information to the investor. Our pledge as integrated wealth advisors is to understand, monitor, address, and control, as much as possible, the relationship between market movements and the fulfillment of your wealth management goals. The fulfillment of that pledge relies upon expertise, deep knowledge of your personal situation, fiduciary care, and a process and team to implement all recommendations.
- Morningstar Direct: Dates
- Morningstar Direct: Dates
- U.S. Bureau of Labor Statistics
- Vanguard Investment Strategy Group, Market perspectives: March 2021 https://advisors.vanguard.com/insights/article/series/vanguardmarketperspectives
NOTE: The information provided in this article is intended for clients of Carlson Capital Management. We recommend that individuals consult with a professional adviser familiar with their particular situation for advice concerning specific investment, accounting, tax, and legal matters before taking any action.