2020 Preview

February 9, 2020

2020 appears ready to offer up another fascinating display of investor psychology battling the astute, manipulative and oft detrimental forces of poor investment tendencies caused by innate human biases. Investors will continue attempting to divine the proper border between risk and reward. Usually poorly. While hoping the expansive bull can stave off the bears and provide yet one more year's solid returns.
The road ahead will hold much at which the average traveler will want to stop and stare. The continuing Santa Claus Rally. Bareknuckle politics. Secular rotation and mean reversion. Trade and economic uncertainty. Geopolitics and international intrigue. It's all there, awaiting your perusal. Like an Oscar Nominated film. So enjoy this "review" of how the film may look, based on what we understand, right here and now.
What follows are not forecasts (a fool's game) but a list of our expectations, as well as currently perceived opportunities and threats, based upon what we know today.
So let's get into it.
We expect asset allocation and secular rotation to serve as key drivers of stock market performance in 2020. After ten years of complete U.S. equity dominance, we believe this year will invite the initial steps towards reallocation to new countries, sectors, asset classes and leadership. As economic conditions become brighter overseas, foreign markets will offer opportunities based on a reassessment of potential returns. All of which will be helped further by an unwinding (partial) of trade war worries and recession concerns.
One caveat? Investor psyches have never fully recovered from the Great Recession. Simultaneously, much of the financial media continues to focus on worst case scenarios. Or what is most likely to go wrong. Consequently, investors tend to chase yield and whatever ideas worked most recently. This can represent a dangerous mindset for some. But an opportunity for those seeking to get ahead of the curve, as oppose to sticking with the same allocation year over year.
In equity markets, non-U.S. markets offer opportunities. Especially emerging markets. Which are less expensive on an earnings basis, and appear ready for a rebound.
We also believe that mean reversion will buoy small and mid-cap stocks -- another group that has long lagged and seems poised for a rebound.
Still threatened are those stocks suffering aftershocks from trade-war fallout. Even with Phase I on the books, tariffs and trade wars will dominate headlines, though settling for second-most impactful headlines, however, as election coverage reaches an all-pervasive crescendo. Many investors don't understand the risks that both topics can pose to their portfolios. And will remain exposed to volatility driven by headline risk
Some of the riskier, more crowded trades concerning the delicate relationship between risk and reward are:
* Bonds
* High-yield (aka "junk") bonds
* Bond substitutes like Utilities, low-volatility factors, MLPs, REITs, closed-end funds, BDCs. There are some good choices, of course, but as an asset class, the prices and risks are high. The apparent security of the yield is misleading.
* FAANG Stocks. In a former era, market gains were concentrated in the "Nifty Fifty." Today, FAANG stocks capture investors imaginations, comprising 18 percent of the market.
More tactically, we believe investors will benefit by owning individual stocks as this bull market evolves. As indexes and ETF's will provide less opportunity for the eye-popping returns of the last decade. And secular rotation will exert even more gravity on some indexes than already existed. Tactical, active management will likely outperform a passive investment approach this year.
Regarding biggest threats to U.S. markets, the biggest concern may be lagging business confidence. The trade war has created a lot of uncertainty. That makes it easy for businesses to defer purchases, expansions and other capital expenditures. Business leaders remain hyper-concerned about the economy and a pending recession. Polls show that respondents have confidence in their own businesses, but worry about everyone else's. Isn't that simple human nature? Always most concerned with the things we can't control?
Business leadership could be assuaged should the Trump administration accomplish further trade progress with China. So lowering some of the trade uncertainty. While continued improvement in economic data would also become wind in our economic sales.
A less discussed but certain threat would be an expedited return of inflation. Most bears remain focused on economic weakness, little inflation and further declines in interest rates. But the labor market continues to tighten.
Which will, in return force employers to pay more for the existing available talent in the workforce.
Which pushes up wages and other labor costs.
Bringing more buyers into the housing market, and so pushing prices higher there. This will merit scrutiny throughout the year. As it is an outcome most investors and market observers continue to discount. Which almost always leads to heightened volatility when the unexpected event comes to pass.
Of course, many clients ask how the political climate might affect the risks and opportunities this year.
The eight months leading up to the election represents an eternity in political time. Making February way too early to even begin guessing at future electoral outcomes. Making the election less relevant for investment decisions at this point. As the caucuses and primaries play out, we'll get a better grasp of the horses in the race. Of course, that doesn't mean that election headlines and investor angst wont meet on occasion, and send markets into the occasional tizzy.
One thing investors should be aware of as the election box is unpacked? The possibility of a change in policies. Which often leads to the effects of those transitions being "pulled forward." As the market quickly digests the facts and makes its determination as to the impact on various facets of the market continuum.
Regarding the yield curve in 2020, and the impacts it will that have on the equity market and economy, we expect gradually improving economic growth and some evidence of inflation. This should bring an increase in yield on the ten-year note. Leading to a slightly steeper yield curve.
Nor do we believe the Fed will resume interest rate hikes this year, with markets currently pricing a 40 percent chance of another cut this summer.
A steeper curve is favorable for banks and reassuring for business confidence, as investors and creditors understand that conditions are improving. And that they will be more generously compensated for locking up investment capital for longer periods of time.
As far as current asset allocations and portfolio positioning, we have recently allocated a bit more to value (as growth stocks have dominated for most of the decade). We continue to have a middling 5-8 percent allocated towards overseas equities. And favor mid-cap over small cap.
Four industries/areas finding extended opportunity in the current economy (and market) that we believe can benefit astute investors are:
* Big data, cloud and analytics companies (across the marketplace)
* Aerospace and defense
* Real estate that benefits by the move to online commerce
* Low-correlation (to stocks and bonds) alternative investments and asset classes (see our white paper)
We believe the investments we have identified in these areas may provide a bit of downside protection in that the trends upon which they're capitalizing are long term. Investors remain very concerned with the length of the bull market. Anxious that its demise must be close based on its current duration, alone. Which is relevant, in that we're riding the longest expansion in the nation's history. Yet, despite the lack of evidence that cycle length predicts cycle ends, people trust their guts. It just seems like something should change. When the pace of the economic rebound is considered, however, this cycle does not seem out of line by historical standards. And still ranks last among all post-WWII recoveries in terms of cumulative real GDP growth since the prior economic peak. Making the biological age of this expansion (how long will it really live?) a bit of a mystery (as they always are).
As for the Million-Dollar Question: who wins November's election?
Ten months represents an eternity in politics. So much could transpire between now and November. But, Americans are feeling better about the economy, a trend that, if it continues, significantly bolsters President Trump's prospects.
Forty percent of Americans say they are better off financially than they were a year ago. Just 19 percent say they are worse off. That's the most positive respondents have been about the economy in the three years the survey has been conducted.
Further, a recent survey from The Washington Post and ABC News, 60 percent of independents said Trump was doing a good job with the economy, up from 46 percent in September.
The increase in confidence among independents is a recent development and might not last. Yet, while myriad variables factor into attracting non-partisan voters, none ranks as critically as the economy. Historically, presidents presiding over strong economies get re-elected. Those riding weak economies are evicted from the Oval Office.
The wild card? Michael Bloomberg. Who largely remains an enigma to the electorate, has billions to spend, and could represent the biggest eventual threat to Trump's re-election.
As 2020 gets underway, Mr. Market has priced in plenty of fear. Possible recessions. The unknown. And a variety of headline risks. All of which operate alongside the lingering memory of the Great Recession. Making investors more anxious and prone to "herd-like stampedes."
And while we can't blame them, we won't join them. We realize stocks cannot rise forever. So we integrate downside protection parameters and other risk-reductions tactics into our portfolio management efforts. That said, current prices are a reasonable 18.8 times forward earnings at a time of very low interest rates. So stocks should have a bit of a valuation premium. For now, the stock market's upward trendline remains intact. And the bull continues to run.

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