The average American household’s net worth soared to $885,000 last year, 65% higher than a decade ago, according to data from the Federal Reserve and Census Bureau¹. Much of the gain came from financial markets where both stocks and bonds surged. Conditions seem supportive for further gains, but valuations are looking full. Even though fundamentals look good, returns in the future should be lower because stock and bond yields sit at historic lows and because markets are already expecting good news.

Rise of Liquidity

Other than a small decline last week on coronavirus concerns, stocks have been quiet. When central banks turned more accommodative a year ago, stock and bond markets began a tear. The Federal Reserve cut interest rates and began to expand its balance sheet, providing support to the market. Facing low or negative interest rates, global investors sought returns elsewhere. Stocks and bonds in the United States proved to be beneficiaries of the worldwide appetite for return.

Another example that shows that liquidity is abundant is the lack of nervousness in interbank markets. A measure of interbank risk, called the St. Louis Financial Stress Index, hit a post-recession low a week ago. All-in-all, markets have been supported by a rising tide of liquidity. As it now stands, markets expect central banks to remain accommodative through the balance of the year.

Record Low Yields

Even though liquidity is abundant, returns in the future should be lower because stock and bond yields sit at historic lows. The dividend yield on the S&P 500, an index of large-capitalization U.S. stocks, is now at a fresh cycle low, below 1.8%. Similarly, 10-year U.S. Treasury yields are at 1.7%, and credit spreads are below average (the Moody’s Baa / 10-year Treasury spread is 2.2% versus a post-2009 average of 2.7%. No matter how you look at this, valuations across-the-board, from stocks to bonds, are elevated. Therefore, we think it is essential to keep return expectations from here reasonable.

Pricing Perfection?

Markets have been generous over the past decade. The average annualized return on a simple 60% stock (S&P 500) and 40% bond (Barclays Aggregate Bond Index, a proxy for the broad U.S. bond market) is 9.3% through this writing. This performance is not quite as high as the 1990s bull market, but it is getting close. It is also higher than our forecast range for returns going forward (chart, below). Rational and mean-reverting markets are basic tenants of investing and we factor this into our forecasts.

The most basic reason returns in the future should be lower is because markets might be pricing perfection. The last year’s rally, plunge in volatility, and elevated valuations point to bullish expectations. Market cooperation, along with easing trade tensions and accommodative central banks, could lead to a global growth pickup ahead. Analysts expect a 9.5% gain in S&P 500 profits this year, far better than the 2% decline in 2019. Given that earnings forecasts tend to fall throughout the year, we expect today’s expectations to fade some.

Conclusion

So it is clear that although liquidity is abundant and profits are high, returns in the future should be lower for two main reasons. First, stock and bond yields sit at historic lows. But most importantly, markets are already expecting positive developments ahead as central banks remain accommodative, and earnings gains are already in most analyst forecasts.

Indeed, the rise in household wealth to records is unprecedented and extraordinary. Extrapolating these returns into the future, however, is probably not such a good idea now.

What to do from here?

1) Look for consistent businesses with low debt.
2) Prefer companies with steady dividend increases.
3) Avoid the temptation to chase yield.

In short, focus on quality.

Kevin Caron, CFA, Senior Portfolio Manager
Chad Morganlander, Senior Portfolio Manager
Matthew Battipaglia, Portfolio Manager
Steve Lerit, CFA, Client Portfolio Manager
Suzanne Ashley, Analyst

(973) 549-4168

Footnotes:

¹ This should not be confused with median net worth which was recently reported as being near $97,000 per household.

---

Disclosures

WCA Fundamental Conditions Barometer Description: We regularly assess changes in fundamental conditions to help guide near-term asset allocation decisions. The analysis incorporates approximately 30 forward-looking indicators in categories ranging from Credit and Capital Markets to U.S. Economic Conditions and Foreign Conditions. From each category of data, we create three diffusion-style sub-indices that measure the trends in the underlying data. Sustained improvement that is spread across a wide variety of observations will produce index readings above 50 (potentially favoring stocks), while readings below 50 would indicate potential deterioration (potentially favoring bonds). The WCA Fundamental Conditions Index combines the three underlying categories into a single summary measure. This measure can be thought of as a “barometer” for changes in fundamental conditions.

The information contained herein has been prepared from sources believed to be reliable but is not guaranteed by us and is not a complete summary or statement of all available data, nor is it considered an offer to buy or sell any securities referred to herein. Opinions expressed are subject to change without notice and do not take into account the particular investment objectives, financial situation, or needs of individual investors. There is no guarantee that the figures or opinions forecasted in this report will be realized or achieved. Employees of Stifel, Nicolaus & Company, Incorporated or its affiliates may, at times, release written or oral commentary, technical analysis, or trading strategies that differ from the opinions expressed within. Past performance is no guarantee of future results. Indices are unmanaged, and you cannot invest directly in an index.

Asset allocation and diversification do not ensure a profit and may not protect against loss. There are special considerations associated with international investing, including the risk of currency fluctuations and political and economic events. Investing in emerging markets may involve greater risk and volatility than investing in more developed countries. Due to their narrow focus, sector-based investments typically exhibit greater volatility. Small-company stocks are typically more volatile and carry additional risks since smaller companies generally are not as well established as larger companies. Property values can fall due to environmental, economic, or other reasons, and changes in interest rates can negatively impact the performance of real estate companies. When investing in bonds, it is important to note that as interest rates rise, bond prices will fall. High-yield bonds have greater credit risk than higher-quality bonds. The risk of loss in trading commodities and futures can be substantial. You should therefore carefully consider whether such trading is suitable for you in light of your financial condition. The high degree of leverage that is often obtainable in commodity trading can work against you as well as for you. The use of leverage can lead to large losses as well as gains.

All investments involve risk, including loss of principal, and there is no guarantee that investment objectives will be met. It is important to review your investment objectives, risk tolerance, and liquidity needs before choosing an investment style or manager. Equity investments are subject generally to market, market sector, market liquidity, issuer, and investment style risks, among other factors to varying degrees. Fixed Income investments are subject to market, market liquidity, issuer, investment style, interest rate, credit quality, and call risks, among other factors to varying degrees.

This commentary often expresses opinions about the direction of market, investment sector, and other trends. The opinions should not be considered predictions of future results. The information contained in this report is based on sources believed to be reliable, but is not guaranteed and not necessarily complete.

The securities discussed in this material were selected due to recent changes in the strategies. This selection criterion is not based on any measurement of performance of the underlying security.

Washington Crossing Advisors LLC is a wholly-owned subsidiary and affiliated SEC Registered Investment Adviser of Stifel Financial Corp (NYSE: SF).