Each quarter, our investment team comments on what happened in the markets and the economy over the past quarter and looks forward at what the next period might bring.
Vaccine developments and reduced uncertainty following elections helped push U.S. stocks up 13% in 2020 Q4. Gains were widespread. Some of the biggest winners emerged from companies left behind in the “stay at home” theme.
Massive stimulus bills and accommodative monetary policy have created an unprecedented state of increased money supply and negative real interest rates. Against this backdrop, stocks posted stronger-than-average gains in 2020 even as S&P 500 earnings fell by more than 10%.
COVID-19 will likely be with us in lingering fashion for a long time, and there is always risk of adverse new developments. Consumer and corporate behavior will be permanently changed in some ways. But we expect economic activity will be much less restricted by the middle of Q2.
Given the surprising sweep of both Georgia Senate run-off elections, tax increases in some form should be expected. From a stock market perspective, corporate income tax rates have more direct impact than individual or capital gains taxes.
U.S. M2 money supply, after increasing steadily at about 6% per year for the last 10 years, shot up 26% in 2020. Only time will tell if inflation follows.
Momentum was the hottest factor of 2020. Valuations compared to sales or earnings in many trendy stocks are now very high. For some, gains in high-flyers can literally be addictive, especially with expanded use of options and leverage. This year, it has been relatively easy to make money buying what is hot. It won’t always be.
What Happened in 2020
In a turbulent year, sticking with a diversified strategy has once again proven a successful approach. Those who reacted emotionally or attempted to time the market typically fared poorly. Speculators and stock pickers had mixed results. Some are emboldened by gains in high momentum stocks. We urge caution for those using leverage and those concentrated in individual companies or sectors without ample consideration of price.
The divergent path of stocks and earnings in 2020 suggests two important points:
- Interest rates and monetary policy have a significant impact on stock prices.
- Changing expectations for future years are often more important than the present.
An increasing supply of money has long been a core driver of asset price inflation, including stocks. In response to the pandemic, the government responded with massive stimulus, and the Fed frantically pumped money into the system. U.S. M2 money supply shot up 26% in 2020. We believe this explains a significant part of the strong rally in Q4.
Twenty years ago, the ten-year Treasury rate was over 6%. Ten years ago, it was close to 4%. At the start of this year, it was close to 2% and now it is close to 1%. It is more reasonable to see stocks advancing to historically high multiples of earnings given historically low interest rates.
Stocks rose consistently in the second half of 2020 even as COVID-19 accelerated, and new shutdowns were introduced. Backed by vaccine progress, we believe these gains were driven primarily from rising expectations about 2021 and 2022, not the current state of the world. Looking at the year ahead, we should consider the outlook for 2022 as potentially more important for stocks than what transpires in 2021. A challenge facing U.S. equity markets is that analysts already anticipate a 20% earnings increase for the S&P 500 in 2021 and another 15% on top of that in 2022. A fair amount must go right to avoid disappointment.
COVID-19 and Economic Shutdowns
Reported COVID-19 cases in the U.S. rocketed from about 40,000 per day in September to over 200,000 per day on average in December. This number appears to have temporarily plateaued as we enter 2021.
The rate at which vaccines can be produced and distributed, as well as the percentage of the population willing to take it, will likely determine most of the remaining economic cost of the virus. Experts believe it would take 75% or more of the population to be vaccinated or previously infected to achieve a high level of herd immunity.
In the U.S., about 6% of the population has tested positive. We believe closer to 20% have been infected. Meanwhile, vaccinations are off to a slower start than hoped but should ramp up quickly.
A recent poll by the Kaiser Family Foundation found about a quarter of Americans said they “probably or definitely” would not get a vaccine. It is unclear if vaccines will be made mandatory in any capacity. Also, no one knows how long immunity may last.
Valuation and Sentiment
Pandemic-related volatility makes traditional earnings and valuation metrics difficult to assess. According to FactSet, Q4 earnings are estimated to decline 10% from a year ago. Ordinarily, this would be terrible, but marks a big improvement over Q3 and full year 2021 earnings are expected to increase 22%.
The projected forward PE on the MSCI U.S. index is 23, according to MSCI, as of the end of the year. This is rich compared to historical averages but should be taken in context of a very low interest rate world. The dividend yield on stocks remains higher than the ten-year Treasury yield. Also, the six largest U.S. stocks (Apple, Microsoft, Amazon, Google, Facebook and Tesla) represent over 20% of the total U.S. market and collectively trade at over 40x trailing earnings. The broad market is less expensive.
Valuations overseas are also more attractive, with the MSCI All Country ex U.S. index trading at 17 times forward earnings as of 12/31. After a decade of U.S. dominance, we believe the stage is set for international stocks to shine in the coming years and that global diversification remains very important.
Investor sentiment overall remains polarized. August may have marked a tipping point where fear of missing out pulled ahead of fear itself. Gains in Q4 were no longer limited to a narrow basket of momentum stocks, but there is still plenty of froth, as evidenced by meteoric IPOs.
Many investors remain fearful, but more seem to be letting greed influence their investment decisions. Because it is easier for markets to climb when expectations are low, we believe current sentiment is a mildly bearish indicator.
The U.S. aggregate bond market was flattish for Q4 and remains solidly positive for the year, providing income and diversification from stocks. International bonds rose for the quarter, primarily driven by a soft dollar.
The Fed has been explicit that short-term government rates will stay near zero for at least a year. Still, a balanced mix of corporate and government bonds can help boost yield even on the short end of the curve. With rising national debt levels and the ingredients in place for a possible increase in inflation, we continue to urge caution around heavy exposures to long-dated Treasuries.
On the campaign trail, President-elect Joe Biden pledged to raise taxes in a variety of ways, primarily on corporations and high-income individuals. As is usually the case, much of what was said will not actually become legislation, though given the surprising apparent sweep of both Georgia Senate run-off elections, changes should be expected.
From a stock market perspective, corporate income tax rates have more direct impact than individual or capital gains taxes. President Donald Trump’s corporate tax cut in 2017 was followed by a double-digit market rally. We would expect that to quickly unwind if these cuts are reversed. The odds of this happening are unclear but are significantly higher with the Democrats taking control of the senate following the runoff elections in Georgia.
Bitcoin and Cryptocurrency
In Q4, almost anything already gaining in value was bid up with enthusiasm. Bitcoin joined the party, rising 176%. With no cash flows, no dividend yield and no underlying assets, the price of Bitcoin and most other cryptocurrencies is determined simply by what people are willing to pay that day. We do not know what that will be in the future.
Our job is to create efficient portfolios designed to help clients meet their personal financial goals. As we do not know if Bitcoin has a positive expected return, and given its highly volatile nature, it is not appropriate for us to include in portfolios.
While the media loves to talk about cryptocurrencies, their overall value remains relatively small in the big picture. We do not believe most individuals should concern themselves, feel like they are missing out, or invest in crypto. That said, for those inclined, a small amount of calculated speculation could be acceptable. Those who do buy Bitcoin, in our view, should either have a designated exit point or plan to hold long-term. They should hope for a strong return but also be prepared to lose most of their investment.
Outlook for 2021
Uncertainty has receded from the early stages of the pandemic but remains elevated compared to a year ago. Pockets of greed and froth suggest a degree of caution is warranted. Monetary and fiscal policy continue to be very supportive of equities. For diversified investors, value and international stocks in general remain largely overlooked and may offer opportunity. More so than usual, it is a good time to avoid emotional decision making and continue to execute on a personalized, long-term strategy.
In an ideal world, the government could keep sending out checks and hold interest rates near zero; we could all consume more; and inflation would remain dormant. That may prove too good to be true. U.S. M2 money supply, after increasing steadily at about 6% per year for the last 10 years, shot up 26% in 2020. History will watch to see if inflation follows.
Officially, inflation has remained stubbornly below the Fed’s stated target of 2%. Unofficially, most would agree many things feel more expensive. The average home price rose 6.9% from a year ago, based on the Case Shiller 20 city home price index. Food prices are up 3.7% according to the DOL. Even Netflix raised its basic pricing model by 7.6% this quarter. In many areas, the pandemic is forcing small businesses and weaker players out. Surviving companies are likely to find themselves with greater pricing power. On the flip side, unemployment remains elevated and energy prices are lower.
Inflation is one of the biggest risks to retirement plans. Lifestyle and buying power are more important than how many dollars you have. This is a major reason why Personal Capital managed portfolios take a highly diversified approach with deliberate allocations designed to thrive during inflationary periods.
Inflation can surface in booms and busts, and stocks can go up or down when inflation runs high. Generally, companies raise prices, and stocks are in a good place to weather the storm. Real estate and commodities also tend to fare relatively well. Declining relative currency is often a driver of inflation, so it is important to retain a healthy allocation to international assets. Long dated bonds face significant peril in a rising price environment.
To be clear, we do not expect hyper-inflation and we do not expect the dollar to crash or lose its status as reserve currency. The major increases in debt in the last twenty years were responses to the financial crisis and COVID-19. Both were probably appropriate to prevent more serious economic decline. Japan has proven a country can have aggressive monetary policy, high debt, and low interest rates for decades with modest inflation, though growth has been sluggish.
Still, overlooking inflation is a big risk, in our opinion. For those frightened by the prospect of owning stocks, the potential for the eroding value of money in cash and bonds also needs to be considered.
Little Bubbles Everywhere
The pandemic brought severe uncertainty, behavioral changes, and heightened volatility in equity markets, including much greater variance between individual stocks. Bigger winners and bigger losers.
Pandemic-accelerated digitalization of the economy has provided a narrative to help many justify why equity valuations for some companies can be largely overlooked. Meanwhile, momentum was the hottest factor of 2020. Investors have continued to buy more of whatever has just gone up. Value has been either ignored or actively avoided.
Momentum trends are self-reinforcing, until they run out of steam. The very biggest technology stocks benefited from these trends in 2020, and as a result drove an outsized portion of returns. The value of Microsoft, Amazon and Apple increased a staggering $2.2 trillion for the year. Most of this increase came in the form of higher multiples while gains in sales or earnings were much more modest. These are great companies with dominant positions and strong balance sheets. In a low interest rate world, their valuations may be viewed as expensive but are easily understandable.
On a percentage basis, the biggest winners of last year were found in a handful of smaller, even higher momentum and more volatile names. Over the past couple of decades, it has been common for high growth tech companies to trade at around 10x revenues. Now we see many companies priced at 20x, 30x or even 50x sales, often with little or no earnings to report. Some of these prices are hard for us to rationalize, and we suspect many are destined to fall as fast as they rose.
IPO Market on the Rise
In another sign of froth, the IPO market is on fire. Despite a nearfreeze to start the year, 2020 experienced IPO volume unseen since the dotcom days. Among recent IPOs, Airbnb is valued higher than Marriott, Hilton, and Hyatt together, yet has less than 25% of the combined revenue. In September, Snowflake more than doubled on its first day of trading, becoming the largest software IPO ever. Upon DoorDash’s IPO in December, it was briefly worth more than Chipotle and Dominoes combined.
One step further than the IPO market is the rapid growth of SPACs, or Special Purpose Acquisition Companies. In a SPAC, investors pool their money, go public as an investment fund, then find an existing company to buy or merge with. It significantly reduces required disclosures and allows companies to go public faster than they may otherwise. Formerly known as blank check transactions with a checkered history, there have usually been 10 or 20 a year. In 2020 there were 242 such transactions, highlighting investor eagerness.
Perhaps the poster child for the wild ride of 2020 is Tesla, which delivered a return never seen before in a company of its size. Tesla is exciting and inspiring. However, its price seems to imply the electric vehicle will be as transformative as the smartphone. The company may need to become more monopolistic, or at least find more recurring revenue streams to grow into its current valuation.
Periods of increased speculation are nothing new. It is hard to know what exactly creates them. With people stuck at home, the spread of commission-free transactions driven by Robinhood and other discount brokers has brought day-trading back to a level of popularity not seen since 1999. Hedge funds and quantitative funds seem to have been funneling assets into the narrow band of momentum stocks, fueling volatility.
We do not know when the momentum trade will lose steam. For longer term investors the timing is not terribly important. We are confident companies will eventually gravitate toward their fair value, whether that be higher or lower. Some of today’s high-flyers will earn their lofty valuations, change the world, and become industry leaders. Others will fade into oblivion.
Diversified investors can take comfort knowing they have exposure to some of the hottest stocks as well as ones being overlooked. Those who rebalance along the way will further benefit from selling high and buying low as cyclical trends come and go.
We urge caution for those with extreme concentrations in individual stocks or sectors. The stock market can be a legal casino if you want it to be. For many people, gains in high-flyers become literally addictive, especially with expanded use of options and leverage. It is important to be realistic about how much is on the table. This year, it has been relatively easy to make money buying what is hot. That can change quickly.