Market Commentary - Q4 2020

Stocks end wildly volatile year at record highs (31 December 2020)

A year dominated by a global pandemic and economic uncertainty; who could have guessed it would be one of the best years in history for US stock markets?

Key Highlights

Throughout 2020, our market analysis and recommendation have been based on a research report we wrote on March 27th, "Seeking Opportunities in Business Cycles". The logic beyond the report is to identify certain asset classes, industries, and companies that tend to outperform in certain stages of economic business cycles. Our aim was to identify where the global economy was in the business cycle at each point in time and to determine areas we believe would outperform the overall market (S&P 500). 

Our investment analysis has proved to be highly successful in a year riddled with fear, volatility, and uncertainty. We have correctly identified current stages of the business cycle as well as recommending the best performing equity indexes in both Q4 and for 2020 full-year.

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• The Dow Jones Industrial Average, S&P 500, and Nasdaq Composite all bottomed out on March 23rd.
• On March 27th, we recommended reducing exposure in bonds and buying the Nasdaq 100 in medium to long-term investment portfolios.
• The Nasdaq 100 was the best performing equity index in the world in 2020, up 47.6%. 
• From the date of our report and initial recommendation (3/27 - 12/31), the Nasdaq 100 was up 69.8%.
• On November 2nd, we released another research report, "Is now the time to buy small-caps?" report identifying a potential buying opportunity in US small-cap equities and recommended purchasing them in medium to long-term portfolios.
• The Russell 2000 (most widely used US small-cap benchmark) was the best performing equity index in the world in Q4 2020, up 31.0%. 
• From the date of our report and initial recommendation (11/2 - 12/31), the Russell 2000 was up 25.9%.
• Source: MarketWatch
  

That being said, it is critical to have a diversified portfolio so that dips in the market are not as impactful on your financial plans. Like full market dips remaining unseen in a portfolio, full market gains are also not seen at overall portfolio performance level given its diversity.

We strongly believe that we are in a new age of investing. Over diversifying in certain asset classes and/or geographical regions, just for sake of diversifying, is an outdated strategy and is not pertinent to the current market environment. We have realized this early on and have been proactively positioning portfolios accordingly over the past 12-24 months.

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2020’s stellar stock market returns would be easy to imagine in times of economic boom, but 2020 has been anything but that for the world outside of Wall Street. The cold reality is that the market’s rally has occurred in the midst of a ruthless global pandemic that has killed more than a million people, halted business and travel, and wreaked havoc on the economy. Although there are plenty of reasons for the market’s sharp comeback in 2020 and beyond, not the least of which is the Federal Reserve’s massive intervention, the staggering rally is still difficult to comprehend for many investors.

The COVID era of investing is vastly different from previous recessions and business cycles. From the sheer velocity of market dips and recoveries, to record low interest rates, to government induced shutdowns, to the new army of individual investors, we are in uncharted territory when predicting how markets will react to events and data. A disciplined, long-term approach to investing will prevail in this environment.

What’s happening on Main Street isn’t necessarily reflected on Wall Street

Many observers, retail investors, and institutional investors have been perplexed by the sharp recovery in US equity markets from the March 23rd bottom. Coronavirus cases were surging, restaurants, stores, and theaters were forced to shut down, airplanes were grounded, and millions of people were now suddenly furloughed or unemployed. 

Everyone, including seasoned market professionals seemed to be asking the same questions, “How could the market be doing so well when the world seemed to be doing poorly?”

The answer: The stock market often begins to recover far sooner than the economy. We touched on this in our March 27th research piece as we believed the market bottom was in place. In the case of the financial crisis, US stocks hit their bottom on March 9, 2009, but it took seven years from then for the unemployment rate to fall below pre-crisis levels.

Similarly, while stocks managed to charge higher in 2020 and finish the year at record highs, many economists do not expect the US to recover all of the jobs lost during the pandemic until 2023 or later. Certain industries, like technology, have thrived under the government shutdowns and others, like travel and hospitality, have far more difficult and longer paths to recovery. Of course, the Fed’s intervention is a driving factor of the markets propelling to new highs in record time.

“A lot of people said the market is disconnected to reality, but stocks are pricing in what’s going to happen in six months to a year,” not what the economy looks like today, said Andrew Slimmon, managing director and portfolio manager at Morgan Stanley Investment Management. During the pandemic, investors who began betting on a stock recovery in the spring were not assuming the economy was about to come roaring back. In fact, they were assuming it would be better months down the line and given the lack of alternatives for return/yield in other asset classes, they proved to be right.

“It’s not until you have this huge rally that suddenly people realize, ‘Oh, the stock market isn’t wrong, I’ve been wrong,’” Mr. Slimmon said.

Time in the markets, not timing the markets

On June 8, 2017 we published a research piece titled “Get invested, stay invested". There has never been a more prime example of the importance of not trying to time the market than in 2020.

With both the COVID-19 recession and 2009 financial crisis, individuals who sold their stocks on bad news and waited for the economy to recover to get back into the market would have missed out on the bulk of stocks’ upside. As emotionally unsettling as sizable selloffs may be, history shows that the vast majority of investors are better off not jumping in and out of the market. Disciplined investors with diversified portfolios, more often than not, tend to be successful investors. Investing for the long-term is the best way to achieve success for your financial goals.

Within the next two years, the long-term investor must ponder the growth of both the economy and corporate earnings. We think that there will be growth in both the economy and corporate earnings, and because of that, we think the market has a solid foundation.

Big tech dominance

Yet again, investors predicting value would finally unseat growth were proved incorrect. The technology sector in the S&P 500 gained 42.2% and was the best performing sector in 2020 versus the overall S&P gain of 16.3%. That is a 25.9% outperformance. Consumer discretionary was the next best performing sector with a gain of 32.1% for the year.

Tech giants such as Facebook, Apple, Amazon, Netflix, Google, Zoom, Peloton, etc, thrived in a remote work environment. Although we believe there will continue to be a large remote workforce in 2021, we do not believe that it will remain this way in the foreseeable future. We think that the majority of employees will return to their offices in the second half of 2021; however, that does not necessarily mean that the technology adopted on a large scale throughout the pandemic is going away. Zoom will likely be a widely used technology for years to come as business travel will recover slower than leisurely travel. Analysts believe that business travel will never return to pre-pandemic levels.

Tesla seemed to defy all odds and finished the year as the best performing stock - and it was not even close. Tesla gained 743% in 2020 and became the world’s most valuable automaker. The next best performing S&P 500 stock was Etsy, which added 301%. 

Airbnb made its public debut with a greater valuation than Marriott, Hilton, and Hyatt, combined. 

Sky high valuations and record returns does not necessarily mean that 2021 will be the year that growth stocks take a back seat to value. Society as a whole was becoming more technology-oriented, even before the pandemic. The end of the COVID-19 pandemic will not be a remedy to companies in already struggling sectors, such as oil or bricks-and-mortar retail.

In Q4, we began to see a reversal as the COVID-19 vaccine was approved on November 9th and is being widely distributed and administered. That same day, stocks including Zoom and Peloton had one of their worst of the year, logging double-digit percentage declines, although they quickly made up ground in the weeks that followed. 

We caution investors that some technology companies have disproportionately benefited from a pandemic that has forced individuals to spend more time at home and online. Valuations of some technology companies are stretched and caution should be taken in heavily overweight technology portfolios. While we are still overweight technology for the long-term, we are not as overweight as in the first half of 2020 and we believe that a rotation from the technology companies with very high price to earnings multiples into stocks that will benefit from a broader market recovery will be the winning trade in 2021.

The New Army of Individual Investors

In recent years, financial literacy has become a focus point and individuals have more of an interest in their personal finances and investing goals. The pandemic closed the door on one of the oldest excuses that individuals used for not paying closer attention to their finances, “I don’t have the time.” Individuals certainly had more time in their houses than ever before and used this as a positive to focus more on their finances and investing goals. Investors have become hooked on the excitement and journey of investing for their future. 

As casino’s were forced to shut their doors, sports were on hold, and increased time was spent within the home, individuals piled in to bet on stocks and more than 10 million new brokerage accounts were opened in 2020. Driving the interest was a combination of factors that started with an industry wide shift to commission-free trading in 2019 but swelled as market volatility grew. Interest is not fading, either. App downloads for brokerage firms, while lower than earlier in the year, remain resilient, with the Robinhood app expected to reach 500,000 downloads in December alone. Website traffic for well-entrenched brokerages, including TD Ameritrade and E*Trade, continues to increase as well.

Some investors, including influential figures for the younger generations such as Dave Portnoy, used the spaces to tout gains and lament losses. On peak trading days in 2020, individual traders are estimated to have accounted for nearly 25% of US trading activity, Citadel Securities estimates. Overall, their share of total trading volume doubled to an average of 20% from 10% in 2019, Citadel said.

While all signs point to the new army of investors being inexperienced and due for a reality check, they might be more sophisticated than many think. Despite the attention on the riskier trades that investors executed, studies have found individual investors performed well in 2020. A June research piece from Goldman Sachs analysts found that a basket of the stocks most popular among individual investors had outperformed hedge-fund and mutual-fund favorites - as well as the broader market - since the March lows, due to individual traders’ quicker embrace of value stocks. Maybe even more importantly, research found that individual investors did not significantly panic when markets tumbled this year, which rewarded them when markets began rising. The 2009 financial crisis is still fresh in people’s minds and many individuals have learned not to panic during market crashes and that often it is time to seek out opportunity.

Although a debate about the risks and rewards that online brokerages enable is likely to continue, few analysts or financial advisers argue that enticing people to begin investing earlier is a bad thing. Studies have repeatedly shown that investing early can lead to bigger gains later in life. The recent introduction by online brokerages of tools such as fractional shares has made trading big-name companies with $1,000 price tags more accessible as well.

Investors should always do their own research before investing and consult a professional. Investing involves risks and past performance is not indicative of future results.

Gold and Bitcoin

Gold is wrapping up its best annual performance in years. What comes next for the precious metal hinges on a handful of unpredictable dynamics ranging from the strength of the global economic recovery to the health of the US dollar.

Most-actively traded gold futures for February 2021 delivery finished the year at $1,893.40 per troy ounce, putting gold on pace to finish 2020 up more than 24% - its best year since 2010. An outperformance of over 8% compared to the S&P 500.

After soaring earlier in the year, gold prices have retreated from a record of $2,069.50 per ounce reached in August, dragged down by signs of improvement in the global economy. Investors tend to buy the metal when nervous about holding riskier assets such as stocks or corporate bonds.

We have been pairing back gold holdings in client accounts in the second half of 2020 to about 5-10% allocation as we believe there are some headwinds in 2021. We expect more moderate gains for gold in 2021 as the economic outlook improves. From Nov. 6 to Dec. 18, investors pulled more than $10 billion from gold-backed exchange-traded funds, according to data from the World Gold Council, a notable reversal from the record inflows earlier in the year. These outflows may have been reallocated by investors to purchase Bitcoin, widely referred to as “digital gold”, as it has hit a record high in December.

Much will depend on the strength of the U.S. recovery. A resurgence in the COVID-19 pandemic and a runoff election in Georgia next month to determine control of the Senate could prompt market volatility in early 2021, traders say, providing support for gold prices.

We still believe that there is a place for long-term portfolios as government spending and inflation is expected to increase in the coming years; however, this should be a small overall allocation - approximately 5%. Investors should caution when it comes to holding gold if real yields on bonds increase.

Natasha Kaneva, head of commodities research at JPMorgan, now expects real yields to climb and gold prices to fall to $1,650 per ounce by the end of 2021. She asked, “If real yields are going up, why would you be buying gold?”

Bitcoin has picked up steam in Q4 2020 as a wider adoption is expected, increased fears of a weakening US dollar, increased government spending, and potentially rising interest rates in the years to come has fueled the crypto-currency to new all-time highs.

Flock to the suburbs

Nationwide, the median single-family home price rose 12% from a year earlier to $313,500, National Association of Realtors stated.

The housing market is benefiting from COVID as individuals and families flock from urban apartments to suburban homes in need of more space from remote work policies. The housing market is seeing red-hot demand for both bigger homes and second homes. Even millennials are moving into homeownership from rental, something that many experts predicted might never be able to happen.

Record-low mortgage rates have motivated home buyers to enter the market and a longstanding shortage of homes for sale has worsened, increasing competition among buyers and sparking bidding wars. Existing-home sales have surged in recent months and reached a seasonally adjusted 14-year high in September. The median price for existing homes in each of the 181 metro areas tracked by NAR was higher in the third quarter from a year earlier.

This broad-based rally for single-family homes marked the first time since 1980 that every metro area tracked by NAR posted an annual price increase in the same quarter, NAR said. Back then, the association tracked 19 metro areas.

We believe that the work-from-home environment will not be the norm forever, but we do believe that people will be less willing to take public transportation upon returning to work and will continue to prefer to live in a home rather than an apartment. We see the trend of individuals and families moving from urban apartments to suburban homes will continue into 2021 and be a multi-year trend. 

We also believe that the auto industry will continue to benefit as more people flock from cities to the suburbs.

Rising interest rates and inflation

One of the biggest headwinds to equity markets in the medium (18-36 months) and long-term (36+ months) is rising interest rates and inflation. There is a massive need for yield as inflation ticks up and baby boomers retire in droves. These individuals will look for a trade off between income oriented assets and risk assets in order to produce an income stream in retirement.

The Fed has reinforced its plan to provide open-ended stimulus to spur the economic recovery; however, this cannot continue forever. Fed officials slashed their short-term interest rate to near zero in March as the COVID-19 pandemic disrupted financial markets and the economy. They also launched an array of emergency lending programs and began large-scale purchases of government debt and mortgage securities.

In December, officials updated their formal guidance around how long those purchases would continue, complementing an earlier pledge in September that set a higher bar to raise interest rates.

The Fed has been buying $80 billion in Treasuries and $40 billion in mortgage bonds per month since June while pledging to maintain those purchases “over coming months.” On Wednesday, the central bank stated those purchases would continue “until substantial further progress has been made” toward broader employment and inflation goals. According to projections released in December, officials do not expect to reach those goals for years.

Where are we in the business cycle?

We have seen one of the quickest “Early” stages of the business cycle in history and a sharp V recovery. Even with the stalling of fiscal stimulus, we believe that we are in the Mid cycle of the business cycle. The Mid stage is typically the longest phase of the business cycle and displays positive but more moderate growth than the early stage.

Headwinds for growth stocks are as follows:

• Regulatory pressure on Apple, Amazon, Google, and Facebook - While we do not believe the tech companies will be broken up, this will be years of court battles and headline pressure.
• Georgia run-off election - If the Democrats sweep the Georgia run-off election corporate taxes are set to increase which will weigh more heavily on the tech industry over others. Also, capital gains taxes will increase under this scenario and investors will look to sell holdings that have the highest gains before this increase takes place.
• Slower roll-out/adoption of the COVID-19 vaccine - The vaccine only works if it is available for administration and individuals receive it.
• Valuations are historically high - While this market is less of a fundamentals driven market than we have ever seen before, many of the tech names have run up quite dramatically from March and the correction we are seeing in these names is healthy.
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• Double-dip recession - The single largest short-term headwind for the market is the risk of a double-dip recession. While this is not our base case for 2021, economic data needs to be watched closely. 
• Rising interest rates and inflation - As a Biden presidency likely means increased spending, the dollar will continue to weaken putting a strain on bond prices and driving interest rates up. The Fed is doing everything in their power to keep interest rates low to stimulate economic activity, however this cannot continue forever and eventually we will see a rotation from stock to income producing assets. However, this is not expected to happen until 2023 at the earliest.
  

We believe there is a place for an allocation to value stocks in a diversified portfolio, but we still favor a slight overweight to growth stocks. We will be using value stocks as more of a hedge against a technology concentration in portfolios and to take advantage of a mid-stage economic cycle as value names are still well off their pre-pandemic highs and could have a rebound strongly as COVID-19 restrictions dissipate over the coming months.

The inability to spend on travel, leisure, and dining out combined with stimulus checks has increased individual’s savings rates significantly. We believe once the broader economy recovers and the threat of COVID-19 reduces, there will be large increases in consumer discretionary, travel and hospitality spending and inflows into beaten down sectors in equity markets.

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It is important to keep in mind that the disconnect between equity markets and the underlying economy is largely due to the simple fact that public markets trade large corporations who have strong earnings and easy access to capital. We invest in Wall Street, not Main Street. While there is an obvious correlation between equity markets and the broader economy, equity markets tend to lead the economic recovery by six months or more.