What Did We See?
- U.S. Large Cap stocks, or the S&P 500 index, was up more than 12% in Q4.
- The developed markets of Japan was up more than 11%.
- Europe was up about 10%, the U.K. up more than 12%.
- Emerging Markets were up almost 20% and Asia (Ex-Japan) was up almost 19%.
- Global fixed income returns were all positive in the quarter barring US Treasuries being down almost 1%.
Where Do We Stand?
- The Fourth quarter gave us the third consecutive quarter of positive equity returns.
- Valuations remain extremely stretched while growth looks set to stall in the first two quarters of 2021.
- I look to opportunities to better position portfolios as current cash levels are elevated and gold allocations remain to dampen future volatility.
- I continue to rebalance your accounts accordingly to ensure targets are within acceptable ranges.
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The fourth quarter of 2020 brought to a close a year like none we have ever seen. From the depths of despair in March to the euphoria of June, early September and the last two months of the year, this market has seen it all. Much of the fourth quarter was driven by the belief that there is not a bubble in stocks and bonds, the Federal Reserve will save us and stocks will always go up.
The past quarter brought us the third consecutive quarter of positive equity market returns. Driven by a relatively clean election cycle, extension of fiscal support measures and positive news on vaccines, the S&P 500 gained about 12% to bring the annual return to more than 18%. Small cap stocks gained about 24% in the quarter, while Emerging Market equites and Developed Market equities gained almost 20% and more than 14% respectively.
As often happens in the markets, we find ourselves at a crossroads. One road leads to higher equity prices, stable interest rates, some inflation and a weaker dollar. The other road leads to the exact opposite. While this may seem too binary in nature, it is important to understand the drivers of each argument and then make educated assumptions about the future. Many times, the truth lies somewhere in the middle and the market forges its own path. For now let’s focus on the divergent paths as we close out 2020.
The Great Bubble
The US Stock market is currently considered a bubble by some, “frothy” by others and fairly valued by most. When compared to historical averages, the Price to Equity ratio of the S&P 500 is almost two times it’s average. Currently the ratio is sitting at around 27 times trailing earnings, versus a historical average of 15 times. This measure of market valuation is now at its second highest level since 1935. It was in this range in 2008 and was slightly higher in 1999. We all know what happened in those market environments. Can it happen again?
Of course it can. Yet, for a moment let’s focus on what can save us from what we saw in 1999/2008.
The Federal Reserve
The Fed must continue to inflate asset values with infusions of cash, plain and simple. Without the Fed’s backing, the markets and asset values everywhere (home prices, etc..) would be much lower. Furthermore, without the Fed’s programs we would likely be in a credit crunch, much like we saw in 2008/2009. The Fed is doing everything in it’s power to avoid such a credit crunch and for now it has been working. Prior to Coronavirus, the Fed infused about $5 Trillion into the stock and bond markets. Since Coronavirus hit our shores it has added another $3 Trillion in relief and is likely to add another $2 Trillion before we are done.
Over the past decade the S&P 500 has gone up about 250%. The decrease in interest rates was responsible for about one fifth of that increase. The rest of the increase could be attributed to Fed easing and investor euphoria. Without the Fed, there is no investor euphoria and the markets would have languished. Whether you like it or not, the Fed is here to stay with us for a while and that can keep equities lofty.
Demographics
The millennial generation has found the bug for investing. Through trading platforms like Robinhood and others they are learning to invest and what it means to be an owner of a company. They started their interest in the markets in the depth of 2009 and so have really only experienced “up” markets. Buying the dips is a religion to many of these investors. They also use Robo-Advisors, which don’t sell emotionally when the markets turn lower. This may be the first generation to actively understand their own biases and when not to act upon them. Or at least allow something else to manage those biases. This is a great thing.
Tech/FAANG
The darlings of the most recent bull market has been the so-called FAANG stocks. This is Facebook, Amazon, Apple, Netflix and Google. These are the innovators and direct beneficiaries of the tech generation. The health of these companies is a bellwether for the new economy in the US. If the general public is not spending money or feeling good about themselves and their financial situation, these companies will show that. Right now they have held up well in the face of the pandemic, some even thriving.
The others
Several other trends will need to happen but have a lesser effect overall in my opinion. Baby boomers need to stay invested in equities. With interest rates at extreme lows I would expect that to be the case. Boomers need to fund their retirements and the old game of “living off the yield” just doesn’t work anymore. Lastly, investors need to believe there is a light at the end of the tunnel. We have seen this with each and every announcement of advances in vaccines so I would expect that they do see the light. Lest we forget, there is huge pent up demand for things like travel and anything that has been put on hold for more than a year due to the pandemic. When the light turns green on escaping our homes the consumer may party like its 1999.
The Bad News Bears
Technically the S&P 500 is trading at historical extremes. Wall Street analysts have been making their predictions for 2021 and many of them are extremely optimistic. Some are calling for 15% returns. The lowest is calling for flat returns. Practically no one is negative on their outlook. The thing to understand here is that analyst are rarely correct and almost always overly optimistic. Because of the inner workings of Wall Street banks, their jobs depend upon it. So, take these projections with a block of salt. The truth (again) probably lies somewhere in the middle. That is because in an economy that is $85 Trillion in debt any advances in inflation or rates could spell disaster. Sure, the Fed can always step in and try to rescue us again. The reality is that earnings will have to improve markedly or prices will have to revert for a time.
Corona-Virus
The pandemic has effected virtually all businesses worldwide. The hospitality industry is in a place it rarely finds itself. While some have been able to pivot their businesses, other have not and will fail. Many have failed already. While working from home has worked for some it doesn’t not solve our problems in the longer term. In fact, only about 30% of our economy can work from home according to the Bureau of Labor Statistics. The rest are either stuck braving the elements or losing their jobs. This not only effects actual paychecks, it effects the psyche of business owners and entrepreneurs (the real driver of our economy). If businesses keep closing and entrepreneurs are not willing to take the risk in opening new businesses then general economic activity has to decline. Less Coronas sold in bars leads to less people who can afford to buy Coronas. That cycle continues until the psyche changes.
“Fedurance” (Federal Reserve Endurance)
The Federal Reserve is controlling the short end of of the yield curve. They do this with bond purchases of shorter dated bonds. This is called easing. In the current environment, if the Fed stops easing stock markets plunge. We saw that in the latter part of 2018. The question arises as to whether or not the Fed can continue easing until the “Corona-Virus” discussed above is behind us. Remember, even when the real coronavirus is mostly eradicated, the ability of entrepreneurs to take risk and restart all those failed businesses may be delayed. It is imperative to get the economy back to full employment that these failed enterprises are replaced. This will take some time. More time than the Fed may have.
Our Portfolios
On average I would tend to lean towards the positive arguments cited above. This does not mean one should not have an eye towards the potential negative events that loom on the horizon. We know that this is not the 2008 environment where markets became structurally unstable. Yet there are many unknowns still out there. The potential for a short and quick recession still lays before us. With it we could have market volatility like we saw in the latter part of the summer or late 2018.
The result of this is that we remain with higher cash positions that normal and a small allocation to gold where appropriate. As always, our allocations to bonds (in line with your individual risk profiles) will help us navigate any volatility that 2021 will bring us. As will our well diversified equity portfolios. Any volatility we experience going forward would be an opportunity to rebalance portfolios and prepare your investments for the future.
If you have any questions or have experienced any changes in your financial situation please do not hesitate to Contact Me.
We appreciate you being a part of the Shorepine Wealth Management family!
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