Poor 2020. You get no respect. You were ushered in with great fanfare, but became a target of contempt and marked as a year that will live in infamy.
It wasn’t all bad, though. You did deliver for investors. Who would have thought, with everything that transpired, that the S&P 500 would finish the year up 18% on a total return basis! And the positive YTD returns were achieved in the final two months of the year!
What will happen in 2021? It’s anyone’s guess. (For this reason, we don’t bother offering yearly market forecasts.) While 2021 is fully-embraced – perhaps more as a sigh-of-relief than anything else – we should not accept as truth the idiom about greener grass.
We are hopeful that in the year(s) to come the nation recovers from a contentious Presidential election, COVID deaths and lockdowns, the destruction of family-owned, small businesses, et al. We are also hopeful that financial markets continue their march higher, but on this one we temper our enthusiasm. (Successful investing is, after all, an artful balance of risk and reward.)
The US stock market in 2020 was a tale of haves and have-nots:
Haves
Tesla
Big Tech
“Stay-at-home” stocks
Have Nots
Everything else!
If you owned the NASDAQ 100, where all the haves reside, you made out great. If you owned the S&P 500, which like the NASDAQ 100, is heavily concentrated in Big Tech, you also did well. If you loaded up on Tesla and Bitcoin, congratulations, you get the last laugh!
Did we buy Tesla or Bitcoin? No. We’re investors, not speculators. We also take into account valuations. Paying nose-bleed price multiples for a hot, thematic stock does not appeal to us. What’s the fundamental value of Bitcoin?!
Bitcoin and crypto-currencies, in general, are intriguing to us, but more as an alternative currency, like precious metals. (Note: neither cryptos nor precious metals fully meet the requirements to be considered traditional forms of money.) We continue to study and learn, but for now the availability of exchange-traded crypto securities is lacking.
The problem with concentration, like leverage, is that it cuts both ways. We like to say that the way to make the most money in the stock market is to own one stock; the way to lose the most money in the stock market is to own one stock.
Currently, the top 5 Big Tech names (Apple, Microsoft, Amazon, Facebook and Alphabet) comprise 46% and 22% of the Nasdaq 100 and S&P 500, respectively. These Big Tech names so outperformed the broader S&P 500 index that their composition increased by 9 percentage points in less than a year! And Tesla was recently added to the S&P 500. So much for diversification.
It’s important for the overall health of the market and the continuation of the rally that we see broader participation by constituent companies. In the second half of 2020 we began to witness the beginnings, hopefully, of a rotation into beaten-down value and “re-opening” stocks. With the roll-out of COVID vaccines and the re-opening of the economy we anticipate turnaround performance by laggards. Notably, the bank and energy sectors have been HOT the past two months.
Something everyone should be paying close attention to is the direction of interest rates. The inverse relationship between interest rates and bond prices is well understood: rates go up, bond prices go down. What may be more difficult to comprehend is the relationship between interest rates and stock prices.
Artificially-low interest rates have been a huge windfall for publicly-traded companies. For one, these companies have been able to refinance debt at lower interest rates, thereby reducing interest expense. Secondly, they’ve been able to issue new debt (at low rates) in order to fund stock buybacks.
Why buy their own stock with borrowed money? Corporate executives are incentivized through stock price performance because they are awarded stock options with relatively short expirations. Reducing the quantity of outstanding shares is the easiest way to drive stock performance because it manipulates higher earnings per share. If you cannot make money the old-fashioned way, engage in financial engineering!
Stock prices have also benefited from low interest rates via discount rates. Financial analysts use different approaches to determine a stock’s valuation. One method is a Discounted Cash Flow analysis, in which future cash flows are discounted to the present using a discount rate. That rate is tied to prevailing interest rates. The lower the discount rate, the higher the present value of the stock. Can you guess which stocks have been inordinately, positively influenced by low discount rates? Growth stocks.
The low-to-negative (yes, negative) interest rate environment cannot last forever. Rates are artificially low because of global central banks’ intervention, not market forces. Central banks intervened heavily following the global credit crisis of 2008. The COVID pandemic was justification for even greater monetary policy adventurism.
The amount of negative-yielding outstanding debt worldwide is in excess of US$17 trillion! Why would anyone buy negative-yielding debt? After all, you’re guaranteed to lose money if you hold the debt until maturity. Some institutions, like insurance companies, must buy long-dated government bonds, regardless of the yield. There are also those who are speculating that interest rates will go even lower or even more negative. Not us.
While it is certainly possible that interest rates could go lower in the short-term, we do not believe that rates will stay low for long. The issue is scarcity, or lack thereof. Thanks to massive, double-barreled monetary and fiscal stimulus worldwide, money is cheap and easy. The term, “helicopter money,” has been no more applicable than it is today.
The problem with easy money is that it’s inflationary…eventually. As bond markets begin to react to the risk of rising inflation and rates, we can expect bonds to tumble. Currently, the 10-yr US Treasury bond yields 1.15%, up from 0.5% in August. (It yielded over 15% in 1981!) At most risk will be bonds with low coupons and long maturities. This is why we have been repositioning client bond exposure into short-duration and/or adjustable-rate securities.
Summary
There are many reasons for the stock market rally to continue: underlying stimulus, price momentum, T.I.N.A. (There Is No Alternative), etc. There are also many reasons for the rally to wane and, even, reverse: monetary policy tightening in light of economic re-opening, rising interest rates and/or inflation, historically high valuations, concentration, etc. One easy solution is to rebalance out of the haves and into the have-nots. What did well in 2020 may not repeat in 2021.
Traditional bonds performed well in 2020. We definitely Do Not expect a repeat performance going forward. The decline in rates and corresponding rise in prices mean that current bond yields are unattractive. In fixed income, perhaps more than in other asset classes, we see the need to be unconventional.
Most everything is expensive and, as a result, expected future returns could disappoint for years to come. This is why it’s more important than ever to be creative, risk-averse and diversified, using multiple engines of return.
Jack E. Ditt, Jr. William L. McCollum
