2020 is finally over. The year ended with a bang, as cyclical and small company stocks that lagged for most of the year outperformed during the final quarter. Cyclical stocks are mostly industrials, financials and energy companies that rely on a strong economy (which may be cyclical) and often perform best coming out of recessions and low-growth periods. The narrow stock market rally that we alluded to in last quarters’ newsletter, powered by the five biggest tech companies of Apple, Alphabet, Amazon, Facebook and Microsoft, finally broadened to include cyclical companies and smaller companies. Through September, these five tech companies were up nearly 60% for the year, and since they accounted for nearly 25% of the S&P 500 Index, contributed to more than 80% of the Index’s gains while about half the stocks in the index were actually down for the year and more than a quarter of the index were still down over 20%[1].
At one point in September, the Equally Weighted S&P 500 Index, where each company comprises an equal 0.2% weight, trailed the traditional S&P 500 dominated by the five biggest tech companies by a remarkable 12% for the year. However, by year-end, that gap narrowed to about 5.5%, as many of the market’s most out of favor sectors and companies outperformed growth stocks. During the fourth quarter, the S&P 500’s industrial, financial and energy sectors were up 15.7%, 23.2% and 27.8%, respectively. The Russell 2000 Small Cap Index was up 31.4%. The MSCI EAFE Emerging Market Index gained nearly 20% for the quarter[2].
As it always does, the market is looking ahead and factoring in successful vaccine rollouts and record stimulus amounts to bridge the gap until we can return to some semblance of normal and corporate earnings can fully recover. The current environment with post-holiday spiking virus cases is likely the worst we will see. Frontline workers and those over age 65 are expected to be vaccinated in the first quarter, with the general population right behind them in the second and third quarters of this year. For certain, there will be changes and continued challenges in this new normal. Thanks to video conferencing technologies, remote work will be more common and business travel will be down, pressuring both travel and hospitality companies and commercial real estate. But, many trends and themes have been pulled forward and are here to stay, such as e-commerce. However, as nice as it is to do things from home, many are looking to escape their homes and eat at restaurants and travel once again.
Do Not Trade Politics
While it seems that political risk remains elevated given the horrific events at the Capitol on January 6th, and the impeachment proceedings that will be underway, the election is over and the market has moved on, with the S&P 500 surging over 15% since the eve of November’s election. Similar post-election surges in risk assets happened after the U.S. Presidential Election in November 2016 and the Brexit vote in June 2016. We must remember that markets do not like uncertainty. However, once the uncertainty lifts, often no matter the outcome, markets can rally.
The Democrats won both Senate run-offs in Georgia, meaning the Senate is evenly split at 50-50, with the tie-breaker going to Vice President Harris. However, Democrats lost seats in the House of Representatives and will operate with the slimmest of margins. Therefore, no party has firm control and it will be more difficult to pass politically challenging legislation, such as a tax hike. Financial markets have historically preferred divided governments that prevent partisan policies from being enacted and there will still be some level of gridlock.
President Biden is pushing for additional stimulus which could include bigger checks for individuals and provide the necessary support that local towns and municipalities will need to avoid layoffs and tax increases since they are forced to operate with balanced budgets. Both parties seem to agree on infrastructure spending, so this could be a 2021 priority, with a focus on broadband and green technologies.
The tax increases that President Biden pledged while campaigning will be extremely difficult to pass while in a pandemic and economic recession. We suspect President Biden will keep any tax legislation on the shelf for year two of his administration – but only if the country can move on from the pandemic and return to economic growth. However, any tax hike could be muted given the nearly even split of Congress.
Overall, a Biden Presidency under the current conditions will likely be more predictable and less consuming and that should be positive for financial markets. Outside of marginal sector and allocation adjustments, it is difficult to profit from big bets associated with certain short-term, binary election outcomes, no matter the conviction. Investors tend to overweigh the impact of government actions on financial markets. Instead, it is best to make changes based on long-term financial and economic fundamentals and trends while considering personal financial goals.
Higher Long-term Interest Rates and Possible Inflation Ahead
One dynamic that is playing out since it became apparent that both Democrats would win both Georgia run-off elections is higher interest rates. The 10-year U.S. Treasury rate, which bottomed out at 0.50% in March and again over the summer, steadily climbed to just under 1% prior to January 5th. However, in the days since the elections the rate hit as high as 1.14%. In theory, Democrats will push for more stimulus and spending, which increases the chances for inflation and higher interest rates. On top of this, there may be substantial pent-up demand in an economy that is waiting for a green light to return to normal activities later in 2021.
The Federal Reserve is tempting inflation by stating its intentions of letting inflation rise over the traditional forecast of 2%. Moreover, the Federal Reserve has pledged to keep the overnight fed funds rate at zero for at least 2-3 years and continues to buy $120 billion in bonds each month to further stimulate the economy. Controlled inflation is considerably more desirable than the continued disinflationary environment of the last decade. And, from a long-term perspective, the U.S. inflating its way out of debt is much more palatable than taking painful measures of austerity.
There may be limits to how high the Fed will let long-term interest rates rise, which are usually market driven. Debt servicing costs would rise considerably if interest rates rise meaningfully and we would not be surprised to see the Fed manipulate the yield curve by keeping a lid on longer-term rates at some point.
We are wary of inflation, as the signals are in place and flashing yellow. However, we would need to see an economic recovery fueled by job growth and productivity to see meaningful inflation.
Global Asset Allocation Strategy
The strategy has been overweight equities since March. In October, the decision was made to reduce risk within the bond portfolio and continue to let equities run. This should allow for more “dry powder” at the next market correction and there should be far more upside in equities than bonds going forward.
Equities are diversified, but there is now a slight bias to cyclicals and smaller companies. These asset classes have trailed in recent years and valuations were preferable to large cap growth heading into the 4th quarter and may continue to rally if the economy fully reopens and the recovery story continues to play out. International exposure is about a third of overall equity exposure, with material exposure to emerging markets. International markets, and especially emerging markets, have trailed domestic equities since the 2007-2009 Financial Crisis and valuation is preferable. The declining U.S. dollar and less reliance on commodities within the emerging markets could alter this trend.
Bonds are shorter in duration and mostly high quality. There are some opportunistic holdings that can profit from a continued run in risk assets, but a substantial portion of the bond portfolio is meant to be defensive. In our view, reaching for yield and taking on more credit risk within bonds makes little sense at this time. The shorter duration should limit any downside from a rising interest rate environment. While we would expect interest rates to rise over time, we still expect to be in a relatively lower interest rate environment going forward.
Municipal bonds with tax-free interest are favored for clients in higher tax brackets with sizeable assets outside of retirement accounts. Municipals are positioned quite well at this time relative to other types of bonds given the potential for higher tax rates and greater stimulus passed to support local states and towns.
The strategy places a priority on tax-efficiency by relying on low-cost exchange traded funds (ETFs) that do not pass capital gains down to investors. Actively managed mutual funds are used only when there is a history of tax-efficiency due to lower turnover (i.e., trading within the fund) combined with lower costs and outperformance.
Focused Equity Strategy
The strategy trimmed technology exposure in August, as detailed in our last quarterly newsletter. The technology sector has led the way in recent years, but valuations became too extreme in some instances late in the summer months. The technology sector has lagged since peaking at the end of August.
Relative to the S&P 500, the strategy continues to hold less technology, with greater exposure to cyclical sectors such as financials (mostly banks) and energy. These sectors were extremely out of favor earlier in the year and, as outlined at the top of this newsletter, have been the best performing sectors since the end of the summer.
The overweight in industrials, however, is heavily tilted towards package delivery companies that may benefit less from a cyclical recovery and more from advancements in ecommerce. E-commerce continues to be one of the biggest portfolio themes. The strategy continues to hold limited exposure to two e-commerce companies in China. Volatility with these two companies has been higher of late, but valuations offset this risk.
There is a slight underweight in health care, a heavier underweight in consumer staples, both of which are traditionally defensive, and mostly absent electric utilities, also defensive and sensitive to rising interest rates. Therefore, the portfolio should be well positioned for a cyclical recovery.
In the fourth quarter, there was one change and it was within the Communication Services Sector: selling Verizon and buying T-Mobile. While we think Verizon is a solid company and well positioned in the mobile telecom space, we believe T-Mobile has more potential for improvement. Having just completed their merger with Sprint, we think T-Mobile has the ability to realize significant synergies, as telecommunications networks benefit from large economies of scale. Thus, as they get larger, it gets cheaper to service the average user. That gives them room to expand margins to a level more consistent with AT&T and Verizon wireless, while having the scale to invest aggressively in network upgrades. The combined T-Mobile also comes with an enviable spectrum position, which provides them extra radio bandwidth to supply advanced 5G services. This will take time to play out, but AT&T and Verizon will likely need to purchase additional spectrum in future auctions.
The strategy has traditionally invested with a value bias. Generally, paying less for companies with solid balance sheets and “earnings power,” with prospects for better compounded annual growth rates pays off over time. We will continue to search for investment opportunities that meet our criteria of having an excellent margin of safety, however, we also look to balance discounted valuations with companies that offer meaningful growth opportunities. Thus, we often add companies to the portfolio that may not look “cheap” by traditional metrics, but we believe have enough growth to justify the price we are paying.
Typically, the strategy will hold cash of 10%, or more in some instances. This allows us to be opportunistic when the time is right and for reduced volatility.
Don’t Fight the Fed or Uncle Sam
Due to nearly $4.5 trillion in government stimulus combined with further support from the Federal Reserve from immediately dropping interest rates and purchasing bonds, the recovery in risk assets has come faster than most would have predicted. It would be natural for a reasonable pull-back in equity prices. Markets do not go up forever in a straight line and there often needs to be a “digestion” of gains. Generally, markets tend to see a 10% correction about every 12 months. There have been signs of excess in recent initial public offerings (IPOs) and retail investor enthusiasm in a small number of momentum-driven companies.
As always, it’s important to remember that investors invest for the long-term. Expect market volatility. Remain focused on long-term financial goals. Consider market pullbacks as an opportunity to invest at lower prices.
[1] “When (And Why) Bigger Isn’t Better”; Barron’s; January 11, 2021
[2] Returns generated from Morningstar and Factset.