“My expectations were reduced to zero when I was 21. Everything since then has been a bonus.”
— Stephen Hawking, Physicist & Nobel Laureate
Markets have managed to not just survive, but thrive, as the world navigated a global pandemic. As investors turn the page on 2020 and glimpse a post-COVID future fueled by the hopes of a nationwide vaccination program, many are disregarding Professor Hawking’s insight and expecting financial assets to continue to soar. When expectations are low, upside surprise is a reasonable expectation. However, when exuberance abounds, disappointment may be lurking around the corner.
As we enter 2021, expectations are extremely positive for equity market returns. After robust broad market gains exceeding 18% in 2020, despite the collapse of 2020 corporate earnings as compared to 2019 levels, Wall Street analysts are still forecasting returns above 8% for the year ahead. A Bloomberg survey of 17 strategists from prominent investment banks had an average expected return of 8.1% on the S&P 500 with several predicting 17%+ returns. None of the survey respondents were forecasting a negative year ahead. Anecdotal evidence from other assets including Bitcoin, up 100% since the start of 2021, implies a growing euphoria that robust growth lies straight ahead. Assets feel like they are priced for perfection yet again.
Resisting broad market sentiment and charting a path grounded in a consistent asset allocation philosophy is the key to long-term success, but it is important to have a sense for where the crowd is gathering and its impacting risks to portfolios. As we seek pockets of opportunity, particularly in private markets, it will likely be in less crowded spaces.
Equity markets in the US had a remarkable year. The S&P 500 started 2020 strong and shrugged off initial reports of an unknown pneumonia spreading from China to Italy and hit a record high on February 19th. Then the phrases corona virus, pandemic, and lock-down became our reality, sending the market plunging -33% from its all-time high and reaching a low for the year on March 23rd. It is notable that March 23rd is also the day the Federal Reserve increased support for markets by opening a program to purchase additional government bonds, back-stop money market funds, support the municipal bond market, and even enter both the investment grade and high yield corporate bond sectors. It is no coincidence that the market began to recover after these actions by the Fed. These extraordinary measures by the central bank were augmented by trillions of dollars of federal stimulus and unemployment benefits which further supported the markets. Since the March lows, the S&P 500 rallied +47%, a result few anticipated and a stunning reversal of fortune given the continued uncertainty surrounding the pandemic.
The S&P 500 remains expensive with a forward price to earnings (P/E) ratio of 23.72, well above the long-term average of 17.61. As noted in previous letters, the elevated P/E is more reasonable when viewed relative to interest rates. With cash paying zero and the ten-year US Treasury bond yielding 1%, an earnings yield on stocks, the inverse of the P/E ratio, of 4.22% provides a spread over fixed income of 3.22%. This is less than the long-run spread of 3.96%, but is in a more reasonable range than the absolute P/E implies. This does mean that equities are vulnerable to a sudden rise in interest rates, but with the Federal Reserve clearly willing to take decisive measures to limit an increase in rates this seems a manageable risk for investors.
In taking a closer look at the dynamics of the US equity market, it is startling to see the consistent outperformance of the growth index versus value companies since the financial crisis. This rally has been led by the rise of the largest technology platforms including Alphabet, Amazon, Apple, Facebook, and Microsoft. These ‘tech giants’ have outperformed the traditional value sectors; financials, consumer staples, and energy; by a wide margin in terms of stock market returns, as well as in actual business performance. While they have been rewarded for their outsize revenue growth, large profit margins, and significant earnings per share, they are now richly valued. These top five market leaders are priced at a forward P/E of 32 while the other 495 stocks in the S&P 500 trade at a forward multiple of 19x. As we look forward to 2021 and beyond, we see room for the other 495, especially those in the traditional value spaces, to catch up to the index leaders. For equity markets to continue the growth trajectory, this rotation is almost a requirement.
The State of the U.S. Economy
The dramatic swings in the equity market were driven in part by historic changes in economic growth in the first six months of 2020. The second quarter of 2020 saw the largest drop ever in US economic growth in a single quarter followed by the sharpest increase in GDP in the third quarter.
Most observers have optimistically project growth normalization based primarily on the assumption that aggressive vaccination efforts would have more than half the US population inoculated by the end of June. However, challenges in the vaccine roll-out combined with certain segments of the population reluctance to be vaccinated implies that the assessments may be overly optimistic. As COVID cases continue to rise during the post-holiday period and a new COVID strain spreads rapidly in Europe, it appears likely that we will be wrestling with the economic and health effects of COVID-19 for most, if not all, of 2021.
A longer battle with the pandemic means the anticipated decline in the unemployment rate could take longer to materialize. While there has been significant improvement in the labor market since last spring, reduced hiring due to new lock-down measures could delay the recovery.
There are however two glimmers of hope on the short-term economic horizon. First, with the Democrats now in control of both the House and Senate, the Biden administration is unencumbered to move quickly on an additional stimulus bill that will augment the package passed in December. The administration is also likely to push for a significant infrastructure spending package which would add further support to the economy over the medium term.
The second reason for optimism lies in the nature of this pandemic induced recession itself. Most recessions are caused by higher interest rates forced by rising inflation or the bursting of an asset bubble and a resulting banking crisis. These “normal” recessions hit industries such as manufacturing hard and take a significant amount of time to recover. That is, once a manufacturing facility is closed it is unlikely to quickly re-open. However, the COVID-19 recession has hammered the service sector (dining, nightlife, hospitality, etc.), but these areas should be able to recover quickly once the virus in under control and restrictions are lifted. Early indications from China show that once the economy re-opens, consumers appear eager to quickly resume dining out, beauty treatments, and travel. There is certainly reason to believe that US consumers will follow suit and aggressively embrace normal activities once it is safe to do so.
Risks: Expected and Unexpected
We opened this letter with a brief discussion of perceived consensus expectations and the importance of resisting the obvious. It is also helpful to imagine the risks that could undermine the consensus as a way to wargame possible scenarios for the future.
The dominant theme in the current financial landscape is the conviction that interest rates, both short and long-term, will remain at historically low levels for the foreseeable future. The Federal Reserve has re-enforced this view by stating they would keep rates low until the economy is firmly growing again and that they would accept higher inflation in exchange for a faster growing economy. In fact, the Fed has changed their approach to inflation and is now targeting an average of 2% over the medium term. This is a subtle, yet significant change from their traditional stance that sought to effectively cap inflation at 2% and not let the economy “run hot.”
The importance of this conviction around rates cannot be overstated. In an environment where it seems all assets are at stretched valuations, their relative attractiveness relies on the fact that the risk-free rate, the yield on cash, is effectively 0%. If interest rates spike higher almost all financial assets would be negatively impacted. In such a scenario, the Federal Reserve would be forced to exert control on the yield curve by purchasing enough treasury bonds to bring interest rates back down to their desired level. This would work for a time, but may have longer-term repercussions including the potential for future inflation or, even worse, expectations for a deflationary overhang similar to what Japan has been experiencing since the early 1990’s. Neither scenario is a happy one for investors. This risk bears close attention over the next few years.
Unexpected risks, such as COVID-19 or a natural disaster, are by definition outliers. Though they can’t be accurately predicted, we can be prepared. The only defense against unexpected risks is to maintain a diversified portfolio with exposure to cash, fixed income, equities, and alternatives that can weather through an extended storm. Thankfully, that recipe also helps mitigate the damage from expected risks that propagate faster than anticipated.
Translating Thoughts into Action
We strive to have our portfolios fully invested at their target strategic allocations with an overlay of tactical positioning after considering the risks and rewards available in the current environment. Given our perspective on where we are today, we expect to implement the following actions:
1) Maintain cash reserves for 18 months of spending and opportunistic investments.
Given rich asset valuations, economic uncertainty, likelihood of additional COVID shutdowns, and a lively political environment, we believe it prudent to have enough cash reserves to cover spending needs for an extended period of time. In addition, this cash reserve can be used to rebalance a portfolio should sudden shocks occur.
2) Balance the allocations to growth and value in equity holdings.
Our growth and technology managers have been on an extended run of excellent performance, but we recognize the risk in becoming over exposed to one strategy. We will continue to trim from growth and add capital to active managers in the value space in order to maintain balance in our holdings.
3) Seek yield in private credit opportunities in real estate and direct lending.
High quality fixed income yields are extremely low and seem poised to provide muted total returns for the foreseeable future. We believe fixed income can continue to provide protection during periods of market stress, but current rates provide little chance for significant positive growth. We are seeing attractive opportunities in private real estate and corporate lending as banks continue to adjust their exposure through the pandemic. We believe we can add substantial income and return to portfolios by taking on liquidity risk in these private markets in exchange for higher yields.
In addition to these three main actions, we continue to monitor emerging market equities and additional alternative exposure in private growth equity managers. As those opportunities and others continue to evolve, we will consider how they fit into our current allocations.
Understanding consensus expectations is critical in gaining an understanding of the future in which markets and investors are currently pricing. Many strategists marketed their 2021 preview reports with some version of the “Roaring 20’s” in the title. While easy to draw superficial comparisons with the spurt of economic growth and creative energy that occurred after the shock of World War I and the Spanish Flu passed, we do not feel it is comparable to our current situation. Society, government, and markets are much different a century later.
Our expectation is to continue to apply a consistent approach to asset allocation while always assessing risks and opportunities that may be present in the broader market. We believe that there are attractive opportunities for investors today in select areas, but agree that broad markets are generally priced for perfection after several years of attractive equity returns. We expect that the actions we have outlined in this note will help guide our portfolios through this choppy environment.
We wish you all the best in 2021 and look forward to visiting with you soon.