2020 ended up as a very good year for the markets despite the global tragedy of Covid 19 and the associated economic pain. As of Christmas week the S&P 500 was up 14.8%, significantly above its 9-10% average annual gain, including dividends, for the last 100 years.
The disconnect, however, with the underlying economy and health couldn’t be starker. Globally, nearly 1.7 million have died from the coronavirus, stemming from nearly 77 million cases. Domestically, the jobless rate started the year at 3.5% and soared to 14.7% in April amid the lockdowns. It remains unacceptably high, at 6.7%.
While nearly all asset classes have appreciated, there is wide disparity. At the top of the leader board is the Nasdaq 100, up 45.9%. Demand soared for these primarily tech companies as consumers retreated to their homes but required tech tools and equipment to stay productive and engaged, albeit virtually. Crashing interest rates made earnings forecasts for many years out relevant; discounting of those future earnings was greatly reduced.
Yet, amid government largesse, from the Federal Reserve and from Washington’s four stimulus packages, some spied incipient signs of inflation. Silver almost kept up with the Nasdaq 100, rising 45.6%, while that barbaric relic, gold, beat the S&P 500 with its 24.1% gain.
On the other end of the spectrum sat energy. Lockdowns meant many vehicles stayed in garages, airplanes on the tarmac. The S&P 500 Energy sector cratered 35.7%, as profits plunged on the back of crude oil’s 19.6% fall. Prices at the pump fell to their lowest in four years. Industry sentiment worsened as it braced for new green initiatives.
Bond investors fared well. The benchmark Barclay’s Aggregate Index has returned 7.5% so far this year. Interest rates declined mightily on the back of the Federal Reserve’s efforts to backstop the economy. The 10-year US Treasury started the year yielding nearly 1.9% but fell all the way to just 0.52% in early August before rebounding to the current 0.95%.
Echoing the action in the economy and the stock market, bond investors prized safety and were willing to pay up for cash flows way in the future, while being skeptical that heftier payouts from credit challenged issuers were sustainable. Long-dated Treasuries, as measured by the iShares 20 Plus Year Treasury Bond ETF (TLT), have returned 17.1% this year despite its current meager yield of 1.4%. Meanwhile, high yield bonds returned just 4.14%, as measured by the SPDR Bloomberg Barclays High Yield Bond ETF (JNK), despite a much better current yield of 4%.
Key Takeaway One
Forecasting is Hazardous: The Fundamentals are Not Easily Predictable, Much Less the Market’s Response to Them!
Last year at this time the pundits, as reflected in the weekly financial magazine Barron’s, mentioned nothing about the coming pandemic, even though some cases had already developed in Wuhan China. The focus was on geopolitical and political issues. Few foresaw the black swan that was COVID.
However, their year-end S&P forecast on average was 3295, up just 4% versus what then prevailed. Contrast that with the current 3709; they were short by a whopping 12.5%. How pessimistic would their S&P forecasts have been had they forecast the pandemic!
Bottom line: It is difficult to forecast the underlying economy and the events that may affect it, to say nothing of the market’s reaction to it.
Key Takeaway Two
Don’t Underestimate the Readiness of Government Policymakers to Use Every Tool Available to Prop Up Markets and the Economy
The only way to reconcile the market’s ebullient response to the worst pandemic since 1918 is to salute the efforts of our Federal Reserve. Unlike the Fed’s response to the 2008 subprime crisis, this Fed boldly lowered interest rates and exercised extraordinary and unprecedented powers to buy and thus prop up volatile credit markets. By doing so, it muted the ripple effect of the economy’s lockdown on the markets, preventing an ugly situation from getting worse.
Why did the Fed move so rapidly, and better its 2008 performance? First, 2008 was still in the Fed’s mind, and the sting of criticism remained that it could have done more and moved more rapidly. The 2008 playbook of not just lowering rates but also using “quantitative easing” was very easy to dust off.
Unlike 2008, there were no villains to potentially teach a lesson to. In 2008, a significant chorus disparaged Fed intervention on the grounds that the financial institutions brought the crisis on themselves and inflicted lots of pain on innocent victims. Those victims were enticed into overborrowing against their homes or to buy risky mortgage paper from the banks. In this pandemic, the sentiment was that no one should suffer economic pain from the downturn as no one was blameworthy.
On the fiscal side of things, the reaction was similar. Relief in the trillions was enacted, under the similar belief that no American should be left economically behind through no fault of their own. With the election just months away, being seen as providing the most help possible was important.
We believe that policymakers will continue to provide the maximum help possible for any economic downturn, thus providing significant support under the economy and the market.
The path of the least resistance seems to be for the markets to continue to march higher. The most important factor is the vaccine rollout. The best news of the year was the development and efficaciousness of Pfizer / BioNTech’s vaccine. Health workers and the elderly nationwide are receiving shots now.
Moderna’s vaccine may be even better, as storage and logistics are simpler. It just received full FDA approval. Other vaccines from J&J and others are poised to follow in January. By mid-year, there’s a chance the country will have developed herd immunity, allowing for the economy to reopen fully, with corporate earnings to follow.
The key vaccine risks include some sort of mutation, making the vaccine less effective. Distribution tie-ups and any refusal to take by a significant portion of the population could also prove a headwind.
The second most bullish important factor is the continuation of the ultra-dovish monetary policy. With interest rates so low “TINA” continues to prevail, meaning “there is no alternative” to stocks. Indeed, the Fed has indicated it sees rates low for years to come, as it’s willing to tolerate inflation well above its legacy cap of 2% to achieve its target of full employment.
Other bullish factors include continued optimism by investors. Positive market outcomes beget more investing; a virtuous cycle is now in place. The recently enacted fifth stimulus package will also help tide the economy over until the vaccines have been widely administered.
Key Risk Factors
Policymakers are doing everything possible to support the economy and markets and seem positioned to do that for years to come. However, we know that there can’t be unlimited blank checks from both the monetary and fiscal sides of government. Economic profligacy may trigger inflation, higher interest rates, and or currency depreciation. While that seems distant now, at some point markets could grow fearful of government deficits and rising prices and refuse to lend cheaply or continue to respect our currency. That could give pause to government policymakers to provide market support.
Investors cannot fail to notice that the Russell 1000 Value index, a composite of stocks trading at cheaper valuations based on such metrics as earnings, sales, cash flow, dividends, and book value, is only up 2% year to date, well short of the Russell 1000 Growth, up 37%. Growth stocks typically trade at higher valuations as investors are willing to pay up for perceived higher rates of growth in revenues and profits.
However, if the vaccine is successful in boosting our economy, many value stocks neglected while the economy was shut will get a second look. If interest rates rise, the discount factor applied to the future earnings of growth stocks may rise, reducing their attractiveness. Any pickup in inflation may help such value-oriented sectors as materials, energy, and industrials.
Almost no one foresaw the black swan event known as COVID-19. Few predicted the resolution of monetary and fiscal authorities to combat the fallout, allowing markets to have an above average year.
2021 will benefit from widespread vaccine distribution, an improving economy and continued support from policymakers. However, with economic improvement comes the risk of inflation, higher interest rates and potentially weakening US Dollar. This may test the resolve, particularly of the Fed, to maintain supportive economic policies.
Note: David Dietze is President and Chief Investment Strategist at Point View Wealth Management.
Point View Wealth Management is an SEC-registered investment adviser and part of Peapack Private Wealth Management. For over 25 years, Point View Wealth Management has been providing customized portfolio management services and comprehensive financial planning solutions for individuals and their families to develop and achieve their financial goals.
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