Market Commentary - December 2020

Monthly Update

The paradoxes of life, and the challenges and opportunities it brings, was no better reflected than in 2020. Stating the challenges of the year is expressing the obvious, both from a personal and professional level, for so many. With respect to COVID, we can certainly say good riddance to 2020. As for the markets, though, what a year it was. After an amazing rally in November, stocks continued their upward trend in December, with small cap stocks leading the way again. For the full year, the S&P 500 ended up 16%, the NASDAQ an incredible 44%, and the small cap Russell 2000 18%[1]. Reflecting the huge influence of the FAANG stocks, the S&P 500 return would have been half this without them[2].

It wasn’t just stocks that saw an impressive year, bonds and many commodities did as well. The 10 yr yield fell to .92% from 1.92% at the beginning of the year, the high yield index saw a yield of just 4.20% by year end vs 5.19%, and IG of only 1.75% vs 2.84% at the end of 2019[3]. Copper prices rallied by 26%, silver by 47%, gold by 24%, corn by 25%, and soybeans by 39%, to name a few commodities[4].

In contrast, it was a tough year for the US dollar, as the euro heavy dollar index fell 7% taking it just shy of the lowest level since 2014[5].

In addition to many technology stocks that benefited from the work from home trend, we can definitely thank the extraordinary level of monetary activism for the performance of many asset classes, even including sports memorabilia. For example, a Wayne Gretzky O-Pee-Chee rookie card in gem mint condition was auctioned off for $1.29mm. This same card previously sold for just under $500k in 2016, and back in 2011, it went for $94k[6]. Also, almost $3 Trillion of fiscal spending helped many small businesses and via transfer payments to individuals and households, more than offset the lost wages and salaries.

The Federal Reserve

As stated, much of the market activity in 2020 was a reaction to the steps the Fed took in response to COVID, in addition to all the policy steps of other central banks around the world. According to the Wall Street Journal, “The Federal Reserve, European Central Bank and Bank of Japan have collectively expanded their balance sheets by around $8 Trillion in 2020. It took them almost eight years to achieve the same growth following the seizure of global financial markets in September 2008.” This is in addition to the Fed taking the fed funds rate back to zero as did other central banks, along with negative rate policy in Europe and Japan.

As a result, the rally in US Treasuries and other sovereign bonds then filtered into a rally in everything fixed income as the search for yield became intense. This was also a main catalyst for the rally in many stock markets around the world. Even emerging markets benefited from the selloff in the US dollar.

November 9th 

Up until November 9^th when Pfizer announced that its vaccine showed more than 90% efficacy, it was the work from home/anywhere beneficiaries that drove the markets, particularly big cap tech. Just 6 stocks make up about 25% of the S&P 500 and drove half the gain this year in the index[7].

Then with the Pfizer news, followed soon after by Moderna, the stocks that were the most beaten down (particularly anything related to leisure, travel and hospitality) saw a sharp recovery to the point where some names got back all of what they lost since March.

The mass rollout of these vaccines in 2021 will see our lives return to most of its pre-COVID normalcy refreshingly. The question, though, is whether markets have already discounted that with their 2020 performance.

I believe the key determining factor of where markets go in 2021 will be the extent of the inflation we see with the economic recovery, and to what extent long term interest rates rise. We know the Federal Reserve will keep short term rates pinned to near zero, but that will not stop the long end of the yield curve from expressing its opinion on growth and inflation. The reason for my belief in the direction of interest rates as being the likely driver of the equity bus is the very high stock market multiples we currently have as they are being rationalized by those low rates.

To this end, the S&P 500 is trading at 22 times 2021 earnings expectations and 18 times 2022[8]. The historical P/E ratio is something close to 15 times the one year forward earnings estimate[9]. I believe predicting the direction of the economy and earnings in 2021, because of mass vaccine inoculation, will be much easier than trying to figure out what the right P/E multiple should be.

The Global Economy 

With many selective shutdowns around the world, the economy is in the middle of a challenging few months, until we can get through winter and pick up the pace in widespread usage of the vaccines. But we know that is coming, so it is why the markets have ignored the current sluggish pace of economic activity, because we assume this changes for the better come Spring time.

The US economy in particular has been massively cushioned in 2020 by the huge amount of federal government spending that was just augmented by the passage of another $900 billion spending package. This has helped many small businesses and individuals and households via direct checks and extended enhanced unemployment benefits. It was to such a great extent that the government transfers more than offset what was lost in wages and salaries.

The result is that as of November 2020 we have a budget deficit of 15.2% of GDP[10]. Go back 50 years and the average is 3%[11]. The US also now has a national debt of $27 Trillion, which is above the level of nominal GDP of $21 Trillion[12]. The question is when all this debt accumulation will matter, and I believe in 2020 it did begin to matter and was expressed through the weakness in the US dollar.

The US Dollar 

Over decades, the direction of the US dollar has a relationship to where the US budget deficit is headed, as well as the US trade deficit and current account deficit. All these deficits are widening to record levels and I believe that is why we are seeing dollar weakness. The Dollar Index, where about half includes the euro, fell 7% in 2020 and I expect to fall further[13].

A weaker US dollar is a benefit to US exporters which can collect more revenue. The negative, though, is that it reflects a reduction in the purchasing power of our money, and that is important for a consumer dependent economy. It also leads to higher inflation because when we import more than we export, the cost of those imports only rises.

Hard Assets

I mentioned the incredible auction price of that Wayne Gretzky hockey card and along with the rally in precious metals and other commodities; it reflects a desire on the part of investors for hard assets that benefit in price from a debasement in one’s currency. The other beneficiary of the weak dollar has been emerging market assets, both stocks and bonds, that hold a lot of dollar denominated debt. To name a few markets, the South Korean Kospi rallied 31% in 2020, the Indian Sensex index by 16%, and the Shanghai composite by 14%[14]. As I expect higher inflation to be a key story of 2021, the demand for hard assets to protect one’s purchasing power will, I believe, become more pronounced.

Congress

As seen with the election runoffs in Georgia, the Democrats now have control of the US Senate with the help of the tie breaking Vice Presidential vote. This will certainly have profound implications for spending and tax policy, where we can expect more of the former and higher taxes with respect to the latter. The timing and the extent would be the only question. We should expect another round of spending in 2021 but it might be until 2022 before we get higher taxes. We’ll be monitoring this closely.

Conclusion

2020 is now just a memory, and with highly effective vaccines, we know 2021 will bring our lives much closer to where they were prior to COVID, if not all the way there. Let’s be thankful for that, but of course we will never forget the challenges of 2020, and the unfortunate lives lost as a result.

The investing environment ended up unfolding a lot easier in 2020 than the way our daily lives progressed, but if there is one thing market veterans have learned over decades of experience, the market is not always the economy and the economy is not always the market. I believe that could be the case again in 2021.

So, let us cheers to a 2021 that will hopefully mostly rid us of COVID-19, to the vaccines that will save lives, to being able to go outside without wearing a mask and not needing one inside, to again eating indoors without worrying about ventilation and distancing, going to a concert, seeing a baseball game in person, to spending more time in person with family and friends, to seeing in person many of you, having meetings in person, and to have many small businesses resurrect their livelihoods, either growing again their existing business, or finding the capital and help to create a new one.

As for markets, as I’m expecting higher inflation and higher interest rates, that could mitigate market returns as high valuations leave no room for error. Either way, whatever the outcomes will be, it is vital that investors have a plan that suits their short term liquidity needs over the coming 2-3 years. Knowing that is covered can help cushion the balance of one’s portfolio against what I believe will be a continued choppy time, for both the economy and markets. Please do not hesitate to reach out at any time with questions or for any discussion on the economy and markets.

Disclaimer