What wound did ever heal but by degrees?
– Shakespeare (Othello, Act 2, scene 3)
At the turning of the year, market letters generally review the prior twelve months and peer ahead to offer forecasts, this time with a great deal of “good riddance” to 2020 and much anticipation of 2021. As to review, there’s a lot to cover – more than can possibly be addressed in this space.
In just the last two months, we have experienced an election, the approval of two much anticipated and very effective vaccines, the passage of a stimulus bill (for better or for worse), and, the approval of a Brexit trade deal. As markets were highly interested in each of these and had great concerns about any potential problems or delays, markets generally consider these developments a collective plus. On the other hand, December brought revelation of a massive security breach of the data systems of 250 federal agencies and departments as well as some of the largest corporations, the election was highly contentious, we still don’t know which party will control the Senate, and after stunning speed in vaccine development, the rollout of its delivery has been disappointingly slow. But testing also started much too slowly and then ramped up and we see no reason to expect that vaccine administration will not rapidly pick up speed.
Spread of COVID-19 has come in distinct waves. After the initial surge in March and April, cases ebbed into the start of the summer. That was followed by a surge from mid-June until mid-July, and then new cases declined until early September. From there, new cases increased, accelerating into November, peaking just before Thanksgiving and then declining briefly. The post-Thanksgiving surge took new cases to new highs and ran just past mid-December when it topped out and started to recede again. That latest decline in new cases was rapid but seems to have bottomed out a few days ago as the anticipated post-Christmas surge appears to have begun. If the post-Thanksgiving surge is a guide, we may expect spread of the virus to get worse for a few weeks, likely reaching record highs, before it begins to get better. Eventually, enough of the population would contract the virus that it will fade naturally, but the roll-out of vaccines is expected to greatly accelerate that process. Whether the post-Christmas surge will prove to be the highest and last surge remains to be seen. The point markets care about is this: at some point relatively soon, distribution of remarkably effective vaccines will be widespread enough that the spread of the virus will begin to fade. It’s also worth noting that the actual number of people who have contracted COVID-19 is estimated to be at least 5 times the number of confirmed cases. This implies that over 100 million Americans already have significant immunity, and thus the impact of widespread immunizations will be felt well before three fourths of the population is immunized. We’re all tired of this pandemic and anxious for it to be over. It’s obviously not yet, and it’s generally expected to get worse before it gets better, but a path to the end is clearly in sight now.
Blindsided by pandemic, the economy contracted at its steepest pace on record in the second quarter. Unemployment reached levels not seen since the Great Depression, and the adjustment occurred within weeks. Since then, we have experienced a rapid, but incomplete and very uneven recovery. Looking ahead, there is great pent-up demand as well as, in aggregate, substantial built-up cash, so a surging economy after the virus fades is widely expected. Another way of considering this is that the savings rate has temporarily jumped to 33%, implying lots of capacity for the consumer to spend after the economy fully re-opens in 2021.
As you know too well, markets reacted harshly as the extent of the pandemic’s economic fallout became apparent. US stocks peaked on 2/19 and then bottomed barely a month later on 3/23, nearly 34% lower, before rebounding back to all-time highs by early September. This represented both the fastest bear market and the fastest recovery in history. The prior record for the fastest bear market was in 1987, and this one was three times quicker. The extreme volatility was head-spinning.
Overlaid upon the market’s volatility in 2020 was a high degree of speculation. The number of initial public offerings (IPOs) of stocks soared to the most since the bubble days of 1999, and many of these IPOs immediately doubled and tripled in price. Margin debt hit new highs (though not as a percent of assets). Bitcoin jumped to an all-time high. While narrowing substantially since then, as of September 2, the five largest US stocks were up 65% while the other 495 stocks in the S&P 500 Index were up 3% (and over a third of those were then down more than 20% from 52-week highs). It was a crazy year for markets in more ways than one.
As to markets in the year ahead, most outlooks are positive now as expectations are that vaccine distribution will end the virus in the relatively near term, and that the economic recovery will continue now and accelerate then. Supporting this view is massive monetary and fiscal stimulus which has just been increased by about $900 billion.
Some, including Chairman Powell of the Federal reserve, considered this latest round of deficit spending for stimulus essential to avoid a stalling of the recovery. Others thought it was a bad idea. We won’t share an opinion on the wisdom of that policy, but we’ll note that any boost today from borrowed spending of necessity becomes a fiscal drag later (for the duration of the bonds issued to pay for today’s largesse). John Adams is widely reported to have said, “There are two ways to enslave a country. One is by the sword. The other is by debt.” There is scant evidence he really said that, but at the risk of sounding old-fashioned, we think there is truth in the sentiment regardless.
Others offer forecasts for markets for 2021, but we consider that a fool’s errand. Instead, we’ll note some concerns. Looming largest is that market valuations are very elevated, which carries little implication for the year ahead, but which with high confidence means already modest return expectations for stocks over the next ten years should now be lower. Perhaps rapidly rising earnings will cure that valuation problem, we’ll see. But for now, the implication is lower long-term returns from stocks from here coupled with a rising risk of market speculative excess in the near-term followed by a valuation correction.
Another near-term concern is the possibility of rising inflation. The money supply has risen nearly 25% over the past year. Perhaps the connection between inflation (with a lag) and money supply rising faster than demand is broken now. We can’t say. But that’s a significant concern as we move later into 2021. It’s well known that the Federal Reserve has committed to an accommodative monetary policy for an extended period. We think that characterization is inaccurate. Instead, we think the Fed intends to remain in an accommodative mode essentially forever to the extent tame inflation allows, and that it will do so until inflation increases enough. The point is the reason higher inflation is likely to have severe consequences for markets is that it would be the catalyst to change the Fed’s posture.
Times are anything but normal, and this next item is such a normal thing we hesitate to reference it, but we’ll additionally note that the first year of the four-year presidential cycle tends to be better than average for stocks. For what it’s worth (perhaps nothing at all) since 1979, the S&P 500 return has averaged 14.3% in the first year of the 4-year presidential cycle.
The recently approved vaccines appear to be unusually effective and are highly likely to result in gradually suppressing this pandemic. The economy is already healing, by degrees. Markets have already anticipated that and recovered past former highs. In this environment, the consensus is for a continuation of the stock bull market in 2021. A recently weaker dollar and prospects of a stronger economy bode well for international stocks versus domestic stocks, for small stocks versus larger stocks, and for cheaper stocks versus more expensive stocks. As such, that would represent a reversal of several of the biggest market themes of 2020.
All that would be welcome in 2021. But the market path is certainly not without risks, especially, perhaps, in potentially higher inflation later in the year. Diversification is the best response to potential risk, but very low yields in bonds today make them unlikely to prove to be as good a diversifier for stocks as they have been historically. Given that, we are focused now on finding better yielding alternatives than traditional bonds and on otherwise adding true diversification to portfolios even at the expense of sometimes giving up a little liquidity.
We welcome 2021 and look forward to its anticipated changes, even if they only arrive “by degrees”.