At long last we turn the page on one of the most tumultuous years in my lifetime. The House of Representatives voted to impeach the president for abuse of power in January. By March, cases of the coronavirus had been found in all 50 states. The stock market responded with one of the most dramatic drops in the last 40 years (-34% in 1987, -34% in 2002, -49% in 2008, and -34% in 2020). In June, millions protested in support of Black Lives Matter. The election in November felt as though it spanned three strained months. Now, an unprecedented movement is underway to overturn the popular and electoral college votes. Finally, beyond all common sense, the year closed with stock prices, measured by the S&P 500, up 3.8% for the month of December and up an eye opening 18.4% for the year. Amidst utter chaos, the stock market is evidently focused elsewhere.
We will probably never know the true disconnect between what was happening on Wall Street and what was happening on Main Street. This will likely become the work of analysts and scholars for some time. As the dust settles, and we turn toward what may unfold in 2021, there are a multitude of causes and outcomes for us to consider. Some we can clearly see, and others will surprise us.
On the positive side, there is a lot to support owning stocks. Vaccines by Pfizer-BioNTech, Moderna and AstraZeneca/Oxford are being administered and still others are in the pipeline. The stimulus already approved by Congress, with likely more to follow, will prove a stabilizer for the economy, likely all the way into 2022. Analyst earnings estimates project record earnings for the S&P 500, in the range of $170 per share. The Fed Funds rate is currently 0.25% and I would not expect interest rates to rise in a threatening way. The Fed’s Chair Jerome Powell, alongside Janet Yellen as Secretary of the Treasury, ought to give the markets comfort. Demand for stocks will be supported by the low rates which limit quality investment alternatives.
On the other hand, there is a lot that could be disruptive in owning stocks. As was the case in the response to the Financial Crisis, politicians now may use debt limits as a mechanism to foil attempts to rebuild the economy. The Federal budget deficit is expected to top 15% of GDP in 2020, and the total deficit now exceeds 100% of GDP, the highest level since WWII. Labor force growth is turning negative, and output per worker is declining, both ominous signs for future GDP growth. At some point, tax revenues will need to be found in order to begin to rein in the deficits, especially in light of low economic growth. If in fact interest rates do rise, they will suppress the market’s PE ratio, make the cost of doing business (owning homes, consumer credit) more expensive, and make financing the federal deficit more costly.
My expectations are that the markets will enjoy a more transparent and clearly policy based attitude from Washington with respect to foreign trade, environmental policy, public health and general support for the whole of the economy. I think some of the disparities in the economy that have been exacerbated by the pandemic will begin to be addressed. While I do think returns have been pulled forward to a certain extent, there are a range of opportunities in play such as electric vehicle technology, alternative and clean energy, ESG themed investment approaches, and continued work-from-home technologies. We are busy looking to incorporate these emerging themes into our portfolios.
Our basic work will not change in 2021. We will continue to put our energy into both leading-edge and time-tested investment management technique with the intent of making money owning quality equities. We will also focus on linking our investment management capabilities with your financial planning needs, to make sure your exposure to risk, asset allocation and future planning is appropriate.
While in many ways nothing has changed from a week ago when it was still 2020, in other ways everything has changed. No doubt 2021 will bring its share of unexpected events. It is our work to navigate and profit from them that will make the difference this time next year.
Happy New Year!
Bruce Hotaling, CFA
Stock prices, measured by the S&P 500 jumped a remarkable 10.7% in November, and are now up 14% year to date. November’s returns are the third best for any month over the last 20 years, led by 12.7% in April ’20 and 10.8% in November ’11. To contextualize these remarkable figures, it is worth pointing out the worst monthly returns during the same 240-month span. October ’08 saw stock prices fall 16.9% with the onset of the great financial crisis. In March ’20, COVID 19 hit, driving prices down 12.5%. Finally, in September ’02 prices fell 11% resulting from the dot com bust, 9/11 and a horrific recession (from its peak in March of ’00, the market had fallen 50% by October ’02). The market will move to the extreme, both up and down, and we often don’t know why until after the fact.
November’s jump in stock prices is likely due to multiple factors. The first, and most important, was the election of Joe Biden and Kamala Harris on November 3rd. The market responded favorably with the expectation that we will see 1) sensible, forward-looking policies to stimulate and rebalance the economy; 2) renewed emphasis on alternative energy and environmental sustainability; and 3) definitive steps taken to begin addressing some of the economic and social barriers perpetuating embarrassing levels of inequality. Importantly, the nonsensical trade war will end, and this alone will provide a boost to GDP.
Positive data was released by Pfizer/BioNTech on 11/9, Moderna on 11/16 and Astra Zeneca/Oxford on 11/23, providing a monthlong hope trade premised on economic re-opening. However, the virus is raging with new daily cases in excess of 220,000 and deaths in excess of 2,000 per day. When the vaccines are approved, the difficult task of prioritizing who receives the vaccine first will come into play. The roll out means help is on the way, but it’s not at all clear when enough of the population will be adequately protected. Nonetheless, November saw investors buying stocks with the expectation the virus will be contained.
Another fundamental driver of the recent stock price surge is corporate earnings. Q3 results were better than feared, we are seeing more companies reinstate guidance and forward expectations are high. In 2Q, earnings fell by over 20% due to the implosion of business activity in the travel/leisure sectors on fears of the virus, in the energy sector with oil prices less than $1 per barrel and in the financial sector with banks making huge provisions for the anticipated loan losses. Now, as businesses attempt to emerge from the pandemic-driven recession, stock prices are discounting a substantial recovery in earnings by late ’21.
November market activity generated a dramatic rotation from growth stocks to value stocks, along with the re-emergence of smaller cap stocks. This pro-cyclical trade is premised on a full economic recovery, rising interest rates and inflation. In my opinion, the cyclical trade has largely run its course and the economy is going to take a long time to fully recover. Stimulus aside, interest rates will remain low for a long time and there are structural shifts in effect which make a return to traditional levels of growth and inflation unlikely.
In my opinion, a drawn-out recovery does not mean that stocks cannot continue to perform. First of all, the economy is not the stock market. Second, we own select stocks in which we are confident they can generate above market returns. Growth, free cash flow and dividends remain critical fundamental qualities we screen for in our selection process. We have shifted our focus to accommodate the cyclical trade, and own numerous stocks today we would have never considered owning prior to the pandemic. We will watch and make further adjustments as circumstances dictate.
As we approach year end, we are available to review your accounts with you, with a special view towards capital gains. The good news is that returns have been solid this year and we can reserve funds for future tax payments. Tax planning, or at least tax awareness, is prudent at this time of year. Please feel free to check in with us; we are continuing to primarily work from home with limited work from the office. Take good care and please be safe out there.
Bruce Hotaling, CFA
In 2019, U.S. based large cap stocks, as measured by the S&P 500, produced a generous total return of 31.49%. Over the last 30 years, the S&P 500 has returned more than 30% only five times or 17% of the time. The average annual return for stocks in the last decade, beginning January 1, 2010 was a heady 14.1%, the only down year being 2018. The average for the prior decade, beginning January 1, 2000 was only 1.2%, with four down years and staggering price drops in 2002 and 2008.
Last year at this time, stocks had just taken a precipitous year-end nose-dive to end the year down 4.4%. Stocks were oversold and the PE multiple was relatively low; the Federal Reserve had raised interest rates the fourth and final time December 20th. A lot of investors were disheartened by the rate hikes and on their heels when the market sentiment turned in early 2019, causing them to miss some of the upturn.
Today, the market is regularly making new highs. The Federal Reserve opted to reverse its 2018 rate hikes with three cuts in 2019. This drove animal spirits that were wrestling with negative fallout from the trade war and slowing growth around the globe. One argument is that the Federal Reserve, bullied or not, became the only adult in the room.
Now, at 18.2x expected 2020 earnings, stocks are more expensive than a year ago. According to JP Morgan, the 25-year average is 16.3x. Just how pricy the market is, of course, is contingent on multiple factors – during those 25 years, stocks have sold for over 24x, and below 10x. FactSet currently estimates $178 per share in earnings for 2020, a nice 9% bump from the $162 companies in the S&P 500 managed for 2019.
My biggest concern for the coming year is a protracted deterioration in our economic relations with China. The U.S.’s self-declared war on trade is now two years old and the loser in the trade war has been the American consumer, forking over billions of dollars in tariffs to no effect. Trade wars are clearly not good or easy. The economy and the stock market will both be better off once there is resolution. In my opinion, the U.S. has been busy wasting time and money in the Middle East, while China has been investing, and building diplomatic and economic relationships around the world. Bullying the Chinese will not help the American economy.
Earnings will prove key to stock prices this year. This may seem obvious, but last year earnings were flat, while stock prices skyrocketed. This jump was due entirely to PE multiple expansion, which in turn was driven by the reduction in interest rates. The Federal Reserve cut rates three times in 2019, and that is unlikely to happen again in 2020. So, if stock prices are to rise this year, it will hinge on improved corporate profit margins and earnings per share.
Our energy is directed at selecting quality U.S. stocks and bonds where we have reliable information. We make active bets on companies we believe from a fundamental and a quantitative perspective are positioned for price appreciation. Stocks and bonds, our asset classes of choice, are reliably non-correlating, counter-balancing each other’s volatility. We manage our bets, and the overall exposure to risk, in each portfolio. This is in distinct contrasts to the use of multiple asset classes, deployed via mutual funds and ETFs, as is the common practice among many investors.
For 2020, I expect the markets will likely behave a lot like they did in 2019, until November. Then, we shall see. In the meantime, we will continue with our emphasis on growth stocks. This tilt has enabled strong performances from our primary equity models over the last several years. If it begins to look as though the expected 9% bump in earnings is not going to come to fruition, we will re-assess and modify our approach. Until then, stocks (even slightly more expensive stocks) remain the best bet. We look forward to getting together with you in the New Year.
Bruce Hotaling, CFA
For the year 2018, stock prices as measured by the S&P 500 fell 4.4%. The late-year selling frenzy came as quite a disappointment to many. Through the end of September 2018, stock prices were up 10.6%. Then, October brought a wave of selling, and prices fell 6.9%. After an attempt to stabilize in November, the bottom dropped out in December, and prices fell another 9.2%.
Since the November 2016 election, stock investors had been quite content. The market went on a run of 15 straight months with positive returns. Then trouble began to stir in early 2018 when prices fell in February and March. Though prices recovered through mid-2018, the year-end disruption led to panicky selling and wiped out cumulative gains for the S&P 500 dating back to October 2017. Investors are now anxiously wondering what’s to come.
We experienced unnerving volatility in 2008 when stocks fell relentlessly in reaction to the financial crisis and the ensuing recession. However, the year was bookended by a 5.5% return in 2007 and a whopping 26.5% return in 2009. Prices recovered quickly benefiting those that remained invested. The height of the dot-com bubble in 2000 sent prices down 9.1% that year and then a further 11.9% and a painful 22.1% in the two ensuing years. At present time, there is no evidence of another financial crisis (a one-year market debacle) or a dot-com bust (a multi-year market debacle) but rather a slowing of growth (which is normal for markets in later stages of the business cycle) and continuing political turmoil.
In my view, there are three things to monitor. First, the backdrop: the trade war with China, the government shutdown, the ongoing Brexit talks, and the realization that political gridlock seems likely to prevail. Second, the Federal Reserve has been raising interest rates, and the old axiom “don’t fight the Fed” clearly remains alive and well. Finally, earnings growth crested dramatically last year and is now beginning to decelerate.
Investing can lead to heightened emotions, and I think it’s becoming more difficult for people to confront the random and reckless commentary from Washington. My sense is that investors are at their limit, feeling that more damage is being done than their prior optimism can counter.
My take on the Federal Reserve is that it views the US economy as generally healthy, though growth is slowing. The Fed appears to be shifting away from its more hawkish position and is messaging more flexibility. Importantly, it has raised rates nine times since near-zero rates three years ago, and that was the responsible thing to do. It does not appear that current policy, with the Fed Funds rate in the 2.25% range, is overly restrictive.
The earnings outlook for 2019 is tempering. Earlier in 2018, consensus was for $178 per share or 10% growth for 2019. According to FactSet Research, analysts now have lowered their earnings estimates for the S&P 500 for the fourth quarter by 3.8%, which has led investors to lower their return assumptions.
Some patience with and confidence in the long-term tendency of the stock market to soldier on is important at this juncture. I believe that the Federal Reserve will take the correct actions and does not need to be brow beaten. While the market has re-rated and P/E ratios have fallen 25% from their highs, stocks are much more attractively priced than they were three months ago.
Stocks are the primary sources of return for most investors. The numbers bear out, as stocks have generated positive returns 75% of the time over the last 40 years. When the markets are in flux, we advocate prudent re-balancing between stocks, bonds, and cash. Since the second bout of volatility kicked up in late September, we have held above-normal levels of cash. Now, our effort is to put cash to work in quality, stable growth companies selling at reasonable prices. Our goal is to remain fluid as the market looks to orient itself between high growth and dividend-paying value companies.
As always, we are available for a call or meeting if you would like to discuss whether some changes to your asset allocation are in order.
Bruce Hotaling, CFA