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Markets Rallied Through December

Markets Rallied Through December

January 17, 2021
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The end of year rally continued through December. Of the equity and fixed income indexes that we report in this space, all but one rose for the month. Small caps continued to outpaced larger companies with the S&P 600 posting an 8.3% gain for the month while the S&P 500 (3.8%) and S&P 400 (6.5%) lagged behind. The Dow Jones rose 3.4% while the NASDAQ Composite gained 5.7% for the month. All eleven sectors rose with Financials (XLF, 6.3%) and Technology (XLK, 5.5%) leading the way. Utilities (XLU, 0.6%) was the laggard again, but even that sector managed to post a positive total return. The small-over-large trend was mirrored internationally with emerging markets (MSCI EM, 7.4%) beating developed markets (MSCI EAFE, 4.7%). As mentioned above, the sole decliner in December was Treasury bonds (-0.3%), but investment-grade corporate bonds (0.4%), high yield corporates (1.9%), and international bonds (2.2%) all gained. Both commodities (DJP, 5.8%) and gold (GLD, 7.0%) had great months as well.

In total, 2020 was a good year for equities and fixed income. The NASDAQ composite led in a big way with an almost45% increase, but the S&P large, mid, and small cap indexes all had double digits gains as well. The Dow Jones lagged, but even it had a gain of 9.7%. While those are all good return figures, none of them (aside from the NASDAQ return) would have seemed all that remarkable last January but from the perspective of March 23rd, those are simply unbelievable. We’ll dive more into the sector breakdown below, but suffice to say that there was a bit of a disparity in their returns. International emerging markets rose 18.7% for the year with developed markets posting a respectable 8.3% increase. In fixed income, US Treasuries, US investment-grade corporate, and international bonds all had total returns right around 10% with high yield corporates rising 7.1%. Finally, gold (GLD) had its best year since 2010 with a 25% gain, and commodities (DJP), despite a 38% surge over the previous eight months from their 2020 low in April, finished with a 4% decline for the year.

With 2020 now behind us, I want to do a brief recap of the trends that shaped the investment landscape for the year. While the main theme will be obvious to anyone who lived through the last twelve months, there were plenty of smaller news items that played an important role in 2020 and that will continue to do so into 2021. It is hard to believe that at this time last year, we were focused on the trade war with China and picking apart the provisions in the “Phase One agreement”. Those headlines may seem like they were being printed a lifetime ago but it really has been only a year. Last January’s year-end recap actually included a section with the header “Recession!! What Recession...?”. While it would be shortsighted to find fault with anyone who failed to foresee what 2020 held in store, it is still quite unbelievable just how much has changed since then. The newsletter in which that headline was featured was distributed on January 6th, 2020 and just one month later, the US economy would officially begin its slide into recession[1].

As the virus swept across the country and business began to shutter in an attempt to blunt its spread, economic activity fell off of a cliff and a recession had obviously begun even though the National Bureau of Economic Research didn’t officially demark a starting date until June 8th. Likewise, the longest bull market in history also met its end in March. It took just 16 days for the S&P 500 to fall 20% from its pre-pandemic high, officially marking the start of a bear market. At its pandemic-era low, the S&P 500 had fallen 34% over the course of just 23 trading days. In contrast to the bull market that preceded it, this bear would be extremely short-lived. Depending on whether you mark a new bull market by a 20% gain from the lows (which was achieved only 12 trading days after the March 23rd bottom) or by surpassing the previous highwater mark (103 trading days after March 23rd), the bear market vanished almost instantaneously.

When people look back on the S&P 500’s performance in 2020, they will simply see a 16.3% gain for the year masking all of the volatility that we actually experienced. We already mentioned the precipitous drop it took from its prior high, but the index went on to rally more than 67% from its March low. March of 2020 saw the highest average absolute value of single-day movements in the S&P 500 by a long shot. If we ignore whether a price move was up or down and just focus on the magnitude of the percentage gain or loss in a day, March’s average movement was 4.95%. The next highest month for the S&P 500 since 1950 was October of 2008 which was only 3.88%. Annualized daily volatility for the index was 34.3% for the year which is lower than the 40.8% from 2008. The month of March, however, had a volatility of 93.0% which far surpasses the worst months of 2008 when the number reached 80.5% in October.

While the major indexes all posted gains for the year, there were definitely winners and losers when broken down by sector. We mentioned a gap in returns at the beginning of this piece and within the S&P 500, Technology (XLK, 43.6%), Consumer Discretionary (XLY, 26.9%), Communication Services (XLC, 26.9%), and Materials (XLB, 20.5%) all rose by more than 20%; Healthcare (XLV, 13.3%), Industrials (XLI, 11.0%), and Consumer Staples (XLP, 10.1%) all saw more modest gains in the 10% range; and Utilities (XLU, 0.6%), Financial Services (XLF, -1.7%), Real Estate (XLRE, -2.1%) and Energy (XLE, -32.5%) all had zero or negative returns for the year (Energy was really negative). Looking at these three groups it is easy to build a narrative about how the pandemic reshaped the economy by accelerating trends that were already underway.

First, the winners of 2020. Technology and Communication Services were pretty obvious beneficiaries of the pandemic economy. Remote work, increased digital communication, and digital entertainment saw enormous spikes in demand and the stocks of those companies followed suit. Within Consumer Discretionary, Amazon (+76%) and Tesla (+742%) had the biggest influence and both of these represent an acceleration of existing trends towards online retail and renewable energy respectively. Smaller names had a big aggregate effect as well including Peloton (+434%) and Nautilus (+935%) in the home workout arena; Wayfair (+148%), Purple Mattresses (+280%), Lumber Liquidators (+215%), and The Container Store (+126%) in home goods and furniture; Penn National Gaming (+237%) and GameStop (+208%) in gaming; and Vista Outdoor (+218%) and Sportsman’s Warehouse (+119%) in recreational outdoor equipment. The fact that Industrials is in this group seems surprising on the surface until you consider that four of the top six performing stocks within the sector are either lithium or mining stocks which represent a large input into the renewable energy shift mentioned above.

The losers of 2020 also fit into this narrative. The slight decline in Real Estate reflects the shifts away from commercial real estate spaces and towards remote work as well as online retail that were already underway before 2020 but got a huge boost when much of the country was placed under stay-at-home orders this year. Companies that could function with remote workers were forced to let their employees work from home instead of in an office. Those that were able to maintain or increase productivity with a remote workforce suddenly saw expensive office spaces as extraneous. The uncertainty of whether or not this shift to remote work continues beyond the pandemic and further hurts commercial landlords is reflected in the flat returns for the sector as a whole. The massive decline in the Energy sector reflects the shift from fossil fuels to renewables that also boosted the Consumer Discretionary and Materials sectors.

Another interesting side effect of the pandemic was the influence it had on retail traders. With most sporting events canceled during the spring and early summer, a major source of entertainment had suddenly vanished. Many of these bored fans and gamblers turned their attention to the stock market and found themselves propelled by the tailwinds of central bank stimulus and improved technology from trading apps like Robinhood. This newcomer to the brokerage scene gave investors with smaller account balances access to the markets and also allowed for fractional share purchases that made it much easier to buy into the stock of companies with high share prices such as Amazon. 50% of Robinhood’s new customers in 2020 identify as first-time investors[2] but inexperience was not a hindrance. Volume surged everywhere with $120 trillion of stock traded on US exchanges in 2020, an increase of 50% from 2019[3]. The average stock in the Russell 3000 index saw its average daily volume increase by 46%. As of right now, retail trading represents 20% of stock volume in the US, twice the level of a decade ago and trailing only market makers and high-frequency traders. Common stocks weren’t the only securities drawing attention, however. In July, 75% of all options trades were in those that had expiration horizons of less than two weeks. These short-term wagers are considered a telltale sign of retail traders.

As of November, a basket of stocks considered by Goldman Sachs to be favorites of the retail market was up 75% for the year, more than 60 percentage points higher than the S&P 500 and double the returns experienced by a basket of hedge fund favorites[4]. Stocks with low share prices that are more easily traded by individuals with small account values also had a great year. The Russell 3000 index increased by 19% in 2020 but stocks whose share price started 2020 below $5 grew by 124%. While the volume of the largest 100 stocks in the index rose by 32%, the volume in the smallest 100 was up 70%. Online forums like Reddit’s Wall Street Bets have become unexpectedly influential players in the equity markets, especially as it relates to options activity. A curious name on their list of favorite stocks for the year was HTZ[5]. You may have heard that Hertz filed for bankruptcy after the collapse in travel and rental car demand amid the pandemic. Nevertheless, the company attempted to issue new shares of stock IN THE NEWLY BANKRUPT COMPANY because the demand from retail investors was so great. Individuals betting on the rebound of a cheap stock in a recognizable name seemed unfazed by the small detail of being at the bottom of the payout chain during bankruptcy.

There are parallels here to the dotcom era of the early 2000s, the last time that retail investors held this much sway. Fundamentals are an afterthought, earning enormous returns seems effortless, and everyone is suddenly an expert in stock valuation. Importantly, however, this time also offers some key differences from twenty years ago. Stocks being bid up by retail investors come from a broader section of the stock market than just the tech stocks that ruled two decades ago. The Federal Reserve is also intent on holding interest rates near zero for the foreseeable future instead of raising them as was happening last time around.

Finally, we ended the year with a Presidential election that saw the highest turnout rate since 1900[6] at almost 67%[7], an increase of eleven percentage points from the 2016 election[8]. This story is fresh in all of our minds, and we covered the topic in last month’s newsletter, so I won’t rehash the events of November, but this is a good segue into looking ahead. With a new administration entering the White House, there are likely to be some changes in store for 2021 as well as policies that remain the same.

International trade relations are one area that may seem like an obvious place for a reversion back to the old policies but that actually may not be the case. First impressions indicate that Biden may not differ all that much from Trump with regards to rebuilding a domestic manufacturing base and addressing relations with China. A paper posted by the Biden transition team on their website talks about ensuring that “the future is made in all of America”, “bringing back critical supply chains to America”, and “rebuilding our industrial base”[9]. The rationale behind these statements is that the US can continue to be aggressive with trading partners if we can come at it from a standpoint of domestic strength rather than bullying via tariffs. This doesn’t necessarily mean that the tariffs enacted by President Trump will immediately disappear. Throughout the campaign, President-elect Biden and Vice President-elect Harris refused to pledge that they would remove the tariffs[10]. Some Biden backers seemingly relish the leverage created by Trump’s tariffs.

In keeping with the focus on domestic strength, Biden has also indicated that he hopes to encourage domestic investment through tax incentives and government spending on infrastructure and alternative energy. This could also include leaving in place the deregulation and tax cuts that Trump enacted[11]. Democrats balked at the benefits that the 2017 tax reform gave to wealthy individuals but tended to agree that a tax cut for corporations was needed. Biden has already talked about rolling back the tax cuts for individuals earning over $400,000 per year but only half of the cuts for corporations, increasing their tax rate to 28%.

A recent trend that could help play into increasing the attractiveness of the US economy would be a weakened Dollar[12]. When the Dollar is strong relative to other currencies, it benefits US consumers and businesses who are able to purchase more foreign currencies with each Dollar and buy more goods internationally. For domestic manufacturers, however, it decreases demand from abroad. The Dollar has fallen more than 12% from its 2020 high[13] and may continue to do so. One element fueling demand for the Dollar was our relatively high interest rates before the pandemic. The Federal Reserve was one of the few central banks that were able to raise rates in recent years which made US Dollar-denominated investments more attractive.

The pandemic will continue to shape the economy in 2021 and possibly beyond. Even though vaccines began to roll out in December, it will still take some time for a sufficient number of people to receive them. Early projections estimated that we could have enough doses manufactured and distributed by June 2021 to return to normal[14], but the 2.1 million doses administered in December had already fallen short of the expected number of 20 million[15], so that timeline could stretch out even further. The longer that vaccinations take, the longer infections will continue to climb, and the longer the current slack in the economy will persist and hover over markets. With an end in sight, it will be up to government officials to enact policies that support workers and businesses until we reach that point. Congress passed legislation before the end of the year that would provide an additional $300 per week in unemployment benefits as well as another round of checks of up to $600 per individual with some lawmakers on both sides of the aisle, including President Trump, pushing for those checks to increase to $2,000[16].

Looking at longer-term implications, the pandemic could have a significant impact on the US labor force. While the headline figure shows the unemployment rate to be 6.7%, well below the 14.7% peak in April, the underlying numbers paint a less rosy picture[17]. The long-term unemployment rate (those seeking work for 27 weeks or longer) continued to rise in November. The labor force participation rate fell to 61.5%, a bump up from the 60.2% figure at the worst of 2020, but also at the lowest levels seen since the 1970s[18]. That means that almost 39% of the US population over the age of 16 is either unemployed or not looking for work. That is 39% of the population who will see their skillset and human capital erode, their productive capacity fall, and their financial well-being suffer. Imagine how prosperous our economy could be if these individuals had meaningful employment and the aggregate productivity of our citizens increased by two thirds (39%/61%). Even if these individuals were to find work in the future, lengthy periods without work decrease their overall productive capacity which requires time to build back up. Further, this increases the strain on the social safety net; 8 million Americans who were not below the poverty line before the pandemic have fallen to that status since with the figure increasing every month since June[19].

Not only is the quality of the current labor force being degraded, but the future labor force has also seen worrying trends emerge since March. Enrollment in K-12 public schools is down about 2%, representing approximately half a million students. FAFSA applications for new college enrollees is also down 18%[20]. Educational attainment is a crucial variable related to future income and productivity and declining attendance at all levels of the educational hierarchy does not bode well for future generations. All of this adds up to a set of significant roadblocks to future success for students.

The narrative of stock valuations being too high will persist into 2021 as well; depending on what measure you look at, equity valuations are at all-time highs. In an aphorism seemingly repeated every time stocks reach new highs, some analysts are pointing out that based on forward-looking earnings estimates, stocks are the most overvalued that they have been since the dotcom bubble. One caveat pointed out is that these levels would be justified if companies do in fact produce large profits next year[21]. Recent corporate guidance indicates that they fully expect that to be the case. More than half of the S&P 500 companies who issued profit guidance for the fourth quarter have subsequently raised those targets[22].

Valuation expert Aswath Damodaran looked specifically at the popular FAANG-M (Facebook, Amazon, Apple, Netflix, Google, and Microsoft) stock valuations and came to the conclusion that while five of the six were in fact overvalued, only one of them seemed to be egregiously overvalued[23]. He came to a similar conclusion back in late summer with regards to the S&P 500 as a whole and even though that index has continued to rise, that aligns with the rising profit expectations we just mentioned.

There is always the chance that something unexpected will dominate the headlines in 2021. After what 2020 put in front of us, I imagine that we are all hoping for as little of this as possible.

Adam Blocki, CFA, CFP®
Sr. Portfolio Manager























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