January 07, 2021

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Closing out one of the most memorable (yet wishfully forgettable) years in modern market history, stocks across the globe broadly finished the year with yet another positive quarter.  Investors chased returns, looking beyond the near-term issues led by Covid, unemployment, and political divisiveness. Heading into 2021, attention has turned to the landmark achievement of manufacturing and delivering multiple vaccine treatments in by far the shortest gestation period for a vaccine protocol in history.  Investors also felt some relief in the determination that Joe Biden will be the next President, with stocks posting a strong rally following the November 3rd election. Recent news that the Senate, House, and Presidency will be under one party control has not derailed the rally as the prospects of increased Federal spending have so far outweighed the likelihood of an increased tax regime.

This past year was remarkable in many ways. It is inconceivable that the S&P 500 Index gained 18% in a year where unemployment reached 14.7%! Maintaining the strong momentum following the Spring shutdown, the S&P 500 Index gained another 12% for the final quarter. That year-end rally completed a gain of over 70% from the market bottom in late March to the end of December, a dizzying series of gains following the sharp losses that began in February.  Growth-style positions led the entire year returns, but in the fourth quarter we saw a notable transition in leadership to Value stocks (such as Industrials and Financials)- particularly after the elections in early November. The large Value index outpaced the Growth index by about 5% for the full quarter.  Growth did not go away- we still saw big returns and ongoing sky-high valuations from specific companies (Exhibit A: Tesla, with a valuation premium rivaling any in history, was added to the S&P 500 at near year-end). But, a general transition towards higher dividends and finding lower valuations does seem to have some teeth. This transition has felt inevitable as the S&P 500 has become increasingly top-heavy. Consider that just three stocks, Apple, Amazon, and Microsoft, accounted for over 50% of 2020’s total S&P 500 Index returns. Investors now seem inclined to look for value, and Value stocks are a good place to start. With the VIX volatility gauge still quite elevated, this cautious approach seems prudent. We are nowhere near the levels of March 2020 yet, but the elevated VIX bears close scrutiny (no pun intended). 

The Fed has continued to maintain its dovish tone, with Chairman Powell leading the charge to provide ongoing liquidity and accommodative rates.  This approach could come under some pressure if/when we see inflation begin to rise, but in the near term the expectation is for the short-term Fed Funds rate to remain right near 0%. Signs of rising inflation expectations have begun to emerge, but rising inflation has been a siren’s song for over a decade. The 10-year rate did notably climb in the quarter, with the rate hovering between 0.85% and 0.95%, rallying further after the Georgia Senate results to over 1%. Bonds broadly provided some upside in the period, with investment grade bonds gaining about 1% in total return while the more aggressive High Yield index gained about 5%.

Looking ahead, eyes will be firmly locked in on the vaccine delivery and implementation process, and on what policy changes will come from the Biden administration.  Even if we do see structural changes to income tax rates and other issues important for investors to consider, note that such changes do not happen quickly and it can be rash to take significant action based on speculation.  There will also be heavy scrutiny placed on data about consumers, with both their willingness and their general capability to “get back to normal” following this unprecedented period of government intervention in their day-to-day activity. Savings rates have ballooned during the pandemic, and the market is depending on consumers to use these savings to restore corporate earnings to their pre-pandemic levels.  This will be a key driver in the pace and level of economic recovery we can expect.

We have identified key data points in recent market commentaries. While these metrics can continue to be difficult to rationalize in this unusual environment, here is where they stand:

• Valuations. Valuations dropped to about 15.5x existing earnings back in late Q1.  Earnings have continued to rise for many stocks since the abysmal Q2 period, but so have share prices- and that has led to stocks increasing their average valuation to about 22.5 times earnings (source: JPMorgan).  This continues to be quite elevated, so much attention will be placed on if/when stocks can “grow in to” the values they are at now. 

 

• Economic growth. GDP increased by an astonishing 38% in Q3, but that followed the equally astonishing 31% drop for the previous period. That quarter was as awful as most expected as we all lived through the complete freeze of business activity. Q4 estimates currently stand at about a 10.5% gain for Q4 (source: Atlanta Fed) as we continue to dig out of that massive Q2 hole. We have seen the Q4 numbers trending lower, a sign that this economic freeze will continue to need time to fully thaw out.

 

• Interest rates. The Federal Open Markets Committee has projected short-end rates to remain at or near 0% out to at least 2023.  Wall Street forecasts had looked for ZIRP (zero interest rate policy) as far as 2025, but recent events have moved that assumption back to 2024. The yield curve has remained fairly normal, and we will be watching inflation levels, which expectations have recently increased toward the Fed’s 2% benchmark, to see if the Fed might need to change its course.

 

• Currency. The USD has continued the recent trend of moderate weakness, and this has continued to help returns for non-U.S. based securities.  This trend seems likely to continue, at least in the near term, and that would continue to provide tailwinds for non-U.S. assets in relative valuations.

Portfolio Positioning
Staying the course during the dizzying market drop and subsequent rally was relatively easy simply through the power of inertia.  Maintaining positioning as values continued to climb took as much determination, if not more, but clients benefited with multiple stock indexes reaching ongoing all-time highs.  It will be difficult for stocks to maintain the broad trajectory they have been on for several years now, but we do see upside opportunity- particularly in areas with lower valuations and higher relative yields, and global diversification.  Volatility will remain elevated, as we grapple with vaccines and policy speculation, but a large part of investing in stocks is understanding that they involve taking risks.

For bond allocations, we continue to favor modest credit risk over duration risk and have positioned portfolios accordingly. For stocks, our focus remains on high quality positions with relatively reasonable valuations and growing dividends. We also continue to advocate an Alternatives exposure, which provided positive returns in 2020 with low correlation to both stocks and bonds.

Asset Class Review
The fourth quarter saw positive results from all major stock indexes. The S&P 500 TR gained over 12%, while the Russell 2000 small-cap index saw a huge gain of over 30% to end the year. Gains in the S&P were led by the beleaguered Energy sector as investors sought out opportunities.  Every single sector was positive for the quarter, and as noted earlier the Value benchmark outpaced Growth. 

Conventional bonds also provided modest positive results, with the Barclay’s Aggregate gaining just over 1% in total return.  The more aggressive High Yield class gained almost 5% as investors seek out yield sources and took on risk to find it. Commodities finished with a collective gain, but this time it was Oil leading the charge while Gold finished roughly flat.

Foreign stocks provided very strong returns for the quarter, with both Developed and Emerging indexes gaining at least 15%.  These classes continue to have both lower valuations and higher average yield than domestic stocks, plus the additional boost from a weakening dollar in converting returns to USD. We continue to view these areas as a source of upside potential for clients, particularly the Emerging Markets space with its strong demographics and positioning for multiple key markets to re-open their societies and economies.

Past performance is not indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment or strategy will be profitable or suitable for a particular investor's financial situation or risk tolerance. You cannot invest directly in an index. Asset allocation and portfolio diversification cannot assure or guarantee better performance and cannot eliminate the risk of investment losses. Source: Morningstar

All opinions and data included in this commentary are as of January 7, 2020 and are subject to change.  The opinions and views expressed herein are of Cutler Investment Counsel, LLC and are not intended to be a forecast of future events, a guarantee of future results or investment advice. This report is provided for informational purposes only and should not be considered a recommendation or solicitation to purchase securities. This information should not be used as the sole basis to make any investment decision.  The statistics have been obtained from sources believed to be reliable, but the accuracy and completeness of this information cannot be guaranteed.  Neither Cutler Investment Counsel, LLC nor its information providers are responsible for any damages or losses arising from any use of this information.