Investor Commentary Q4 2020
Happy New Year!
Welcome to the roaring ’20s where we see a “Gatsby-Esque” boom for investors and the companies they own while unfortunately, the majority of people suffer a slide in their financial position. Asset owners have had a stellar pandemic thanks to the US Federal Reserve. Since Q1, the Fed has boosted the amount of money (monetary base) by a whopping 49.79%. This geyser of money made its way into housing prices, bonds, and stocks. Even international stocks performed better for Americans than they did for locals because abundant U.S. Dollars necessitate a weaker currency which, in turn, pumps up the value of non-dollar assets. As a result, our portfolios performed well last quarter.
Placing last year’s performance into context, gains were not evenly distributed within markets or the economy. The larger the company, the better the benefit, no matter how financially sound: It may seem surprising to learn that the S&P restaurants & bars index outperformed the S&P 500 last year. Of course, this index includes names like Chipotle, Starbucks, and McDonald's which were uniquely situated to re-orient towards takeout and increase their sales per order (going to buy lunch for one became getting lunch for the whole family). Additionally, these firms had ample access to the same capital markets into which the Fed was injecting cash. We are often asked, “How can the market be doing so well when I see local businesses shuttered or struggling?” The apparent paradox serves as a firsthand reminder that perception is not always reality and that the stock market is not the economy.
Last year, the tech sector, 21% of the S&P 500, was the biggest gainer rising by 41%. If we remove the tech sector, then the index falls from about 14% to only 5.71%—closer to the growth rate of the real economy. Once again, the reason is that tech firms were larger and had ample investor liquidity especially if they reach public markets. The worst sector was energy which declined by 34% and shrunk to only 5% of overall market capitalization.
If we look at the stock market gains in inflation-adjusted terms, by dividing them by the increase in the money supply (M2 x velocity) we arrive at a monetary inflation rate of 7.48% which, subtracted from returns takes the S&P 500 “real” gains to 10.92%. So, what lesson can we draw from the events of 2020?
Most of us are surrounded by news of great fortunes and portfolios that have risen now for 10 straight years nonstop. While we spill a lot of ink in these pages parsing returns and risk, the reality is that we have been able to make money rather consistently year in and year out. Remembering that this is exceptional, not normal, equips us emotionally for future success that might appear in a more inconsistent pattern; i.e. slow years mixed with good years.
Looking forward by looking back at US stock market periods: when we have seen today’s current P/E ratio of 23, the forward 5-year returns have been closer to 1-2% per year. This would be my expectation along with continued wide divergences between sectors such as tech and energy. As a consequence, I am going to be rebalancing towards bonds which, it is worth noting, also yield 1-2% but in a much less risky manner. As such, we have to be precise about which assets we pick and more importantly, our diversification amongst asset classes.
Diversification Remains Valuable
Beyond domestic equities, I also believe a lot of the potential to gain still lies in non-dollar markets (i.e. your international allocation). Outside of stocks, drivers of value could arrive via classes like international, commodities, and even fixed income.
Moving forward, what are the risks we face? The Fed has sound reasons to boost the money supply to prevent a depression however, US debt has exceeded its annual income for the first time since WWII. It's dangerous for an economy to rely on money printing for its growth as this gusher can easily run dry. When it dries is not up to the Fed, but rather, the bond market. As we know, bonds are harmed by inflation and as bond investors “deflate” assets, the way I did above with the S&P 500, they will inevitably demand higher interest rates to compensate for inflation. Higher interest rates attract capital and in the horse race between stocks and bonds, this would attract money from the stock market into fixed income causing the market to decline. As the issuer of the world’s reserve currency, the US also faces a risk of capital flight which would cause the dollar to collapse even further. This is a stagflation scenario similar to the ’70s albeit with an intractable pandemic layered on top.
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