Q1 2021 Market Street Quarterly Commentary
“Bull markets are born in pessimism, grown on skepticism, mature on optimism, and die on euphoria.” - John Templeton
What a Difference a Year Makes
The pre-COVID world as we knew it came to a screeching halt in March of 2020. Overnight, we witnessed a wave of unprecedented shutdowns, quarantines, school closings, business stoppages, and sports cancellations.
COVID will be one of those defining moments in history we wish we could forget but will forever be recorded in the history books. My wife and I went from our normal routine of work and shuffling the kids off to school to a completely new reality overnight. Both of our employers went to remote work environments while our kids’ daycare and school shut their doors. We found ourselves trying to balance our own new reality while also caring for our kids and helping them adjust to an e-learning environment.
In the midst of our personal chaos, the markets were experiencing an unprecedented downturn. Over the span of 31 days (February 19th – March 23rd), the S&P 500 fell 34%! During this period, we saw single day drawdowns of 7.6%, 9.51%, and 11.98%. Many advisors and investors never thought we would see a period as scary as the Great Financial Crisis (GFC) in 2008 but I think many of us would agree that March 2020 was an even more unsettling experience.
If I had asked for market predictions at the end of Q1 2020, I suspect few, if any, would have predicted we could have recovered from the March lows back to the previous February highs within the year, let alone do it in six months! As the chart below illustrates, the previous highs (2/19/20) were re-obtained only six months later (8/18/20).
On August 19, 2020, the markets began setting new highs and never looked back. The sudden market recovery coined the phrase “the stock market is not the economy.” As we fast forward to the end of Q1 2021, we saw the S&P 500 advance 61% over the trailing 1-year period. If we look at the 1-year trailing return from the market low on March 23, 2020, the S&P 500 was up a staggering 76%!
While I will never say never, I find it very unlikely that we will ever see 1-year returns like this again. Since 1915, history only reports two periods with higher 1-year returns. This occurred in July 1933 and March 1934 during the recovery from the Great Depression.
Have We Reached the Point of Euphoria?
While the post GFC bull market may have been the most hated, the current bull market could be considered the most confusing. We have seen terms such as meme stocks and NFT (non-fungible tokens) become popularized via the internet.
Meme stocks are knowns as stocks that have seen an increase in volume not because of company performance, but rather because of social media hype and being propped up via online Reddit forums. This has been how bankrupt companies like GME (GameStop) and AMC (AMC theatres) became overnight success stories and have reached valuations that make zero sense.
We have also witnessed the continuation of the crypto craze and, while I think there is some staying power with Bitcoin, it is hard to understand how a literal joke internet coin (Dogecoin) has a $50B market cap. I don’t share these stories because I think they are great investing ideas, but rather because these are the pockets within the market, I feel represent the current-day euphoria that Templeton spoke about and carry similar risk associated with gambling. The short-term returns may remain but the ability to prove successful over the long-term is much less certain and unproven as a viable investment strategy.
With that said, I do think there is reason for optimism by way of a sound investment strategy that is rooted in diversification and uncorrelated assets classes. Below are three themes that support this renewed optimism and the ability for this bull market to further mature.
- Vaccine-Led Restart – The distribution of the COVID-19 vaccine is allowing businesses to reopen and for a sense of normalcy to return to the consumer. The idle consumer generated from the shutdown has created a great deal of pent-up demand.
The current fiscal policy response has been very different from prior crises. In the past, policy response has been implemented to stimulate growth whereas the response to COVID has been to bridge the gap to the post-COVID world. In other words, absent COVID, the economy likely would have continued growing and fiscal intervention was not needed. Instead, the consumer was forced to stay home to protect the most vulnerable and to slow the spread of the virus.
This phenomenon is supported by the chart below, which shows that disposable income over consumption spending is at an unprecedented high. In fact, there is a current excess savings buffer of around 14% since February 2020. This correlates into the consumer having both the desire to purchase (demand) and the cash to do so, which should ultimately spur economic growth.
Source: Blackrock (March 2021)
- Unprecedented Shock – The Great Financial Crisis (GFC) saw a reduction in GDP of roughly 50% in the US. It is expected that the impact of COVID will be a fraction of this with a 12.5% GDP reduction. Yet the economic response has been more than 4X as much with COVID when compared to the GFC. Unlike in the aftermath of the 2008 Financial Crisis where stimulus money was needed to spur growth, much of the COVID era shutdowns would have likely returned without fiscal support.
The fiscal support provided the bridge to weather the shut down and has provided the consumer and companies additional resources to invest or spend. The chart below shows the difference in GDP reduction (left side) and the fiscal response (right side) between the two most recent market crashes.
Source: Blackrock (February 2021)
- Fiscal Boost Not Yet a Market Risk – While the level of debt infused into the economy is mind-boggling ($3.3T in 2020 and $1.9T in 2021), we have seen the debt service cost (interest rates) actually move lower. This is really a perfect storm for continued growth as the economy has been primed with excess stimulus and net interest payments as a percent of GDP are declining.
I think we can all agree that carrying debt at 140% of annualized GDP is not a good long-term strategy, but there is an argument to be made that it can spur economic growth in the short-term assuming rates can remain low. Policymakers have been very relaxed in their response to the increased debt levels, which is in stark contrast to what we saw in 2008 when austerity measures quickly emerged.
Many economists believe that these austerity measures associated with the GFC actually stalled growth and held the economy back. While that point can be debated, it appears clear that current day policymakers seem poised to remain patient before raising rates or tapering new debt issuance. This approach may prove effective as long as inflation and long-term rates remain low but will quickly break down if we move to a period of higher real interest rates that outpace economic growth and cause the debt service costs to soar.
Source: Blackrock (March 2021)
Tying it All Together
I believe there is reason for optimism over the next several months. As indicated above, the fiscal response has been unprecedented, and the consumer is ready to engage. In a low-rate environment there will be continued support for equity investments. There is also a record level of cash sitting in money market funds ($4.3T as of the end of 2020). This represents cash on the sidelines that was raised during the COVID crash through selling investments which has never been reinvested. From a historical standpoint, we have seen the ensuing 3-year performance be quite strong after a peak in money market assets. The period after to dot.com crash saw an annualized 3-year return of 16.4% where the 3-year period following the 2008 GFC was 19.2%. Time will tell how the post-COVID recovery turns out.
Source: Blackrock (December 2020)
I should caution that there are underlying risks. A spike in cases or vaccine ineffectiveness against mutated strains could lead to future shutdowns, which could stifle growth. The rising risk of inflation and/or interest rates is also a concern. If inflation soars and the Federal Reserve is forced to raise rates to pull money out of the economy, it could have a negative impact on future growth. As we look forward to Q2, we are making some subtle adjustments to our portfolios which include:
- Increasing our tactical overweight to equities by 1% for a total overweight of 4%
- Adding a small allocation to energy stocks to tactically take advantage of the accelerating growth trade
- Continuing to shorten the duration of our fixed income holdings by selling longer-term investment grade bonds and US treasuries
Hopefully, the temperatures are on the rebound and the snow is finished. Enjoy the remainder of spring and the upcoming summer months. We are forever grateful for your continued support. Please reach out to your lead advisor if we can be of assistance. We look forward to meeting with many of you in the coming days, weeks, and months. Stay safe!
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