Q4 2020 Market Street Quarterly Commentary
“The stock market is a device for transferring money from the impatient to the patient.” - Warren Buffett
What a year…
We hope you and your family are doing well and staying healthy in the new year. What a year 2020 was. In some ways it felt like a decade and in others it felt like it passed in the blink of an eye (some may challenge me on the latter part of this statement).
As I took time to reflect on the past year, I can recall so many firsts. It was the first time where I recall seeing true fear over basic needs such as toilet paper and sanitation wipes. I remember walking the aisles of the grocery store seeing empty shelves. I watched sports stop at halftime and the world come to a complete stop in the week that followed. In those early days, I saw the good in humanity as we helped one another, checked on neighbors, and cared for our first responders and health care works in a way that I had not seen since 9/11.
Unfortunately, the pandemic was not the only challenge we faced in 2020. Last year delivered a number of unprecedented events that included civil unrest during the summer months. In the fall, we turned our attention to a bitter presidential race with politics dominating the headlines and creating further division of our nation. The election results of November 3rd did not immediately deliver a definitive winner and the next several weeks were marred by legal challenges and political bickering. Our sacred holiday traditions were altered as families adjusted to protect loved ones. We closed the year out and ushered in 2021 with a vacant Times Square.
I think it is safe to say, it was a year like no other.
While 2021 has felt like a continuation of 2020, there are reasons for optimism. We have a vaccine that has been proven effective in clinical trials and is being distributed nationwide. Many of our first responders have been vaccinated and our most vulnerable are currently being vaccinated. As in past crises, we have once again seen America rise to the challenge.
The ingenuity and creativity of the business sector has been inspiring. Businesses shifted to remote environments overnight and proved they could be productive while serving their customers and creating the goods we rely upon. We saw service industries reinvent how customers interact via contactless pay, curbside pickup, and delivery. We have seen schools and teachers answer the call of duty to keep our kids educated and in the classroom. Restaurants reengineered their operations by separating dining rooms, creating partitions, and opening outdoor seating.
Maybe the greatest achievement has been the public/private partnership that has created a safe vaccine in record time that will help bring an end to this pandemic. These inventions did not happen on their own. It once again shows the resilience of the American people and our ability to face the crisis at hand.
Impact on the markets
If I were able to foreshadow how 2020 was going to unfold, I think many of you would have asked us to remain on the sidelines. Nobody could have predicted how the markets would have behaved last year and once again proves why “staying the course” is often the prudent play.
2020 was marked by periods of extreme volatility and sharp swings in the equity markets. In March, the S&P 500 declined 33.79% from the previous high. As the virus spread across America, we saw the fastest 30% drawdown in history, which only took 22 days (it still shocks me when I read that)! As illustrated by the slide below, 2020 was the 4th most volatile year dating back to the tech crash in 2001 and was the most volatile year since the financial crisis in 2008 and 2009. We saw 44 trading days in 2020 with single-day price moves of at least 2% or more and 38 of these days occurred in the first half of the year.
(Source: Blackrock Student of the Market – January 2021)
This level of volatility can cause even the most patient investors to become inpatient. As you may recall, we sent out a memo in March that discussed some possible adjustments to our clients’ equity allocations. We ultimately decided against these adjustments and that decision proved beneficial as the recovery ensued. A lesson I learned from this past crisis is that human emotion is real and when you are in the heat of the fire it is not easy to sit idle even though this is exactly what we should do!
I was also reminded how markets can quickly and efficiently process new information. I firmly believe that markets can accurately account for the daily noise better than stock pickers and market timers. This does not mean that market timers will not win from time-to-time. However, over the long-run, I think 2020 will be another case study that proves that those who were patient benefited over those that capitulated near the bottom and went to the sidelines. Buffett’s quote bears repeating “The stock market is a device for transferring money from the impatient to the patient.”
The recovery began on March 23 with one of the fastest snapbacks in history which saw the S&P 500 jump 17.57% in just three trading sessions. Three! As a whole, we saw a swift recovery in the global stock market as returns across the board were above their historical norms. The S&P 500 finished the year in record territory with an 18.40% return.
Is there is disconnect between Wall Street and Main Street?
I do not want to come off sounding insensitive as I fully recognize that many Americans have, and are, still suffering great pain from the COVID pandemic. Furthermore, small businesses across the country are trying to find their footing while balancing the challenges of protecting their employees and customers.
However, I do think it is important to review the interplay between Wall Street and Main Street. How can the markets be sitting at new highs while the economy remains sluggish? This has been a common question I have been asked over the last three to four months. I have heard several investors rationalize the run-up as nothing more than a bubble that is bound to burst in the coming days, weeks, or months. I am not saying that asset prices are not expensive or that certain overvaluations do not exist, but I believe the answer lies within the efficiency of the markets.
As we have discussed, markets have the ability to process a tremendous amount of data real-time. Furthermore, markets are forward looking. I believe investors are looking past the short-term impact of the pandemic and focusing on the expected rebound of business activity and the eventual return to more-normal market conditions. This is the essence of what makes markets efficient. They are able to process current news while also pricing in future expectations which provides us accurately priced securities.
What does 2021 hold for my investments?
While I don’t dare make short-term market predictions, I think there are some underlying themes worth discussing. Below is a summary of three areas I think will be important as we navigate 2021 and that will drive some of the subtle changes we will be making to our model portfolios in the year ahead.
1) Embrace the new normal – low interest rates
The 10-year Treasury rate has collapsed over the past decade and central banks across the world are hinting that rates will remain low for some time. The amount of stimulus injected into the economy means that the government would like for rates to remain low to help service our national debt. Inflation has not been a concern up to this point and I think the Fed is willing to allow inflation to creep slightly above their 2% target before they get excited about raising the fed funds rate (I think it is worth noting that while the Fed can control short-term rates and help influence long-term rates, they do not have full control over interest rates).
What this means for investors is that income yield is hard to find and the fixed income allocation for investors will likely deliver muted returns for the foreseeable future. Fixed income has benefited in the past several years from price appreciation as rates have fallen to historic low levels. (As interest rates drop, bond prices increase. As interest rates increase, bond prices drop.) With rates near rock bottom, it seems unlikely that we will see continued price appreciation in bonds.
Fixed income will still play a pivotal role in diversifying our client portfolios. In 2021, we will be looking to increase the quality of our fixed income holdings across the board. This was started in 2020 with the removal of our high yield bond exposure and will continue in 2021 as we look to reduce our corporate bond exposure in favor of Treasuries.
It is also possible that we may recommend a slight tactical overweight to equities to counterbalance the low yields offered in the fixed income markets. This low-rate environment will likely continue to drive demand for the equity markets as investors pursue total return strategies. The transition of our bond portfolios to higher credit quality issues will help provide support to the overall portfolio during periods of stock market declines.
Finally, we will also be reducing our long-term capital market return assumptions for the year ahead. Given the rise in equity and bond prices over the past two years it is reasonable to assume that long-term return expectations need to be tempered.
2) Winners and losers
2020 highlighted the importance of staying broadly diversified. This is a combination of geographic, market weight, style, and sector diversification. The market downturn in 2020 impacted certain sectors and industries more so than others. For example, airlines, hospitality, and retail industries suffered disproportionately when compared to communications, online shopping, and technology. Owning a broad mix of securities has proven successful compared to trying to pick the winners and losers over the long-term.
Last year, the S&P 500 highlighted the difficultly in picking the winners and losers as the top five names accounted for 52.9% of the index’s total return. The top 20 names accounted for 81.5% of the total return while the bottom 400 names only contributed 9.3%. The chart below from JP Morgan illustrates the importance of sector diversification and illustrates how vastly different certain industries performed in 2020.
(Source – JPM Guide to the Markets)
3) Stick with the plan
Of all the lessons I learned over the past year, this is the one that resonates with me the most. Sticking to the plan has proven beneficial in both the good and bad times. I understand that this can be difficult when we go through periods of immense volatility. However, evidence suggests, and I believe, it is the best method to building long-term wealth over time. I will close out by sharing one of my favorite charts. The chart compares the returns of a diversified 60/40 portfolio to the S&P 500 over the last 20 years. Nobody likes to lose money. Unfortunately, when markets fall a well-diversified portfolio will still lose money. It is also likely that the same diversified portfolio will often trail the broad market index during up markets.
So, the question becomes, “If I am losing money on the way down and trailing on the way up does diversification actually make sense?” The answer is “yes”. By limiting a portfolio’s drawdown and participating in the upside, a 60/40 diversified portfolio has actually slightly outperformed the S&P500 over the last 20 years while providing a lower standard deviation (portfolio risk). Patience, perseverance, and sticking to the plan is the great equalizer and has consistently built long-term wealth.
(Source: Blackrock Student of the Market – January 2021)
Let’s all make 2021 a great year and be kind to one another. 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 virtually in the coming days, weeks, and months. Stay safe!
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