2020 is in the books. From the market’s perspective, there is little to no difference between the environment on the last trading day of 2020 and the first trading day of 2021. On the other hand, through the lens of the investor, flipping of the calendar gives us a chance to take a breath, reflect, learn, and plot our course for the upcoming trip around the sun.
Take a breath
We all deserve it. 2020 was trying on so many fronts. Although we are not out of the woods yet, thank you for doing your part to keep the people around you safe. Thank you for remaining optimistic and thank you for persevering. Despite all the struggles, 2020 gave so many of us so much to be thankful for – so before we write it off, let’s acknowledge that in many ways it will make us better going forward.
If you had told me last January that BSW would be relying more on data from the CDC than from the BEA (Bureau of Economic Analysis) to navigate markets, I would have politely said you were crazy. In retrospect, even if you told me that a global pandemic was coming and that economies would effectively shut down, I wouldn’t have guessed that the market would respond as it did with the shortest recession on record.
One of the primary lessons of 2020 is likely this: No matter what is currently happening on the ground or on Main Street, Wall Street is a forward-looking, unfeeling, discounting machine that often moves counter to investor sentiment. Just like AlphaZero, the artificial intelligence computer program that taught itself the game of chess in under four hours, the market contemplates its steps based upon multiple anticipated future counter moves.
Plotting Our Course
Akin to getting directions from Google Maps (yes kids, we used to stop at gas stations for directions), we need to start by defining our current location. As of January 2021, we believe to be located between the corners of Nothing is Cheap Avenue and Lower Rates for Longer Boulevard.
The massive stimulus that governments around the world have injected into the economy has essentially given the markets breathing room to look past the pandemic. The saying in 2020 was that the market was “living in the back half of 2021.” This meant that the market was pricing in an economy that looked more normal post vaccines – a time when businesses could get back to normal and people could get back to work.
Since we are now ever closer to this hopeful future, BSW, along with the market, is looking towards the end of 2021 and early 2022. Below is what we are seeing as the most probable risks and opportunities given current fact patterns.
Let’s start with the perceived risks
It is no surprise that having rallied over 65% from its March 2020 low, the S&P 500 is now seemingly expensive on almost all metrics. Even given rosy earnings projections for this year and next, we believe there are extended valuations for most U.S. stocks.
The narrative as to why stocks can trade at such high levels has been this: compared to the yields on offer in bonds, stocks are attractive. This brings us to the next risk in our view. If the economy gets going again in late 2021, we could see inflation pick up. With increased inflation comes higher bond yields, which could take some steam out of stocks as the preferred source of investor capital.
The sheer pace of this stock market rise and the level of investor optimism and risk taking has us concerned. BSW has never purported that we can accurately time the top of a bubble – nobody can with any consistency. What we are saying is that the ingredients that define a “frothy market” are now present and have our attention. In this environment, it seems there is less room for error when it comes to earnings and revenue expectations.
On the opportunity side of the ledger
BSW is focused upon relative value. In our opinion, foreign stocks and emerging markets (EM) in particular look more attractive than U.S. stocks at this stage in the cycle. Emerging markets may have a few tail winds, such as:
- Weaker U.S. dollar leading to beneficial lending environment
- Historically performed relatively better in a low and rising inflation environment
- More effective early virus control and therefore quicker opening their economies
- EM stocks are being supported by coordinated government initiatives within some sectors
- Potentially less contentious trading relationship with the Biden administration going forward
At current levels, BSW is also getting close to another triggered portfolio rebalance. The BSW Investment Group has predetermined upside and downside stock market levels that, if hit, swing us into action. Since stocks are now near our upside target, this rebalancing would entail taking some chips off the table in stocks and adding to other asset classes that may now be underweight in portfolios.
Tying this all together
BSW sees a 2021 market environment well supported by government stimulus and Fed bond purchases that should keep interest rates low. Given the government mandates to shudder or curtail certain businesses (based upon health concerns of the broader public), it makes sense that the government may help in reimbursing those most affected. In my opinion, this is a page right out of the Takings Clause within the Fifth Amendment. Like a city constructing a highway through your backyard to benefit the broader public, businesses and business owners should be reimbursed (at least in part) for their financial losses stemming from obeying health mandates.
To this end, and assuming interest rates stay low, we believe the stock market can still give us reasonable returns this year. The big question on our minds (attempting to think a few chess moves ahead) is: come the much anticipated summer, what will investors see when they look up from their beach reading? Post vaccines, post business re-openings and post stimulus efforts – will they see a thriving, fully employed economy that looks sustainable (not too hot and not too cold), or will there be lingering doubts? Most global stocks are priced for the Goldilocks scenario in our opinion, so anything shy of that might serve as a reason for the market to at least pause until earnings can catch up to expectations.
Having just been through 2020, a year that nobody could have predicted, it should be clear that BSW does not rely on a crystal ball. We are not making big “bets” one way or another based upon the unknowable. Rather, BSW is attempting to manage risks, leaning into the most probable outcome/s and staying diversified and balanced. Although we are not run by computers (just humans on the new hire list this year) we are accounting for a myriad of possible futures in our planning and are ready to take them on to help clients achieve their goals.
Happy New Year!
Craig Seidler, BSW Director of Public Investments