The 2020 Stress Test
2020 could not end quickly enough. What else can we say about a year that brought a public health tragedy so deadly and devastating that it seems like an unending bad dream? On top of the pandemic, there was deep social unrest and a divisive, extra-contentious election that seemed to throw a wet blanket on everything.
Yet, the stock market ended much how it started – making new all-time highs. If you had gone to sleep in January and woke at year-end, you would assume it was just another good year for stocks. What actually happened will be a case study for financial markets in years to come.
The S&P 500 peaked on February 19th, 2020 as the virus information was in its early stages. From there, the market quickly dropped 34% within 33 days - the fastest bear market on record, faster even than the 1987 crash that lasted 3 months. From the market low, the S&P 500 rose almost 70%. Those who stayed the course recovered initial losses from the selloff by June. Global stocks finished 2020 up 16.3% including dividends, led by small stocks which were up 20% for the year.
The velocity of the recovery can be attributed to enormously accommodative monetary and fiscal policies by the U.S. Federal Reserve and Congress, giving investors the confidence to take risk. The Fed slashed short-term interest rates to near zero and re-established asset purchase programs, including buying corporate debt for the first time in history. In addition, Congress passed the $2.2T CARES Act to assist workers, small businesses, and municipalities. All of this amounted to a bridge loan for the economy during the worst health crisis in a generation.
While it was entertaining to watch the hottest technology or “stay-at-home” stocks soar this year, the impact of the public-sector economic support was most evident in the bond market. The 10-year U.S. Treasury yield, after touching 0.50%, ended the year at 0.94%. These historically low interest rates eased credit availability for businesses and set off a refinancing boom for mortgage debt. Real yields (nominal yields less inflation) are well below zero. Falling yields boosted bond returns – most notably Treasuries and TIPS (inflation-protected Treasury bonds), which gained 8% and 11%, respectively.
It goes without saying that 2020 was atypical. What can we learn from a year that felt like one giant stress test? Here are some takeaways:
The financial markets do not equal the economy. Markets are always looking ahead. This year the stock markets began regaining ground lost through the summer – even as a second wave of the virus spread. Stocks made further big gains again in November with news of a successful vaccine despite the prospect of worsening COVID-19 and potential lockdowns.
A consistent commitment to your investment strategy was more important than your actual allocation. A hypothetical portfolio of 50% in global stocks and 50% in broad U.S. bonds returned 11.9%, while an 80% global stock/20% bond portfolio gained 14.5%[1], a difference of just 2.6%. If an investor sold the 50/50 portfolio in March, he or she would have lost 15% for the year. Selling the 80% stock portfolio in March would have locked in a 25% loss. It didn’t matter all that much whether you picked the relatively moderate 50% stock strategy or the more aggressive 80%. What mattered is that you did not abandon your chosen strategy.
Rebalancing is highly effective in a period with large swings in asset prices. A hypothetical dollar invested in bonds through the end of March and then moved to stocks on April 1 (pretty good but not perfect timing) would be worth $1.50 at the end of the year. That dollar “outperformed” other dollars that were riding out the stock market or remained in bonds. Not every rebalance will have such a large impact on the overall portfolio, but done consistently and methodically, rebalancing adds value over time. Of course, in hindsight, this seems simple, but the real challenge is pulling the trigger when it feels as though the world is falling apart.
Don’t own bonds just to “clip the coupon.” As interest rates fell, bond returns were driven by capital appreciation last year, with actual interest income taking a back seat. The price appreciation helped offset the drawdown in stocks and dampened the overall decline in portfolios. A 50/50 portfolio captured 75% of the gains with only 48% of the drawdown of an all-stock portfolio.
Information moved quickly in 2020, and the market reaction was often counter-intuitive, making it even more difficult to react. Timing the market in 2020 was all but impossible except for the very lucky. Fortunately, luck was not required to have a good investing year.
WHAT’S NEXT?
Everything seems to move fast these days. Has the speed of this recovery pulled some long-term returns forward? The quick recovery in prices has exceeded the recovery in current earnings, lifting valuation measures. The U.S. stock market indicates a forward price/earnings (P/E) ratio of 23 times, just as it was in 1999, and the Shiller cyclically adjusted P/E (CAPE) has just exceeded its October 1929 level. But are these historical thresholds even relevant?
First, much of the higher valuation ratios are a result of the historically low interest rates. Low interest rates tend to lift prices of everything – houses, stocks, gold, and even bitcoin. Adjusted for low rates, stocks may not be in such nosebleed territory after all.
Second, the COVID recession is unique. Modern-day recessions have typically been born from economic excess – too much debt, too much optimism, too high interest rates. What makes this cycle different is that it results from a health crisis. A health crisis that hopefully can be solved, or at least highly mitigated, with widespread vaccinations. Eventually the economic “on” switch could be flipped for a quick return to normalcy, justifying higher asset prices today.
That isn’t necessarily an all-clear sign. After a 70% rally in stocks in nine months, there are some pockets of market froth. Initial public offerings, when companies issue new shares to investors, are the highest in over 20 years. Many of the new IPOs are household names like DoorDash and Airbnb but are currently unprofitable. The poster child of market froths this year may be electric vehicle maker Tesla, up 739% for 2020. Tesla is worth more than Volkswagen, Toyota, and Ford, combined, yet produces only a fraction of the cars. The increased popularity of SPACs – blank-check shell companies used to take companies public – suggest some investors are willing to put money down before knowing anything about what they are even buying.
What should investors do now? First, it makes no sense to hide from the volatility. We counsel clients to reconfirm their financial plans and stay the course. History proves, time and again, that attempting to time the stock market is not a productive exercise. Now is not a time to chase the most speculative stocks.
Perhaps this is finally the year for international stocks. We are modestly increasing our allocation to foreign stocks to a 25% target and expect improving returns after a decade of underperformance relative to large U.S. firms. China has put its economy back on path quicker than others, and developed Europe is so beat up by the pandemic that it is attractive to invest again.
We have previously written about the concentration risk in the S&P 500. A move away from the largest stocks started in the fall and continues to play out. Long depressed value plays may finally have their day. We like many beaten up value stocks, as the early-stage recovery and new infrastructure spending continues to be supportive for these companies.
After the Fed’s intervention during the financial crisis, nearly everyone was certain we would have higher inflation as a result. That never happened. Now, ten years later and after even more monetary stimulus, no one thinks there will be inflation. We think it is prudent to position portfolios in case this view is wrong.
In bond portfolios, we continue to reduce U.S. Treasury allocations and increase positions in investment-grade credit/corporate bonds. At the same time, Treasuries are an important part of a bond strategy. We continue to favor TIPS, which are performing well as the Fed continues with expansion programs.
WHAT IT ALL MEANS
Extreme levels of investor optimism can be a warning sign the markets are vulnerable to a sudden decline – but the markets are always vulnerable.
The range of possibilities is wide. There could be unanticipated complications from the Federal Reserve’s moves. The jury is still out regarding the extent to which monetary programs impact the real economy longer term. There will likely be unknown consequences from the pandemic, or possibly issues with vaccines. Consumer behavior could forever change in ways we do not yet understand. On the other hand, pent-up demand combined with easy money could unleash high economic growth – should we call it the roaring 20s?
There are many reasons to believe we will survive this tragedy and carry on, as will the financial markets. You have to be there to benefit, and the only metric that really matters is progress toward your goals. As always, contact us to update your personal situation or discuss any specific questions or concerns.
Best wishes for a happy and safe new year. We look forward to working with you.
[1] Global stocks are represented by the MSCI All-Country World Index. US bonds are the Bloomberg Barclays U.S. Aggregate Index.
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