To our Valued Clients and Friends,
We here at Custos hope you and your loved ones had a Merry Christmas and a very happy holiday season. This year, perhaps more than most, we are thankful for your trust and friendship. This post is both a bit of a “year in review” and a look to the future. We believe 2021 will be a make-or-break year for this economic recovery and cycle. Can you slam the breaks on the hottest economy in a generation in response to a pandemic and hit restart with little to no lasting effects? Can a combination of potent fiscal and monetary policy save both the financial economy and the real economy without inducing inflationary pressures? We do not have those answers currently, but they are the right questions, and we expect we will spend most of this year searching for the answers.
We will skip the “what a year it was,” clichés…. For many Americans it was not a great year. As we went to print on this post, we learned a very dear friend who was also a client had passed. He was a great man who built an incredible business and raised a wonderful family. He is already sorely missed. In a world with very few universal truths we think it’s fair to say all of us were negatively impacted, in some way, by the global pandemic. As is always the case, the pain fell disproportionately on some. Despite the talk about shared sacrifice the reality could not be further from the truth. This might be the first US recession where the wealth gap widened. Typically (as was the case in 2008-2009 and even in 2001), the decline in asset prices – perhaps perversely – narrows the wealth gap. Who would have thought that the very year the US economy entered recession, ending the longest period of expansion in recorded history, we would also see one of the best equity return years in the past two decades? Or that housing prices would accelerate at the fastest pace (8.4%), year over year, since early in the housing market recovery (after a nearly 30% decline) during the financial crisis. Unemployment peaked at the highest level since the Great Depression at more than 14%. As of the end of November the US economy is still down more jobs (-9.8M) than at the trough of previous recession (-8.7M).
A combination of unprecedented fiscal and monetary stimulus has kept the economy on life support. We find it nearly impossible to overstate how extraordinary the federal government and the Federal Reserve’s actions were. We remember when Congress failed to pass a $700B economic rescue package in September of 2008 after countless mortgage originators went under, Bear Stearns had been rescued by JP Morgan, and Lehman Brothers (still to this day the largest bankruptcy in US history) had failed. There was a real question as to whether there was a single safe deposit in the country. This year, Congress passed two rescue packages totaling more than $3T for an economy that, prior to February, was the hottest any working age adult in this country has ever lived through. The Federal Reserve added over $3T to its balance sheet in just over two months, a feat it previously took 100 years to achieve. The Fed started buying corporate bonds, high yield ETFs, and municipal bonds, none of which they touched in the Global Financial Crisis (GFC). To us, this highlights how incredibly concerned the nation’s central bank was.
Moving on to where markets stand now entering 2021 –
An entire book could be, and certainly will be, written about the year 2020. We saw one of the largest intra-year percentage point swings in the S&P 500. The index traded down as much as -32% in March and closed out the year up 16%. For the third calendar year in a row (and 10th year since the GFC) growth outperformed value. At a full 3700bps or 37%, 2020 represents the biggest single year divergence between the two styles since the Russell indexes were initiated in 1992. Small caps staged a late year rally to outperform large cap stocks for the first time since 2016. Momentum was the only factor strategy that outperformed this year and continued a decade of strong relative performance to the S&P 500. All of the money piling into the largest names have led to a situation where nearly 25% of the S&P 500 is in the six biggest names (Apple, Microsoft, Amazon, Facebook, Tesla, Google) which caused the equal weighted S&P 500 index to underperform the market cap weighted version by over 500 bps (or 5%) on the year.
As we look to 2021, we take stock of the risks and opportunities in markets –
As discussed above, we enter the year amidst the most supportive fiscal and monetary environment in history. We’re confident the largest injections of stimulus are behind us but there is an explicit promise from the Federal Reserve to be supportive and, although to a lesser degree, some level of commitment from Congress to do the same. This should provide some good support for asset prices. The banks appear to be in good shape and ready to lend to both the consumer and corporate markets, which has been confirmed by our recent experience with clients. Prior to the pandemic we had one of the strongest economies the country has ever seen – the unemployment rate was the lowest in more than two generations.
Valuations are at the highest levels they have been in a generation. The last time Price to Earnings (P/E) multiples on the S&P 500 were above 20x, things ended very badly – the index fell nearly 50%. What makes the current P/E particularly high is the anticipated growth baked into earnings for next year. The numerator of the ratio (the price of the S&P 500) is known. Although there are several different angles to look at the P/E ratio (trailing EPS [Earnings Per Share], current year EPS, next year’s EPS), the most common for market participants is the “next twelve month’s” EPS (or “NTM”). Of course, future EPS is not known with certainty, but the average estimates of market participants give us a good approximation of what the “market thinks.” Currently, the market expects ~$169/share EPS in 2021. That would be a greater than 20% increase from 2020 and completely recover all of the pandemic losses and then some. EPS in 2018 and 2019 were $161.93 and $162.97, respectively. We probably don’t need to do the math for you, but we will. If the market gets the >20% earnings growth it expects (and that’s far from certain) EPS will be up about 4% from the full-year 2018 and during that time the index gained nearly 50%.
In 2020 things like call option buying smashed records and nearly doubled from the previous year.
The Wall Street Journal had an eye-opening article on the record level of margin debt outstanding – just shy of three quarters of a trillion dollars…. Investors have never borrowed more against their portfolios. Albeit anecdotal, some of the individuals the Journal interviewed said they used margin to buy options (the article can be found here: https://www.wsj.com/articles/investors-double-down-on-stocks-pushing-margin-debt-to-record-11609077600). Price action throughout 2020 in names like Tesla and Plug Power, bankrupt or nearly bankrupt companies like Hertz & Chesapeake Energy, and a massive resurgence in Bitcoin (of course this list could go on) all leave a fundamental-minded investor with more questions than answers but suffice it to say: that kind of price action rarely ends well.
Admittedly, overbought, stretched markets can persist for longer than anyone (including us) thinks they can. With that said, there are some styles and sectors that look attractive on a relative basis. Value, dividend growth, lower volatility stocks, smaller cap, and REITs stand out as offering attractive relative value. We continue to favor US Large Cap Stocks and are working right now to see if we want to add positions in these sectors and styles that look attractive or continue to monitor – sometimes things are cheap for a reason.
Since our inception in 2018 we have chosen to underweight developed international equities (Europe & Japan) to approximately half their index representation. In Early 2020, we completely eliminated our allocation to that part of the world in favor of the US and Emerging Markets. That proved to be very beneficial to portfolios as the developed world outside of the US achieved less than half the return of the US and Emerging Markets. While we will continue to evaluate our global allocation on a regular basis, we expect our significant underweight to developed international markets to persist for all the reasons we have discussed previously – bad demographics, high debt to GDP ratios, lack of innovation and generally less-friendly business climates.
In our view, bonds continue to be one of the most confounding aspects of the market today. As a result of the global pandemic the Federal Reserve took its benchmark interest rate to zero and promised to maintain an accommodative stance for the foreseeable future. During their December 2020 meeting the Federal Reserve Board projected no change in the Fed Funds rate through 2023 with a long run target of 2.5%. As recently as Q4 2018 we had a 10-year treasury yield north of 3%. Through a combination of a slowdown in later 2018 and the pandemic, the 10-year yield got to as low as 0.50% and ended the year just above 0.90%. The previous low in the 10-year treasury was 1.31% in the middle of 2016.
While literally every portion of the fixed income market made money in 2020, nothing performed quite as well as good, old-fashioned treasuries and the longer the duration, the better.
As is always the problem for the bond market after periods of outsized returns, it is as close to impossible as it could be to replicate those returns this year. For example, we came into 2020 with the 10-year yield of 1.92%, which is effectively the expected return for the year. 10-year notes ended 2020 with a 10% total return, so the market essentially prepaid the holder of a 10-year treasury for five years of returns. Think about that – if you bought a 10-year treasury January 1st, 2020 and held it for the year, you made as much in one year as you expected to make in five years of owning the security. Below is a look at where current yields stand.
We have long lamented the “race to zero” (or below) in high quality fixed income. Unfortunately, the primary beneficiaries of low interest rates are governments through lower borrowing costs and weaker currencies. Over the long-term, we think the entire economy can be hurt by low interest rates, but savers are most immediately punished in the form of investment returns that almost always lag inflation leading to (among other things) a lower quality of retirement.
Fortunately for the core bond portion of our portfolios, we have been able to find municipal bond and investment grade corporate yields that are higher than yields of treasuries. That’s not to say that yields are “high” but the index yields on municipal bonds and US investment grade corporate bonds are 1.07% and 1.74%, respectively. Both yields are at or near record lows.
The low yields have forced us to look for alternative sources of yield both within and outside of traditional fixed income. Portions of the fixed income market like preferreds, emerging market debt, and high yield have been good places to allocate capital within the fixed income space. Currently, we still generally like those areas of the fixed income market. We recognize, however, that spreads have tightened significantly, and while there could be room for further tightening the absolute level of yields in all the aforementioned sub-asset classes are the lowest on record.
Investment grade (IG) credit is one of the areas where the Fed’s easing has had the most profound impact. After IG credit spreads blew out to the widest levels since the GFC, credit spreads (the additional yield above treasuries investors pick up for taking credit risk) have tightened to nearly the tightest levels of the last 20 years.
A Final Note on Comparisons to 1918 & the Spanish Flu
As market participants constantly evaluate research and data, historical comparisons inevitably come into play. We love to try to find a historical period that feels like the current period and say “this looks a lot like that so maybe we know how it all plays out.” Recently, some have compared the 1918 Spanish Flu pandemic and the subsequent “Roaring 20s” to the 2020 COVID-19 pandemic and the hope for another “Roaring 20s.” A lot of money has been lost making similar comparisons, but we will bite and at least entertain the idea.
First, the similarities: 1918 and 2020 were both pandemic years. And that’s about where it ends.
Next the differences:
The severity of the Spanish Flu versus COVID-19 is almost not comparable. While COVID-19 has not yet run its full course, the Spanish Flu killed 50M people worldwide with 675,000 in the US alone compared to 1.77M worldwide & 333,000 in the US with a global population 4x higher today. In addition, the disproportionate impact the Spanish Flu had on children and working age adults cannot be overstated when compared to COVID-19. For more information, here are two links from the CDC (with a summary on the 1918 Spanish Flu) and Johns Hopkins (with a very well-organized dashboard we’ve often referenced).
World War I
The Spanish Flu occurred against the backdrop of a world war. The movement of troops into and out of Europe helped spread the virus around the world. Inconveniently, the US joined the war just months before the flu was first identified. 1918 also saw the end of the “War to End All Wars.”
Unlike COVID-19 and the year 2020, the ten years preceding 1918 and the start of the Spanish Flu had seen almost no growth in the US stock market. The stock market closed for four months in 1914 during the start of WWI. 1918 was actually one of the better years with the market gaining nearly 10% on the year.
The Depression of 1920-1921
Before the “Roaring 20s” there was 1920. Not long after the end of WWI hostilities, a depression ripped across the globe. High inflation caused by tight labor markets from the Spanish Flu as well as the transition from a wartime economy to peacetime led up to the 1920/21 depression. The stock market was cut in half and the period is remembered for one of the most deflationary in history.
We do not subscribe to applying historical outcomes to current markets, but for those wishing for a roaring 20s following a pandemic they may have forgotten an important part of the path in getting to the good times.
As we look forward to the new year with hope for a return to normalcy, we are balancing the reality that markets have already priced in a lot of very good news which presents increased risk to portfolios with the promise of significant fiscal and monetary support. All-in-all we think 2021 has the potential to provide low single digit equity returns and could prove to be bumpy with the first part of the year being less volatile than the second half. We expect selloffs to be sharp but possibly short-lived with investors using options and leverage get washed out quickly. We expect yields to drift higher during the first half of the year as inflation starts to creep in but overall a very modest year in fixed income returns. Earnings will be very much in focus for the year with the highest estimates of this cycle in front of us and we will track earnings closely. A new administration with very different priorities will be taking power shortly and we think very few people know what the agenda will be.
We here at Custos want to wish you a happy, healthy 2021 and we look forward to seeing you all again, in person, at some point during the year.
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The views expressed in this newsletter represent the opinion of Custos Family Office, a Registered Investment Adviser. This material is for informational purposes only. It does not constitute investment advice and is not intended as an endorsement of any specific investment or services. The information provided herein is obtained from sources believed to be reliable, but no representation or warranty is made as to its accuracy or completeness. Investing in equity securities involves risks, including the potential loss of principal. While equities may offer the potential for greater long-term growth than most debt securities, they generally have higher volatility. International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles, or from economic or political instability in other nations. Past performance is not indicative of future results. Investments are not a deposit of or guaranteed by a bank or any bank affiliate. Please notify Custos Family Office if there have been any changes to your financial situation or investment objectives or if you wish to impose or modify any reasonable restrictions on the management of your accounts through Custos Family Office.