What a year it has been. You have to go back nearly a century to find a similarly disruptive year (the Spanish flu of 1918, The Great Depression starting in 1929 and lasting until 1933, World War I and II). The global coronavirus pandemic has impacted everybody, disrupting daily life in ways most of us have never experienced. One of my favorite parts of being an investor is the amazing vantage point it gives us to observe the different developments in the world — everything is relevant in the complex decision in how to allocate capital.
My goal with this month’s newsletter is to provide an update on some of the important things that have happened in the financial markets and economy this year. I’ve tried to make it a fun visual journey with lots of charts and data, all in an effort to explain how we got to this point in time where the stock market, after declining 34% at a faster rate than it ever has in history, has fully recovered and is now up 8% for the year. This is an incredibly unusual time and markets reflect that. A number of long-term trends have been put in place, and now more than ever we are being extremely careful and thoughtful in how we invest and allocate capital across assets. Investment portfolios today must be robust to a wide range of scenarios.
Global stock markets crashed in March as the coronavirus made its way to the United States. The S&P 500 fell 35% in just a month, it’s fastest ever decline, as government lockdowns quickly spread across the world. Stress across financial markets reached a crescendo on March 23, the day the Federal Reserve announced unprecedented monetary support which included for the first time the purchase of corporate credit as well as other securities. Market participants saw the Fed stimulus telegraphed and decided to pile into risky assets, knowing that they had a massive Fed tailwind at their back.
This unleashed a tidal wave of liquidity across the most critical parts of the market. As the virus spread and panic ensued, even some of the safest and most liquid assets saw buyers and sellers so far apart on price that huge losses were incurred in some of the safest fixed income markets (investment-grade corporate credit, MBS, ABS, CMBS, and high yield bonds). Corporations rushed to fortify their balance sheets at an unprecedented pace, drawing down credit lines and shattering the all-time record for debt issuance. Easy credit for companies provided a financial bridge to see the lockdowns through and get to a more normal world of economic activity. The Fed committed to buying an unprecedented array of assets never before seen in the United States.
“Don’t Fight The Fed”
If there has been one common thread in investing over the past decade, it has been to never underestimate the power and extent to which global central banks will go to boost financial markets. Legendary investor Marty Zweig (who famously lived atop the Pierre Hotel in the most expensive penthouse in New York City) popularly coined the phrase “Don’t Fight The Fed” in his book Winning on Wall Street. Marty, known for his exhaustive analysis of financial data, discovered that one of the best signals in predicting the direction in the stock market was whether or not the Fed was easing or tightening monetary policy.
History may never exactly repeat itself, but it certainly rhymes. Once again, stimulus from The Federal Reserve has been the primary force behind the dramatic recovery in the stock and bond markets. The combination of monetary with fiscal stimulus from governments across the world created a backdrop that has boosted asset valuations to lofty levels. Across the world, governments injected huge amounts of capital into their economies, an astounding 41% of GDP in Germany and nearly 20% in the United States.
As central banks raced to lower interest rates (a considerable challenge in countries across Europe and Japan where interest rates are zero and even negative) the valuations on equities began to take off. Investors were forced to look far into the future and rushed into high-quality equities with the motto that there is no alternative. Put simply, global investors have been forced into riskier assets to achieve adequate returns as the yield on U.S. Treasuries (see the 10-year yield) has fallen to a mere 0.67%. As things stand today the PE ratio on the S&P 500 sits at 26x, high by any standards, but one can also argue justified given the low level of interest rates.
FAAMG (Facebook, Amazon, Apple, Microsoft, Google)
It is always important to have exposure to the best areas of the stock market, but in 2020 it has been essential. Today, companies and industries face widely divergent prospects (think the restaurant industry compared to large technology firms), and now more than ever it is critical for investors to be invested in the right sectors and companies. At Athos, we have always been focused on high-quality growth and technology stocks, and this bias has always served us well. Looking into the future we now believe more than ever that it is important to be invested in the right areas of the stock market. While passive investing in large-cap U.S. equities is and has been a successful approach, we believe there is significant value that can be added through the use of skilled stock pickers. Evidenced by the rise in the number of mutual funds outperforming the S&P 500, the pendulum has already begun to swing back in favor of active management.
The two charts below show just how important it has been to own the five most valuable companies (Facebook, Amazon, Apple, Microsoft, Google) in the S&P 500. Take them out of your stock portfolio and you have significantly trailed the market in 2020 as well as over the past 5 years.
Performance within the stock market has also been remarkably different this year with wide variation across sectors and industries. As evidenced by the chart above, the market has been powered by technology stocks. Many businesses are doing well despite the challenging global economic conditions.
This trend is likely to continue and why we remain highly selective in our stock market allocations. One of the keys to successful investing is getting behind multi-year trends and investing in companies with open-ended earnings potential. This is why we remain focused on the sectors in the market you want to have exposure to.
The Rise of The Retail Trader
A phenomenon that cannot go unmentioned in 2020 has been the rise of the retail trader. Zero commissions and tremendous ease have made the trendy investing app, Robinhood, a powerful force in markets.
While it’s hard to pinpoint exactly how the rise in retail trading has impacted the markets, I believe it has likely contributed to the huge increase in volatility within the market. In normal times, it is very uncommon to have stocks rising and falling 50% a day and new initial public offerings rising many times over. Today, it is common for people across the world, from China and India to the United States, to view investing in the stock market as a get rich quick opportunity. The dot-com bubble was the last great increase in retail trading and also saw a period of irrational price movements. The vast majority of retail investors are in highly speculative issues and at risk of considerable losses. History has shown that it has been incredibly challenging for the most sophisticated and intelligent, well-trained, and well-funded market participants to beat the market. This has not changed; if anything, investing is getting harder not easier for even the best hedge funds.
As aforementioned, an incredibly important key to the sharp rebound in asset prices has been the massive issuance of corporate debt in the wake of the Federal Reserve’s promise to backstop markets and “do whatever it takes”. The first six months of 2020 have seen a near-record amount of debt issuance – and there are still six months to go. Many struggling businesses have been given a lifeline to see the crisis through. Not only has the issuance of debt been great in size but companies have been able to borrow at record low-interest rates. 80% of all newly issued corporate debt has been issued at a 3% coupon rate. The intended effect has been achieved, as capital has been made readily available, even for businesses that are no longer viable. This is a classic “kick the can down the road” exercise but for now the effect has been a massive rally in financial assets.
1 The famous words of Mario Draghi, former head of the European Central Bank, who stemmed the European Debt Crisis in 2013.
U.S. single-family house prices have remained surprisingly resilient in the face of the government shutdowns and record unemployment. Record low-interest rates and availability of financing along with migration out of large city centers have proved strong forces to buoy the market. Smaller cities that have long seen migration from the large gateway cities have seen larger price increases.
Rally Continues in Gold
Gold, also benefiting from the actions from the Federal Reserve this year, has been in an upward trend since 2018. A store of wealth for millennia, the precious metal has become attractive as an asset due in part to the multitude of risks globally but largely because of the trillions of dollars of negative-yielding debt around the world.
How will the election affect the stock market? This is a common question I get from clients. We find ourselves in an election year so the obvious question to ask is – how has the stock market performed during election years? The table below shows the return for the stock market for every election year going back to 1948. The S&P 500 has produced a positive return 16 out of 18 years, and on average has delivered a 9.8% return in election years. Interestingly, the frequency and rate at which the stock market has behaved in election years has been remarkably normal and true to form. 10% has historically been the return on U.S. equities over 10+ year time horizons, and it is true that the stock market rises most years.
These statistics suggest that investors should continue to practice healthy investing and asset allocation – change very little and maintain as much equity exposure as your risk tolerance will allow. Great investing is about buying high-quality assets and then letting them compound in value over time. Patience is required and as Warren Buffett likes to say “If you aren’t willing to own a stock for ten years, don’t even think about owning it for ten minutes.” Fluctuations in economic growth and interest rates usually matter more than the electoral cycle.
Fixed Income Has Performed Well and is Still an Important Component in Portfolios
Fixed income has quietly produced nearly the same return as equities but with just a sliver of the volatility – once again proving itself as a worthy portfolio diversifier. Many market strategists lament that increasingly minuscule yields across the fixed income universe mean have lost their power within a diversified portfolio. For sophisticated investors at endowments and foundations, this has been seen as an issue for the past two decades. The route most large capital allocators have taken has been to increase allocations to alternative asset classes such as hedge funds and private equity.
If one studies the historical data they will find that prospective returns in the bond market tend to end up being approximate to their entry yield (the yield on fixed-income when they make the investment). If today the 10-year U.S. Treasury yields 0.67%, then will an investor only receive a 0.67% annual return?
What is the scope for price appreciation at such a low yield starting point? We have two great examples of other countries that have already been in a prolonged period of plunging interest rates. Japan and Europe have had interest rates around and below these levels for decades. Now in some countries, they even have negative interest rates. This raises two very large questions facing investors in the United States:
- What have bonds returned in Japan/Europe and have they been an adequate portfolio diversifier?
- As a Japanese investor what were the best asset classes to have exposure to?
The level of interest rates in an economy and financial markets is incredibly important. All financial asset values are based on what is called the “discount rate”, and the lower that discount rate the great the alternate asset values. A prime example of this is the incredible expansion in the valuation of U.S. stocks as shown by the PE ratio. A PE ratio of 26x is high as we look back on history, but very little of history has seen interest rates at such low levels.
I have long told friends and colleagues that I think the ultimate question for those of us in finance is “what will interest rates do over the remainder of our lifetimes”. Despite its incredible importance very few study this topic as it’s very hard to predict the future based on the historical data we have – we don’t have data going back but more than a couple hundred years and who is to say the future might develop in an entirely different way were there a pattern. At Athos Capital, I have always invested with the view that we will likely see interest rates continue to grind lower. We have studied the economic history and financial markets of both Japan and Europe very closely, and the common denominator in both economies’ has been their declining demographics. In the United States we are on a similar trajectory; about a decade behind Europe and about three decades behind Japan.
The problem that arises when you have an aging population (and eventual decline) is that it becomes harder to grow the GDP and inflation at healthy rates. Deflation, a decline in the prices of goods and services, has been the experience in Japan. Economies with aging demographics have huge debt burdens and very high savings rates and thus lots of capital that must be deployed into limited opportunities. All of this results in interest rates staying stubbornly low. A change in the demographic trajectory of the United States could certainly occur but appears unlikely especially when considering that all population growth in the U.S. over the past two decades has been from immigration and that has been significantly reduced under President Trump’s administration.
Looking to the future, we remain cautiously optimistic and are investing accordingly. We focus on creating well-diversified portfolios robust to a wide range of scenarios. Asset allocation – the mix between stocks, bonds, cash, and alternatives – remains paramount. We maintain our high-quality equity focus and continue to find selective high return special investments. Pockets of the fixed income market remain attractive and offer investors income and total return potential. Now more than ever we believe investors need to be highly selective. Investing through highly skilled and focused investment managers will add value to portfolios.