Buckle-Up for the Ride 2.0
From the standpoint of investment returns, it is unintuitive that the major stock markets produced positive returns for the year despite experiencing the terrible COVID-19 impacted first quarter. The S&P 500 gained 16.2% and the NASDAQ gained 43.5%. The heavily-concentrated high-tech NASDAQ did particularly well as many of those companies benefited from the life-altering changes people were forced to adopt due to the COVID-19 pandemic. For the NASDAQ, it will be increasingly more difficult to maintain such a torrid pace without a correction.
During the fourth quarter of 2020, the S&P 500 Index gained 11.7%, the NASDAQ Index gained 15.4%, the Russell 2000 Growth Index gained 29.4%, and the iShares Barclays 7-10 yr. Treasury Bond ETF (IEF) lost 1.5%.[1]
Below are my predictions for 2021 and the 2.0 version of Buckle-Up for the Ride. The key themes are:
- The stock markets will end the year higher, but it is doubtful that returns will develop in a straight line.
- The Federal Reserve will continue their accommodative policy.
- Interest rates and inflation will be on the rise.
- The US dollar will weaken against other foreign currencies.
- The COVID-19 disruptions will continue until the second half of 2021.
- The civil unrest we experienced in 2020 will abate.
While these are my predictions of what may happen in the future, these are by no means a given. If one critically looks back at their own and other’s prediction, no one has a crystal ball, so investing in such a method is dangerous. During my graduate studies at the University of Chicago I was trained to rigorously challenge my own and others’ beliefs in the context of long-term proven principles.
One principle I follow when evaluating investments is current worth. In its simplest form, today’s value is the sum of all future returns adjusted back to today’s dollars. Since the many inputs in making such a calculation are subjective to all the investors, entities, theorists, and computers, it can make for a wide spread of valuations.
Today I see a bifurcated stock market with much of the gains skewed to a relatively small number of companies leaving the balance of a much greater number of companies largely ignored in terms of price movement. The skewness of returns works both ways in terms of gains and losses.
This irregularity has been present since before 2020 and has only been exacerbated by the COVID-19 fallout. To put this in perspective, let us examine the S&P 500 stock market index which is comprised of approximately 500 large companies and was designed in 1957 to be a broad representation of large publicly traded U.S. companies.
Even though the index continues to be widely regarded as the best gauge of large-cap U.S. equities, its value as that proxy may not be what it has been in the past. CNN recently reported that a mere six companies, Apple (AAPL), Microsoft (MSFT), Amazon (AMZN), Google owner Alphabet (GOOG), Facebook (FB) and Tesla (TSLA) are now collectively worth more than $8.1 trillion, accounting for nearly 25% of the total $33.3 trillion market value of all the companies in the S&P 500.
Everyday investors who believe in the value of diversification to reduce risk should take careful note of this statistic and closely examine the underlying investments if they hold mutual funds or ETFs. This concentration of names is not an isolated occurrence and can be seen in a surprisingly high number of mutual funds and ETFs. A close inspection will also show that many sector funds hold many of these names in disproportionate amounts. One reason for the index-like concentration of names in funds and ETFs is that their performance and holdings are many times measured against an index. In competing for investor dollars these funds and ETFs are pressured to either hold the prominent names of an index or risk being forced to explain any dispersion, or variance, in performance and portfolio make-up.
I strongly believe this is not a good long-term investment philosophy. We at Torii Asset Management are not pressured to succumb to this herd-like mentality. We have the discipline, experience, and expertise to make the right decisions for our clients even if they appear to go against the grain.
This brings us to 2021. On the first trading day after the Georgia Senate run-off we may have seen an inkling that the stock market landscape may be experiencing a change. This particular point in time is pertinent since the conclusion of the Georgia election lifted a material source of uncertainty from the market and institutions were poised to put new money to work.
Prior to the opening bell on January 6th there was a divergence between the big-tech laden NASDAQ, futures index which was down by more than 2%, and the Russell 2000 small-cap futures index which was up by more than 2%. At the closing bell the NASDAQ regained much of its losses, but still closed down. The Russell 2000 index closed up 4%. In addition to the small-cap advance, some large non-tech names moved higher on the day.
As an example, Caterpillar Inc. (CAT) and Deere & Company (DE) were up more than 5% and Freeport-McMoRan Inc. (FCX), the world’s largest publicly traded copper producer, was up more than 6%. The divergence in performance between big tech, non-tech and small companies leads me to believe that the new administration’s promise of another stimulus program (debt), infrastructure spending, and warming relations with China have prompted institutions to adjust their allocation models to begin moving more towards cyclicals and smaller companies. We will have to watch for a confirmation that a trend has developed and is backed with earnings gains.
I do see potential setbacks during the year which may bring about a correction in the stock market. Depending on the root cause of a market correction and its significance, as of today, I view a material pullback as an opportunity.
Catalysts for a correction:
1. Longer than expected COVID-19 disruption. My guess is that things will get back to normal in the second half of the year and people will be ready to get out on the town.
2. The high expectations of continued economic and earnings growth reflected in current market prices are not met. This can be earnings report misses or muted comments from corporate management about future prospects.
3. Further government stimulus causes U.S. Gov’t creditworthiness concerns and the U.S. debt rating is lowered, which has not been in the news but is a real concern to me.
Despite the probability of a pullback, which would be healthy, I believe the accommodative Fed and pent-up demand from the pandemic will provide a positive backdrop for further long-term stock market gains. Areas of interest in stocks include past laggards once they show revenue and earnings growth. They include consumer discretionary and staples, restaurants, financials, and energy. A traditional favorite is technology, but as a whole the sector looks expensive. For fixed income buyers of CD’s and bonds, I would caution against stretching for more yield by going for longer maturities. If the U.S. dollar is weak, I would expect continued strength in commodities and precious metals.
To our existing clients, I extend my sincere thanks for your business. You have our continued commitment to your success. To prospective clients, I invite you to come and grow with us.
Very truly yours,
Martin L. Yokosawa
[1] These returns are priced based and exclusive of dividend reinvestment.