The Margin of Safety Quarterly Winter 2021
Fourth Quarter 2020
- This year was a tragic one. Yet global stocks were up 16.3% for the year.
- U.S. stocks did a bit better, with large caps up 18.2% and small caps up 20.0%.
- Developed international stocks gained almost 10% and emerging market stocks gained over 15%.
- Core investment grade bonds gained a strong 7.6% for the year.
- Credit sensitive bonds, high yield bonds and floating rate loans posted 6.2% and 3.1% gains, respectively, for the year. Our international bond manager returned just over 2% for the year.
- Our diversified alternative strategy posted a strong 6.3% return for the year.
- The comforting full year returns mask the incredible volatility and stress investors faced earlier in the year
Fourth Quarter 2020 Investment Commentary
The year 2020 proved to be one of the most tumultuous in modern history, marked by a number of developments that were historically unprecedented. But the year also demonstrated the resilience of people, institutions, and financial markets. As tragic as 2020 was, global stocks were up 16% in 2020. However, using the MSCI global index, ex U.S., the return was only 7.59%, which speaks to the dominance of a handful of U.S. large cap stocks that we have written about in prior newsletters. U.S. stocks did a bit better than global equites as a whole. During the dark days of March, with pandemic fears rampant and the global economy falling off a cliff, very few (if any) would have predicted this year’s outcome for stocks. Despite being a cliché in investing, the benefit of “staying the course” in times of volatility once again proved prescient. We know a number of advisors and investors who did not do this and it was to their detriment. Attached is a chart that illustrates as much as we could of 2020, headlines and markets, on one page.
In fixed income, core investment grade bonds gained a strong 7.6%, benefiting from falling rates as investors sought low risk assets earlier in the year. Our flexible bond strategies and floating rate loans materially outperformed core bonds during the last three quarters of the year. But they still have some ground to make up from the tremendous selloff suffered in March.
In a challenging and chaotic year, our client portfolios performed reasonably well. Our prior newsletters discussed in some detail portfolio changes made during 2020 that benefited returns, so we will just summarize the changes in this newsletter – in March, we added about 4% to U.S. stocks, which in hindsight was done close to the March lows. In May, we exited our passive position to European equities and added an active international growth manager which in the short term added to returns as well. We did make another change in December, adding an emerging market growth manager, while reducing the weighting to a passive emerging market value strategy.
We are optimistic that our recent portfolio performance is the beginning of a more sustained trend. There are reasons to believe prior years’ headwinds may be turning into tailwinds for our portfolio positioning.
For 2021, the likelihood of widespread vaccine distribution supports the case for an economic recovery beginning in the second or third quarter. Central bank monetary policy is almost certain to remain very accommodative for at least the next year or two. And fiscal policy is unlikely to be restrictive and could be stimulative, depending on political outcomes. This backdrop should be supportive of equities and other financial risk assets at least for 2021.
Looking forward over the next five years, our research, reading and discussions with investors we respect indicates that U.S. stocks continue to look expensive in absolute terms but not relative to extremely low bond yields. Meanwhile, non U.S. stock markets, emerging market stocks in particular, have much higher five year expected returns than U.S. stocks. If the U.S. dollar continues its recent decline, U.S. investors in international assets could receive an additional currency return.
Of course, we must assess the risks. In the next few months, there could be a sharp economic slowdown from pandemic induced lockdowns and, potentially, inadequate supplemental fiscal relief. And the current extreme investor optimism leaves the market vulnerable to disappointment. Longer term, two big concerns are the specter of inflation and China. We discuss these two concerns later in the newsletter.
Financial market history teaches us: expect the unexpected; expect to be surprised. And positive surprises happen too. It’s important to note that although our base case is for a cyclical recovery, our balanced portfolios are built to be resilient across a wide range of potential scenarios. That said, we’d be happy to see our formerly contrarian views become the consensus in 2021 and beyond.
In our first quarter 2020 newsletter back in April, which feels like an eternity ago, we recognized that we were living through an incredible period of history. The pandemic weighed heavily on us then, as it does today. While many risks remain, the effective vaccines that are starting to be distributed provide a real light at the end of the tunnel.
We said in the first quarter that we would get through this crisis and that things would improve and recover. Financial markets recovered first, experiencing both their quickest decline and rebound on record, despite the significant global economic contraction. Economies have made great progress too but are not back to their pre-COVID-19 levels yet and may not be for another year or two. On the health side, despite the approval of several effective vaccines, the authorities warn us that we may be in for dark days this winter before they can be widely distributed to the general populace. This may set back economies and markets in the near term and keep us isolated and sheltering in place in some cases. But we expect that 2021 will see the end of the pandemic and our society can then follow markets and the economy in bouncing back as well.
The comforting full year returns mask the incredible volatility and stress investors faced earlier in the year. Stock markets around the world were down 30% – 40% for the year by March 23, the year’s low point. From there, stocks skyrocketed into year end. Amazingly, the major large cap indexes are all up over 65% from their lows; smaller cap U.S. stocks have nearly doubled since then. During the worst days of March, with pandemic fears rampant and the global economy falling off a cliff, very few predicted this year’s outsized performance for stocks.
The returns for the stock market as a whole also mask the differences between picking the best sectors for the year and picking the worst sectors for the year. The best sectors were up over 100% on the year, including semiconductors, freight, and internet retail. The worst sectors were down over 40% including oil, banks, retail, and airlines. Investors had be to diversified during the year to do well.
Looking Ahead to 2021 & Beyond
As we move towards exiting the crisis stage that was 2020 and begin rebuilding and recovery, the challenge for investors is to discern what the “new normal” will look like. The vaccines, easy financial conditions and stimulative fiscal policy are all reasons for our optimism for society, the economy, and markets looking ahead. The likelihood of widespread vaccine distribution supports the case for a cyclical economic recovery beginning in the second and third quarter of 2021. Central bank monetary policy is almost certain to remain very accommodative for at least the next year or two. And fiscal policy is unlikely to be restrictive and could be stimulative, depending on political outcomes. This backdrop should be supportive of equities and other financial risk assets, at least for the next year.
U.S. stocks have high absolute valuations, regardless of the metric used except when compared to the extremely low bond yields. In our view, non U.S. stock markets, emerging market stocks in particular, are more attractively valued and have much higher five year expected returns than U.S. stocks. It’s important to repeat that the plausible argument that low interest rates justify higher U.S. stock valuations is only more applicable overseas where stocks are even cheaper compared to bonds, which sport negative yields in some places. This was part of the reasoning behind the portfolio changes we noted earlier, adding to growth stocks outside the U.S., where prices are cheaper and the potential for future returns are greater than here in the U.S. at current price levels.
Currency is another potential tailwind for non U.S. stocks over U.S. stocks. If the aforementioned global economic recovery and extension of accommodative monetary policy plays out, we’d expect the U.S. dollar to continue its recent decline. As a “counter cyclical” currency, the U.S. dollar tends to move in the opposite direction of global growth. If the dollar declines, U.S. investors in non U.S. stocks will earn a currency return on top of any equity return. A falling U.S. dollar will also benefit our international bond position and while we wait, the yield is just under 5%, greater than what is available here in the U.S.
It is important to remember that when we say that U.S. stocks are expensive, this is when viewed as a group. We think that there are areas within U.S. stocks that look less expensive. Financial stocks, as an example, are trading at reasonable valuations and if interest rates do go higher eventually banks should benefit. Select consumer stocks and industrial stocks are also attractive.
The Risks To Our Outlook
As always, there are numerous risks that we think about. Unexpected shocks can happen at any time, whether a jump in inflation, domestic political dysfunction, geopolitical conflict, or trade disputes. Financial market history teaches us to expect the unexpected and expect to be surprised, as we mentioned earlier.
Over the next few months, there is a real risk of a sharp economic slowdown from pandemic induced lockdowns and, potentially, inadequate additional fiscal relief for households, small businesses, and state and local government budgets. The current extreme investor optimism also leaves the market vulnerable to disappointment. But given the positive macro and investment backdrop, we would likely view any financial market drawdowns as temporary.
Looking out longer term over the next five years, the big risks we are watching are the specter of inflation and China.
Inflation is a lower concern at this point, but the risk isn’t zero. Rising demand stemming from spending unleashed after the pandemic could coincide with a supply side constrained by the retreat of globalization to instigate an inflationary spiral. Clients should know that we have several asset classes and strategies in our portfolios — flexible bond strategies, floating rate loans, alternative asset classes and global stocks — that should do well in an inflationary environment. We also have other inflation sensitive investment options at our disposal should we see the need for additional tactical protection.
Turning to China, we are focused on the risk and opportunity it presents because of its outsized influence within the emerging markets. China has handled the pandemic relatively well, but its stock market has also been one of the best performing ones in 2020. We wouldn’t be surprised to see stocks there pullback, especially as China reins in excesses and reduces stimulus (after all, according to the International Monetary Fund, China is the only country expected to have generated positive GDP growth in 2020). We also expect trade and tech conflicts to continue. But longer term, we remain bullish on China and emerging market stocks in general. Our research on valuation for emerging markets indicates that there is plenty of room for emerging markets to surprise on the upside using conservative assumptions. We think we are in the early stages of investors rebalancing their portfolios to increase non U.S. equity exposure, especially emerging market stocks (so demand is rising) and recent capital flows data confirm this. The trade war and the potential reversal of globalization have only underlined the importance of global diversification for equity investors.
Lastly, there is concern about the signs of a bubble from the long U.S. bull market, a topic Jeremy Graham wrote about in his most recent memo Waiting For The Last Dance (January 5, 2021) and we wrote about in our December 29, 2020 blog posting, Speculating In Market Excesses. We do not know when bubbles will burst but we do think that prices in the areas noted in the blog posting, including new IPOs, cloud computing and electric cars, have grown to extreme levels. Small changes in assumptions about future growth or interest rates would lead to potentially large price movements in these overvalued areas and prices are reminiscent of 1999. We would emphasize the need for a long term game plan and for investors to look beyond what is doing well currently when constructing a portfolio to meet their long term goals.
Partnering With Our Clients
In addition to financial market gains, 2020 offered numerous wealth and tax planning opportunities. At the start of the year, the SECURE ACT resulted in new retirement and estate planning opportunities. As the pandemic broke and Congress acted, we worked with clients to evaluate and implement relevant provisions of the CARES Act around tax planning, charitable giving, and small business advisory support through our affiliated CPA firm, Smoak, Davis & Nixon LLP. Due to the elections and the potential for tax law changes in 2021, at year end we worked with clients on the timing of income, deductions, and estate transfers. We helped clients navigate the PPP application and documentation process during 2020, as well as summarizing and recapping relevant PPP guidance that dripped out over the weeks and months. There is also another round of PPP loans available to help struggling businesses, PPP 2.0, and we will again help clients with this process, working closely with Smoak, Davis & Nixon to keep clients updated with important information in this area.
We were also busy during the year updating client financial plans, modifying existing plans and working with clients to put a financial plan in place. This work reinforced that a financial plan is not a “one and done” exercise and the plan needs to be periodically reviewed, updated and revised. Having a well thought out financial and investment plan for our clients means that they have in place the analytical frame work to make financial and tax decisions, while keeping emotions at bay.
Our portfolios are well positioned for the base case cyclical recovery from the global pandemic, but our positioning always incorporates a wide range of potentialities. Should a less sanguine outcome occur, we have investments in the portfolio that can offer downside protection. And we are prepared to prudently, but opportunistically, respond as events unfold as we did in 2020.
The market has always exhibited dramatic mood swings, whipsawing investor sentiment, and 2020 was no different. We recommend investors ignore the crowd’s actions completely and, as we closed our first quarter newsletter, “stay the course.”
Better yet, be prepared to take advantage of the market’s mood swings, as we did in 2020 to our clients’ benefit. We’ve seen countless studies of unguided investors selling their stock exposure near the market bottom, then reinvesting as markets stabilized or fully recovered — the investor sentiment “whipsaw” effect that we often warn about. Instead, one should be greedy when others are fearful. Our disciplined approach allowed us to do this successfully in 2020. We thank you for your continued trust in us and for the referrals provided to us.
After partnering with clients during such a tumultuous year, we appreciate more than ever the trust placed in us. As we welcome a hopefully brighter 2021, we wish you and yours a healthier, happier, and prosperous New Year.
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