Do the “Roaring Twenties” Beckon Again?
After closing the chapter on a harrowing 2020, it seems naïve to be asking such an optimistic question again! However, if history does not always repeat itself, it often rhymes – and there are faint echoes today of what occurred in the 1920s, ultimately setting up a decade of robust economic growth, widespread prosperity, and investment opportunity. We will get to this comparison in greater detail in our outlook, but we begin by reviewing last year and exploring the investment themes from which our strategies should benefit in the coming months.
Review: The Coronavirus Crash of 2020
Stock markets rallied sharply after the conclusion of the Presidential election to post one of the best quarters in a decade, putting a capstone on a tumultuous year. After falling more than 30% from peak-to-trough last spring, U.S. stocks, as measured by the S&P 500, returned 18% during the 2020 calendar year, while bonds returned a mere (!) 8%1. Remarkably, growth stocks gained 38%2. By any measure, the opportunity set for investors was rich last year.
Yet, for many, it was an extraordinarily difficult year, as 2020 featured a sequence of seismic events, making it easy to succumb to emotions of fear and anxiety and submit to the temptation to time the markets rather than staying the course. The challenges included a global health pandemic; a sharp and severe recession; unemployment which peaked at levels not seen since the Great Depression; oil prices which briefly traded negatively as energy demand collapsed; social unrest; a highly contentious election cycle in the U.S.; and further afield, the United Kingdom finally consummating a “Brexit” deal to leave the European Union more than four years after voting to do so.
Despite the headwinds, our portfolios fared well, materially outperforming their benchmarks. Last year amplified a trend which started three years ago featuring capital markets with more normal3 levels of volatility and asset class dispersion, allowing the benefits of our diversified approach to become especially clear. When compared to a peer group universe of more than 200 investment firms, our strategies consistently rank within the top quartile, and in many instances, top decile, over any time frame longer than a year for the last decade4.
In 2020, our results were driven by two key factors: firstly, we emphasized stocks over bonds, even as markets crashed in the first quarter. Our models signaled we were not entering a sustained bear market because stock markets never became extremely overvalued compared to bonds. Secondly, our process led us to tilt our exposure to winning areas, such as U.S. Large Cap Growth stocks and gold, and away from underperforming areas, such as value and international stocks. Not since 1999 has the spread in returns between growth and value stocks been as wide, with investors seeking resiliency from stocks with sound balance sheets and an uninterrupted recurring revenue business model during an economic lockdown.
Enduring Lessons from 2020
2020 underscored the importance of the key hallmarks of our approach:
- Our unemotional, model-driven approach. We use objective, quantitative measures of both relative value and momentum to guide our decisions, which insulates our decision-making from subjective and emotional assessments while giving us confidence our past track record will be repeatable in the future. Crucially, we use momentum to objectively confirm whether relatively cheap asset classes are a mispriced opportunity, or whether relatively expensive asset classes should be sold. Cheap asset classes can become cheaper and spend years out of favor before investors reward them again, as anyone who has invested in value and international stocks over the last decade will realize. This balance between relative value and momentum is what drives the consistency of our track record.
- Doing nothing is an active decision. During volatile years such as 2020, there is often a powerful impulse to act and make decisions impatiently when sometimes the best course of action is to stay above the noise by maintaining existing positions, as uncomfortable as it may feel at the time. This is very different from lazily “staying the course” and simply riding out episodes of volatility. Our process is geared toward reducing risk when it objectively confirms a significant and extended bear market lies ahead, such as when stock markets become extremely overpriced relative to bonds and future interest rates. It also looks through the inevitable corrections of 10% – 15% along the way or infrequent crashes (when prices drop precipitously, which usually resolve themselves quickly) if underlying overvaluations do not exist.
There were other enduring lessons learned by investors during 2020 on which we expound upon in greater detail in our Quarterly Webinars along with helpful resources and suggested readings available by request on our website5.
2021: Investment Themes and Strategy Positioning
As we start 2021, our models are cuing off several major investment themes which are influencing our outlook:
- Progress in distributing and adopting the vaccine. Scientists and epidemiologists achieved an historical accomplishment by developing and testing vaccines for a novel virus, COVID-19, which was approved at “warp speed” late last year, in under one-tenth the time it usually takes to do so. Attention has now shifted to how quickly vaccines can be distributed and adopted by populations here and abroad. This logistical challenge may be greater than the development of the vaccine itself. Progress is key to opening several areas in the services sector, which remain stranded in more targeted lockdowns as the virus has surged again during the winter months.
- The potential for further, larger than anticipated, government spending. In early January, the Georgia Senate runoff elections delivered control of the Senate to the Democratic party, reinforcing its ability to advance its economic agenda with control over both houses of Congress and the Presidency. Unlike the Global Financial Crisis in 2008/09, there are no longer debates about the need for austerity or stimulus. Congress has already passed five rounds of fiscal stimulus in bipartisan fashion over the past year, amounting to nearly 18% of GDP. With unemployment remaining elevated at 6.7% and increasing signs of permanent job losses in certain idle sectors, the Democrats are likely to push for more spending on unemployment benefits and infrastructure, areas in which they have common ground with the Republicans, to build a bridge for the unemployed to a post-pandemic economy.
In the short-term, the size of this stimulus is likely to be larger and happen more quickly than what markets were anticipating in November, when government looked more gridlocked in the immediate aftermath of the elections. Over the longer-term, once the pandemic subsides, how we pay for the exorbitant privilege of being able to finance deficits of this magnitude will become the central investment issue of the early part of this decade. With government debt expected to exceed GDP, Congress will need to broaden the tax base6 and address reform of entitlement programs. Key questions will center on how much inflation will rise and how far the price of the U.S. dollar will fall to rebalance our debt-to-GDP ratio to a more sustainable trajectory.
- A prolonged period of easy money and low short-term interest rates. The Federal Reserve (Fed) has signaled clearly that it is not worried at all about inflation in the near-term. In fact, it is committed to allowing the economy to “run hot” by tolerating a period of above average inflation to hit its target of 2% on average, after a decade of persistently falling short of it. This means short-term rates are likely to remain near zero well beyond this year, even if the Fed slows the rate at which it has been purchasing assets to support a wide range of capital markets. The Fed’s balance sheet has ballooned by an eye-popping 70% since the pandemic began in efforts to provide liquidity and ensure a smooth functioning of fixed income markets. All this monetary stimulus has translated to the money supply growing at an annual rate of around 20% over the past nine months. As a result, inflation expectations are on the rise as are long-term interest rates, steepening the yield curve and putting downward pressure on the U.S. dollar, which has declined by more than 10% since its peak in March last year.
- A burst of technological innovation boosting productivity growth and corporate earnings. As discussed in detail during the past few months, the “tech-celeration” unleashed in 2020 is a positive tailwind for corporate profits. The pandemic has forced many companies to adopt game-changing technologies more quickly than otherwise, which will allow them to do more with less. Examples include virtual communication, automation of manufacturing, digitization of payments, and artificial intelligence. This will help to contain incipient inflation pressure over the longer-term as the economic recovery continues. In the near-term, estimates of corporate earnings, which were expected to grow by 20% for the S&P 500 in 2021, may be ratcheted up even further as additional fiscal stimulus arrives early in the year. Forward 12-month earnings expectations for the S&P 500 are now already in excess of year-end 2019 levels. Corporate earnings growth is expected to be even higher in international emerging markets.
To summarize, in 2021 the combination of the benefits of a broadly adopted vaccine and continued stimulus will lead to a robust economic recovery, which will accelerate during the second half of the year as pent-up demand for services in lockdown is unleased. Inflation may start to rise, but it is unlikely to reach problematic levels for the Federal Reserve to remove the punchbowl from the party anytime soon.
Themes driving our positioning:
With higher corporate earnings expectations and a steeper yield curve, stocks are modestly inexpensive relative to bonds and interest rate expectations. Coupled with positive relative momentum, we remain near the top end of our ranges in stocks and bottom end of our strategies’ ranges in fixed income.
The post-election market rally was propelled by broad participation across many areas. This is a healthy sign which often confirms a sustainable bull market. Many of the distressed cyclical and value-oriented areas of the economy, which had been left behind by the recovery from the March lows, rallied as markets anticipated the arrival and distribution of an effective vaccine. International markets, given the tailwinds of a declining dollar and a global economic recovery driven by an early return to normal from manufacturing, have also begun to outperform, especially in the emerging economies.
Though our models suggest it is still too early to confirm the long-awaited rotation away from growth to value stocks, they did call for two changes to positioning within our global equity allocations:
- First, relative momentum confirmed we should increase our allocation to emerging market stocks7. Key factors in this shift include: the low price of emerging market stocks relative to their own histories and the U.S. after years of underperformance; the manufacturing-based focus of their economies, which may be less vulnerable to pandemic restrictions; and a potential tailwind resulting from a period of further dollar weakness, which the Fed will likely set up in pursuit of inflation.
- Second, we implemented an allocation to the U.S. Energy sector. Amid the COVID-19 pandemic, the energy sector drastically underperformed as the global economy was ground to a halt. With the advent of the vaccine rollouts, this sector has also rebounded most sharply as markets are beginning to anticipate an eventual return to normalcy. For context, even though the energy sector was up 34% during November and December, the sector remains 36% off its closing price at the end of 2019. The next lowest sector performance is financials, which was down merely 4% in 2020. Our model is indicating8 U.S. Energy, a cyclical sector closely tied to the health of the domestic and global economy, has started an upward trajectory and presents a strong investment opportunity, as well as an above-average dividend yield.
These two positions were funded from our U.S. Large Cap Growth exposure, which we continue to emphasize.
History Does Not Repeat Itself, But It Does Rhyme
A century ago, the year 1921 heralded the dawn of a decade of economic growth and widespread prosperity which later became known as the “Roaring Twenties,” driven by recovery from the devastation of the First World War and a global health pandemic -the Spanish Flu. Construction and deferred spending were boosted and sustained by the productivity gains derived from the widespread adoption of new technologies, such as the automobile, electricity, radio, and television9. Some sectors, such as farming, stagnated while others in manufacturing boomed to drive the United States to become the richest country in the world. The festivity ended on “Black Tuesday,” October 29th when the Dow Jones index collapsed after months of frenzied speculation. The Wall Street crash become a key cause of the Great Depression.
2021’s investment themes outlined above echo many of the influences driving the economy in 1921 beyond the obvious comparison to the Spanish Flu and Coronavirus pandemics. Whereas back then it was construction and deferred spending from a war which drove prosperity, today it may be infrastructure spending and pent-up demand for services which may catalyze robust growth. In 1921 automobiles and electricity powered productivity gains, today it is technological innovation in communication and automation. The comparison between the 1920s and 2020s also brings one important reminder to investors: it is ultimately higher inflation and interest rates and euphoric speculative excess that bring an end to a period of expansion and high returns, which is why our discipline is so focused on measuring how expensive stocks are relative to interest rates, which will ultimately allow us to reduce exposure to risk assets in advance of major equity bear markets to build up “dry powder” to take advantage of lower prices. We currently do not see relative value extremes nor signs of abundant speculative excess10 that typically characterize a major market top.
We have just published our annual Capital Markets Forecast, which is available on our website. As usual, it looks beyond the current year to evaluate the ranges of expected outcomes realistically possible from today’s starting point over the next market cycle across a range of asset classes. We use these inputs regarding expected returns, risk, and liquidity constraints to design the foundation of our portfolio construction. This year’s edition, The Economy and Capital Markets in a Changed World, addresses central longer-run challenges and opportunities for investors in the coming years, such as:
- With risk-free interest rates at rock-bottom levels, into which other asset classes should diversification occur to provide reliable capital preservation in times of duress?
- Wall Street’s Greatest Rivalry of Growth versus Value and how investors should position their portfolio.
- What is the risk to capital growth from today’s elevated valuation levels?
2020 was one of the most disruptive years in generations. The experience and discipline of navigating several previous market cycles helped us perform well on behalf of our clients. Though the coming years may not perfectly resemble the Roaring Twenties of strong economic growth and abundant prosperity from a century ago, there are reasons to remain optimistic about the near-term investment outlook while staying mindful and realistic about longer-run risks and challenges.
1As measured by the total return of the S&P 500 and the Barclays Aggregate Bond indices respectively.
2As measured by the total return of the Russell 1000 Large Cap Growth index.
3In other words, closer to long-run historical averages than the unusually calm and narrow bull market from 2000 to 2017.
4As tracked independently by the performance reporting firm eVestment.
6The Democratic party’s agenda is to do so by increasing taxes on the wealthy and partially repealing the corporate tax cuts of the 2017 Tax Cuts and Jobs Act.
7As an aside, after underperforming for years, Emerging Markets are very attractively valued relative to US stocks. Our discipline uses strictly momentum measures to confirm objectively when to capitalize on that opportunity because a new cycle of outperformance has begun.
8Within our model-driven process, our sector model identifies opportunities by requiring the presence of three investment criteria: the sector has significantly underperformed other sectors over recent years; the sector exhibits inexpensive historical valuation relative to itself and other sectors; and the sector experienced strong momentum over recent months.
9In fact, the economic recovery was so strong in the early part of the decade that President Calvin Coolidge was re-elected President in 1924, despite the fact that a recession had occurred within two years of the election, the only time that has occurred over the last 100 years, including last year.
10For example, levels of cash holdings remain high despite improved investor sentiment. However, the plethora of Special Purpose Acquisition Companies appearing bears watching. These “blank check” vehicles are designed to take corporations public without going through the traditional, more rigorous, IPO process and allow retail investors to participate in private equity transactions.
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