Nauset Wealth Managment
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Category: Investment

Nauset Market Commentary – Q4’20

Market Performance Recap: Stocks Close 2020 on New Highs

The strong stock market rally off March lows continued in Q4 on the news and rollout of two highly effective vaccines. This occurred while the US economic recovery slowed in the face of surging Covid-19 infections. Forward-looking investors drove the Russell 1000 up +13.7% in the quarter to finish the year at +21.0%. Tech and consumer stock sectors outpaced the market, while energy and real estate lagged. US small cap stocks were the big winner for the quarter with a gain of +31.4%, up +20.0% for 2020. International stocks posted 2020 gains of +7.8% for EAFE and +18.4% for Emerging Markets index. Bonds posted a small Q4 gain of +0.5% to finish the year at +6.4% per the Barclays Intermediate Gov’t/Credit bond index.

Economic & Market Discussion: Market Rally Redux?

Investor consensus points to another positive year for the US and global stock markets. With effective vaccines expected to tame the ongoing Covid-19 pandemic, investors foresee a ramp up in the synchronized global economic recovery. Is the optimism justified and what could go wrong?

  • Massive Government Support – The US and most major global economies are being supported by historic levels of monetary support from aggressive bond-buying programs and zero or near-zero short-term rates. Add to that, record levels of fiscal help from commercial loans and grants to direct stimulus checks to individuals. The chart below shows this tremendous economic support as a percent of GDP offered by major governments and central banks around the world.

  • Light Blue Policy – With Biden as the new President, we must consider the prospect of new or changing policy in key areas. We do expect new stimulus programs, as well as indications of potential change in tax, trade and infrastructure policy. While immediate major policy shifts are unlikely given the slim Democratic Senate advantage, these hot button policy issues can positively or negatively impact the ongoing economic recovery and thus the markets. We welcome more stimulus to support the economic recovery, and will closely monitor any policy shifts that might create economic headwinds.
  • Unknown Unknowns – With economies poised to recover and vaccines being rolled out, all signs point to a favorable market outcome. Right? If 2020 has taught anything, it is unforeseen factors and events that roil the markets can and do happen. Given the unusual nature of the pandemic and its impact we feel the current economic recovery is particularly vulnerable to the unexpected. Therefore, we all need to keep in mind that there are a multitude of uncertainties that could derail the economy and the markets as the new year unfolds.

Portfolio Strategy: Conviction with Flexibility

Our base case is that easy money policies and positive earnings growth will continue to support stocks despite current full valuations. We are optimistic for gains in 2021, but will be remain balanced and ready to adjust allocations as we move forward.

  • Stay with Stocks – Even with the strong 2020 results, we believe stocks continue to show favorable relative value compared to other asset classes. Therefore, we will continue to hold slight overweight equity allocations in most portfolios.
  • Tech and Industrial Overweights – We continue to focus on tech and tech-enabled investments across our equity allocations. While some mega-tech stocks may face possible legislation, we believe tech-related investments will continue to provide attractive long-term value, especially during the continued pandemic-induced uncertainty. We have added a new allocation to industrial stocks which we believe will benefit from the expected economic recovery.
  • Maintain Flexibility – As the economy continues its recession recovery, we expect new opportunities to arise. We intend to seek attractive new investments in stock as well as bond areas as they develop during the next several quarters.

Coronavirus – Market Impact

After mostly ignoring the potential impact of the coronavirus that originated in China, US markets have suffered a sharp sell-off, as the S&P 500 Index is currently about -8% off its recent all-time high. The fear is the virus may spread more broadly than originally predicted and negatively affect economic activity around the globe.  

This COVID-19 viral outbreak is a very real headwind to economic growth in China, globally, and the US. The extent of the eventual damage is difficult to predict, but it will temporarily lower GDP growth across the globe. The good news for the US is that, while there will be some impact due to disrupted supply chains and reduced exports, the US economy has a solid foundation of low unemployment, improving wage growth and is much less dependent on the rest of the world than most countries.

How bad will the impact be? How much further will the markets decline? Both answers are unknowable at this point. However, we can say the following – until the global outbreak is successfully contained, markets will trade on fear and hope, not on fundamentals of growth and profit. And that will lead to continued volatility.

Nauset’s portfolio strategy has prepared us for this type of volatility with an allocation to securities that provide market buffers. Additionally, our long-term financial planning focus takes into account and anticipates market declines. As long-term investors, we don’t want to make the mistake of trying to call a short-term market bottom or time the market. 

If you’d like to read more about the coronavirus impact, the Independent Market Observer’s article, How Should Investors React to the Coronavirus?, is an excellent piece. 

Waiting for Godot?

The chorus of investment pundits calling for an end to the current US stock rally has grown larger and louder and yet, the market continues higher. Let’s examine why a correction will happen, why predicting it is hard (and potentially hazardous to your portfolio) and how we think about it.

Corrections have a strong track record of showing up (unlike Godot), as part of a normal market. A correction is commonly defined as a -10% decline. The average intra-year decline is historically -14%. Even in positive years, it is unusual not to experience a mid-to-high single digit decline. (See chart).

We have been waiting for a correction (like Godot), but not for very long. The last S&P 500 correction began in the summer 2015 and hit its low for the year in October. The drop happened to be a decline of about -12%. From November 2015 until February 2016 the market again took a double-digit dive. Since then the market has climbed +33% with fresh highs being set on July 12, experiencing one measly -6% drop along the way.

Based on history we expect a correction to occur before the end of the year. However, timing and duration are elusive and we are not trying to predict it. A correction may be triggered by almost any event – Fed Reserve action, oil prices, a poor jobs report, or a geopolitical incident. Rather than trying to guess the timing, the key is to understand the drivers of any correction in order to assess new investment opportunities.

Post-election Views or Much Ado About…

Well, we can’t say nothing. We aren’t going to rehash the election surprise. What we will do is share our views on the post-election market behavior, outline a possible scenario and actions we are considering and what we will be watching for over the coming months and years.

What happened? Virtually no one in the financial world predicted a rally immediately following a Trump victory, which also very few people predicted. For the record, the S&P 500 opened the day after the election, November 8, at 2130 and closed at 2182 on November 16. This equates to a +2.4% rally that leaves us just below the all-time market highs hit this past August. Now the underlying story is a bit different. During this same 8-day period financial stocks, particularly banks, rallied over +10% and some individual stocks by close to +20%, but many tech companies like Amazon fell by -3% or more. Healthcare and bio tech have also experienced a nice bump up. Bond prices have been knocked down driving yields on the 10-year Treasury bond from 1.88% to 2.35%; right at the 1-year high.

It’s important to note that other than bank stocks making a very decisive move up, none of these numbers are, in and of themselves, eye-catching from an absolute perspective. We have seen most of them in the past 12 months.

What do we see driving this behavior?  Right now we surmise the biggest driver is speculation on the third derivative of policy expectations. It is clearly not investing based on observed facts. Many market participants have made big rotations based on policies President-elect Trump hasn’t made clear, haven’t been implemented and whose effects are just hypotheses, i.e., speculation on the third derivative. Here is a summary of the big themes:

  1. Bank regulations get relaxed or go away so banks are more profitable
  2. Obamacare gets changed or eliminated and capping drug prices is not on the agenda, helping health care and biotech companies
  3. Fiscal stimulus, primarily through infrastructure spending goes up, international trade gets choked off, taxes are lower, all driving inflation and interest rates which helps banks and generally hurts bonds.

Now we don’t argue that these sound directionally right. However, the market movement was quick and in some areas sharp. Quick and sharp are not words often associated with governmental change and therefore we believe the market has over-reacted.

What do we hypothesize will happen over the next 12 months?  Here is a working, third derivative hypothesis, roughly in order of our conviction. It is not precise as we are using the third derivative —  think compass orientation not laser targeting.

  1. We get fiscal stimulus and lower taxes
  2. Rates and inflation rise, but not dramatically
  3. Bank regulations get tweaked not thrown out
  4. The economy improves a bit.
  5. Obamacare gets changed. What’s the effect? See the third derivative, i.e., who knows?

So what are we doing?  We have not been making major investment decisions. As investors, not speculators, we don’t react to quick market moves driven by assumptions from third derivative hypotheses. We are spending a lot of time looking at how we implement our existing overweight positions to technology, healthcare and biotech. We are also looking at financials as a possible overweight. We have been selectively adding to real asset positions due to higher expected inflation and what we believe has been undo pressure on REITs and our infrastructure positions. We have been selectively selling out of some fixed income positions.

What will we be watching? We will be watching measures of economic activity that might indicate a coming recession because we haven’t had one in over 7 years. We will be looking for dislocations in the market to add/rebalance to core positions. We will be listening and looking for real policy statements and activity that give us a better idea as to how those policies will eventually be implemented. We are particularly intrigued to see what happens to US Treasury rates as they will be a good indicator of how the world judges the relative safety of our markets versus all others.

In dealing with the next few years, it will be best to embrace Confucius’ blessing (curse?): “May you live in interesting times,” and to maintain a diversified and carefully monitored portfolio. 

Private Investment Update

As a result of our continued search for investments that can provide true diversification, Nauset recently worked with Calare Properties to present our clients with an opportunity to invest in a multi-use, multi-lessee commercial property in the Boston area. The expected return profile of this private investment is driven primarily by rental income with the added benefit of potential capital appreciation at exit. Calare Properties is a leading commercial real estate investment and management company.

Why we do like this investment? It is ownership in a real business with a real cash flow underpinned by a real asset. It’s actively and professionally managed by a specialized firm with its own capital at risk. As an illiquid investment it isn’t subject to the whims of capital flight from one part of the market to another.

Nauset did not receive any financial consideration from Calare, nor do we promote any private investments. Our clients invest directly in these private investment funds with no sales charge.

Author: Nauset Investment Committee
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Tags: Investment