Nauset Wealth Managment
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Category: Market Update

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.

Nauset Market Commentary – Q3’20

Market Performance Recap: Stocks Rally to New Highs

The sharp rally of Q2 continued into Q3 with large cap US stock indices hitting new all-time highs before a pullback in September. As the US economy slowly reopened for business, the Russell 1000 rose +9.5% in the quarter and is up +6.4% year-to-date through September. The upswing was once again led by technology, consumer discretionary, and industrial stock sectors. US small cap stocks were positive for the quarter, though not as strong as large caps, with a gain of +4.9%, but remain off -8.7% year-to-date. The non-US MSCI EAFE developed country index gained +4.8% for Q3, now down -7.1% for 2020, while the emerging market index added +9.6% in the quarter and is down only -1.2% year-to-date. Bond prices were steady during Q3 as Barclays Intermediate Gov’t/Credit bond index edged up +0.5%.

Economic & Market Discussion: Gauging the Election Impact

The Presidential election is fast approaching, bringing a rash of fear-inducing headlines. Will the election outcome affect the track of the financial markets? Should we get defensive to protect portfolios from potential policy changes of a new administration? Here is how we view the upcoming political event.

  • Elections Are Usually Positive – For the past fifty years of Presidential elections, the S&P 500 stock index has gained about +4% on average for the three months following a Presidential election. The chart below shows that the market usually drives forward after an election regardless of who is at the wheel. The key takeaway is that Presidential elections are but one factor in determining market direction, and are usually not as powerful as the three fundamental factors we track: corporate earnings growth, interest rates, and market valuations.

  • Manage to Actual Policy Shifts – While much has been written about what each candidate will do post-election, our view is to wait for policies to be enacted before adjusting our asset allocation strategies. In the short term, we expect supportive fiscal policies to continue to help the economy recover from the negative effects of the pandemic. Beyond that, we know that major shifts in trade or fiscal policy usually take time, and are often modified to less impactful new legislation. On the monetary side, the Fed has prioritized employment over inflation which keeps rates low and provides support for market valuations. Therefore, our most prudent course is to be more reactive than proactive with regard to post-election fiscal policy changes.
  • Contested Election Risk – A worrisome development is the potential for a contested election which could delay the final outcome. This scenario would occur if one or more state votes are challenged and subject to review and possible recounts. While specific rules and margin thresholds may limit the actual recounts, any uncertainty will be viewed as a negative by the markets until resolved. Once resolved, we believe investors will move on and refocus on the economy. We will, of course, monitor any such developments closely.

The history lesson on Presidential elections and investments: Elections matter less for markets than most anticipate, so don’t be too defensive in the face of potential political shifts. Instead, focus on the current economic scenario. While today’s pandemic recovery track is unique and uncertain in many ways, we remain positive on the markets and the economy following a victory by either party.

Portfolio Strategy: Optimism Amid Headwinds

Despite market choppiness during the past month and uncertainty regarding new fiscal stimulus, we believe that two key elements will continue to support the markets: synchronized global economic recovery and extremely low interest rate policies. As such, here is how we are managing portfolios going forward.

  • Stay with Stocks – Even with the strong recovery rally, we believe that stocks continue to show favorable relative value compared to other asset classes. Therefore, we hold slightly overweight equity allocations for most portfolios.
  • Quality Rules – Our emphasis for both stocks and income-producing securities is on quality during the continued pandemic-induced uncertainty. We favor investments with a margin of safety, such as large cap US tech and health care stocks, as well as US Treasury and investment-grade bonds. 
  • Maintain Flexibility – As the economy continues its recession recovery, we expect new opportunities to arise. We intend to seek attractive new investments in credit as well as stock areas that develop over the next several quarters.

Nauset Market Commentary – Q2’2020

Market Performance Recap: Historic Stock Bounce Back

The Russell 1000 notched its best quarterly performance in 21 years, rising +21.8% in a strong bounce back from the pandemic-induced market decline in the first quarter of the year. While the Covid-19 pandemic continues to hinder economies across the globe, the strong rally puts the US large cap Russell 1000 index down only -2.8% for 2020. The surprising Q2 rally was led by technology, consumer discretionary and communications stock sectors. US small cap stocks posted an even stronger rally of +25.4%, but remain off -12.8% year-to-date. For international stocks, the MSCI EAFE developed country index gained +14.9% for Q2, now down -11.3% for 2020, while the emerging market index rebounded +18.1% in the quarter and is -9.8% year-to-date. Barclays Intermediate Gov’t/Credit bond index posted another solid quarter with a +2.8% increase.

Economic & Market Discussion: Making Sense of the Market Rally

As US equity markets posted their best quarter in over 20 years, the US economy has struggled through its worst quarter on record. How and why did this happen? And what does it mean for markets going forward?

  • Economic Rebound – Broadly speaking, the market is reacting to better-than-expected economic data as shown in the graphs below and a reversal in unemployment data in May and June. Despite the current surge in Covid-19 cases in many states, the market is supported by the likelihood that there will not be a second nationwide economic shutdown. Also aiding the market upswing is investor optimism regarding vaccine development. While the market may have reacted too strongly and quickly to the positive economic trends, the rebound is underway. Given the strong Q2 stock gains, the market’s reaction to future good economic news may be muted, while any setbacks in the economic rebound would be negative.

  • Don’t Fight the Fed – The Fed has stepped up in a huge way to support the economy by ensuring the mechanics of the credit market and purchasing bonds across several markets. The Fed has also committed to low interest rates for several years. As with positive economic data, the markets have reacted very strongly to the Fed’s easy money policies. In the short term, we expect the Fed to continue to act as a backstop to the bond markets and lessen the negative effects of the pandemic on the economy.

  • Winner, Winner – Another key to understanding the exceptional stock market gains in Q2 is that the largest US public companies, especially tech firms, have been hurt less by the effects of the pandemic than smaller and private businesses. Thus, the earnings of many US large cap public companies should outperform GDP despite the impact of lower aggregate demand. Additionally, accelerating structural changes in the economy caused by the virus are also likely to benefit the mega-cap US public companies.

While the rationale for a stock market rebound is understandable, the speed and strength of the rally may have anticipated a faster economic recovery than what is unfolding. For that reason, we are cautious with respect to further gains in 2020, and markets are likely to experience more volatility as small businesses and schools reopen this quarter. There are plenty of factors to monitor in the coming months. In addition to the usual economic and market data, we are also watching Covid-19 vaccine progress, the Presidential race and social injustice protests. Any of these elements could have positive or negative market impact over the next quarter as the recovery continues.

Portfolio Strategy: Maintaining Balance

Anticipating a V-shaped economic recovery, the US stock market is now fully or slightly overvalued. Keeping with our usual long-term perspective, here is how we managing portfolios entering the second half of 2020.

  • Near Neutral – The market rally and recent rebalancing have placed most portfolios at or near neutral allocations for equities. We expect to maintain that stance unless market conditions drive market levels significantly in either direction, in which case we would likely rebalance back to neutral.
  • Stay with Strength – As a form of defense, we will continue to focus on quality in both stocks and income-producing securities during this period of market uncertainty. We will favor investments with a margin of safety, such as investment grade bond funds, and large cap US tech and health care stocks. 
  • Open to New Opportunities – As the economy continues its recovery amid the uncertainty, we will search for attractive opportunities in credit as well as international and smaller cap stock areas based on valuation.

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. 

Nauset Market & Strategy Update

Key takeaways regarding recent market activity:

  • The market’s old companion volatility is back and likely with us in 2018
  • Rising rates and inflation concerns will continue to be a key concern for all stock markets
  • Despite solid US and global economic fundamentals, potential for market gains are lower than in 2017
  • Our approach is to stay diversified and rebalance as opportunities occur

What Happened: Welcome Back Volatility

A market correction can be unsettling but it’s important to remember it is normal. We haven’t seen one in a while as we have been in an unprecedented period of low volatility. The market sell-off of the past week was swift and appeared just days after a new market high. The S&P 500 stock index hit a new all-time high of 2873 on January 26. Thirteen days later on February 8, the S&P 500 was down -10.2% from that high, mostly from losses in the past five trading sessions. To put this into perspective, the S&P 500 is down -3.5% for 2018 due to the spike up in the first three weeks of the year.

The reason for the sell-off: rising interest rates on the 10-year Treasury bond along with a whiff of wage inflation from the Feb 2 jobs report got the attention of stock investors. Higher rates are generally negative for equities, especially after the prolonged period of historically low rates. The 10-year Treasury yield moved up from 2.4% at the end of 2017 to 2.8% in early February. And when coupled with a forward P/E ratio on S&P 500 stocks at the upper end of its historic range, investors got nervous. Add to this mix, the intention of the Fed to push up short-term rates at least 3 times this year, and the stage was set for a sell-off. The sell-off itself was likely amplified by short-term trading programs and hedging activity, which often dominate daily trading.

The irony of the situation is that S&P 500 earnings have been excellent this quarter and are projected to continue to be strong in the near term. And that is usually positive for stocks. We believe that the positive economic environment will likely limit the decline in equities. However, the bottom line is that rising rates will likely make it difficult for markets to move up in 2018 as the current US economic cycle, now almost nine years old, may finally be in its late stage.

Going Forward: Why Stay Invested?

So, what happens now? The economic backdrop continues to be positive, which will support markets. While growth is almost always a good occurrence, too much growth and earnings momentum can cause inflation to rise, which above a certain level is problematic. Some analysts believe the recent cut in corporate tax rates may push the economy toward an overheating phase. We are not in full agreement with this view, as the impact of tax reform on both consumers and corporations is still unclear. However, if inflation does rise, the Fed would address it by raising rates more quickly, which in turn would push up interest rates in general. And that scenario would likely be negative for stocks.

Under almost all scenarios, we do see rates and inflation rising. The concern for the markets is how much and how quickly. Right now, the bond market is expecting the Fed to tighten 2-3 times this year, up from lower assumptions only six months ago. That means that the bond market’s expectations are much closer to the Fed’s projected tightening path. Which, in turn, suggests that the 10-year yield may now be closer to “fair value” than it has been, and interest rates may settle in the current range and perhaps move slowly to the upside. As such, we will keep a close eye on both inflation and rates.

Even with rate and inflation concerns, the solid economy and earnings picture does provide a way forward that may result in gains for stocks this year. It just won’t be the smooth ride of 2017. Whether the market settles down from here or continues to exhibit high volatility is not knowable. Our view is that it will stay choppy for a while. The recent whipsaw is a reminder that volatility and pullbacks are the price we pay for the excellent returns that stocks can produce over the long run.

The chart below shows that sizeable sell-offs and pullbacks are normal even in years where the market is positive.

 

Finally, let’s put some context around the current market sell-off. The US stock market has had a strong run over the past 15 months without even a -10% market pullback. As a result, the S&P 500 was up over +30% in that period. Corrections of -10% are normal and happen about every 2-3 years, so it is no surprise that one would occur now. Over the past 50 years corrections, defined as a -10% to -20% price drop from the peak level of the market, have averaged about -14% and bottomed in about five months.

While we can’t predict what will eventually happen, this provides some context. At worst, a bear market, defined as a drop of -20%+ in the broad index, could develop from this correction. We put a low probability on that occurring given the US economy is on solid footing and not showing any signs of a recession, which usually accompanies a bear market. In summary, a correction is normal, and for long-term investors who stay the course, it’s often a healthy development that can help markets consolidate and eventually move higher.

Current Investment Strategy: Keeping Our Balance

As we have noted at volatile times in the past, we at Nauset are long-term investors, not traders, so our mantra is to stay balanced, diversified and disciplined. Our advantage is that we are long-term investors and we can handle short-term volatility as we manage positions for the long-term. 

We build clients’ portfolios for the long run and to fit clients’ financial plans. As part of that approach, we weather market corrections like the current sell-off, and as conditions evolve, we adjust to new market realities. While a market correction may be unsettling, we have a bias to action around the following three areas:

  1. Rebalancing – we continuously monitor our clients’ portfolios and will take steps to rebalance to specific client asset allocation target ranges and risk profiles. 
  2. Tax-loss harvesting – With the recent sell-off, recently purchased positions may be in a loss position. We may sell these positions from taxable accounts to create a capital loss and buy back the same security 31 days later, or buy a similar security, to replace it in the allocation. This will provide clients with a tax offset for a portion of earned income or gains we take in the future.
  3. Opportunistic buying – Volatility and sell-offs often create price distortions and thus opportunities in individual securities, subsectors or sectors. We are monitoring the market for the opportunity to add to areas that we find attractive, such as cyclical and growth stocks in tech, financials and consumer discretionary sectors.