Stocks gain momentum: how to structure portfolios now
Will last year's upside surprise continue?
2020 was supposed to be the year of earnings growth. Oh, how quickly things changed!
After spending most of the previous year watching the U.S. and China argue about a trade deal, the expectation was to see international trade relations return to normal, tariffs to be removed, and growth to follow. It was also the year everyone expected bond yields to begin their recovery by moving back to a range of 2.5%-3% on the U.S. 10-year Treasury bond.
Everyone now knows that as the China trade representatives were in Washington signing the trade deal, a virus was spreading in a relatively unknown city that would soon become infamous for all the wrong reasons.
The resulting outbreak quickly got out of control and spread around the globe. In an age of cheap flights and frequent travel, the virus was virtually impossible to contain. It initially shut down the supply chains of many technology and manufacturing companies. Ultimately, it led to the total lockdown of cities and borders around the world.
The dreams of earnings growth resulting from recovering global trade quickly vanished. Bond yields fell to zero, commodities collapsed, with the exception of gold, and by mid-March most global equity markets were down 30% on the year.
Then, a strange thing happened. Governments and central bankers responded with massive fiscal and monetary programs, larger than ever seen before. The fears of a repeat of the global financial crisis, in which inaction led to a worsening of the crisis, never came to pass. The flood of new money in the system quickly found a home in the stock market.
One lesson every investor learned, or perhaps re-learned, in 2020 was that the stock market is not the economy.
With 2020 ending with most equity markets back at all-time highs following a historic six-month rally, market observers are once again making their routine predictions and forecasts for the next year. Most parts of the world remain in some form of lockdown, small businesses are on life support, and unemployment remains much higher than anyone would like to see. But looking at the stock market, you would never know.
Turning point in sentiment
November should be seen as the turning point in sentiment. The month saw a fiercely fought U.S. election come to a conclusion with what could be argued a perfect result for markets. However, the real game-changer came in the second week of the month as a string of positive news around vaccine trials allowed investors to look over the valley and see a return to normal in a few months, something many had feared would take years.
Most predictions for 2021 are very bullish, almost similar to the start of 2020. With bond yields creeping higher, expectations are they will get closer to 1.5%-2% by year’s end. GDP growth is expected to rebound off the recession lows, and stocks are expected to increase by 10% on the back of earnings growth. But predictions are just that.
Given the shock to the system many people experienced in 2020, you could expect some degree of caution. Yet, sentiment readings have been near record-high levels for the last month. It does make you pause to wonder if all the good news is now in the market. But with central banks printing money faster than ever before, do you really want to fight them?
With so much money in the system via central banks, one phenomenon that most didn’t see coming was the rise of special purpose acquisition companies (SPACs). These “blank-cheque” companies have seen remarkable returns on the optimism they would produce the next DraftKings or Virgin Galactic.
It’s important to note these SPACs are on the clock to do deals or give the money back. As a result of this shot clock, close to $100 billion has to be spent on acquisitions in 2021 or be returned. This should guarantee the M&A theme will be alive and well this year.
One prediction that will have to materialize if markets are really to have a positive year is the long-awaited rotation from growth to value (or cyclicals). The large technology stocks led the bounce higher as their business models proved perfectly suited to the new world. Consumer and business trends that would have evolved over 10 years were implemented much quicker through the lockdowns.
The reopening trade, which started in November involves seeing the banks, transports, materials, and energy sectors joining the party and outperforming. Many of these groups have seen great gains in the last few months but are still well off their highs. The price of copper, the bond market and a lower dollar will set the tone here.
After a year in which so much happened, but markets finished positive, it may be easy to ask what all the fuss was about. However, these are far from normal times, and the after-effects of the pandemic will be with us for a long time.
At some point, government spending will have to slow down, central banks will have to become more neutral, and the economy will have to try to stand on its own two feet. Those should be problems for beyond 2021, but as the markets looked over the valley to see the positive future of a reopening, are they as optimistic now that we are starting to live in that future?
Those esoteric questions are difficult to ask and as investors we must always bring ourselves back to more practical basics, like portfolio structuring. To be prudent investors, we have to ask ourselves these questions and challenge our own views and assumptions. It’s part of keeping ourselves honest.
How to structure portfolios now
So, how should investors structure portfolios amid the confusing mix of news and sentiment? Well, 2021 will likely remain volatile. The lesson of last year is to have a long-term plan and not get shaken out of sound strategies by short-term moves. Time in the market is better than timing the market. To wit, if an investor missed the best five days of 2020 on the S&P 500, they would have returned -21% rather than the 16% gain it ended with. It’s not easy to ignore scary headlines, but sticking to a plan works.
What about fixed income, an asset class that has seen its utility come into question amid plunging rates? Many investors were wrong with their expectations of higher yields in 2020. The pandemic changed things so quickly that central banks slashed rates to zero. As a result, long bonds were one of the top-performing areas of fixed income. However, with rates at zero and a global reopening underway, it’s time to predict again that yields will likely recover from here. In this scenario, investors will want to have shorter duration. We also believe active management is crucial to taking advantage of pricing dislocations. There is still a lot of opportunity out there to earn an attractive yield in areas such as high yield, credit and investment grade fixed income.
And lastly, we need to stay focused. This environment, while increasingly positive, still has the potential to turn quickly again. Given the speed and magnitude of the market bounce following vaccine trials, the biggest risk is that markets have priced in too much good news. Signs that the reopening will not go as smoothly or timely as hoped could be a negative surprise.
On a more micro level, once we get into the second half of the year, investors will be expecting stronger earnings growth coming off the depressed 2020 numbers. Investors gave management teams the benefit of the doubt last year given the macro struggles, but they may not be as kind this year if they don’t deliver better numbers.
And on a final note, best wishes to all in 2021. May this year bring you renewed success and happiness. Happy New Year!
Greg Taylor, CFA, is the Chief Investment Officer of Purpose Investments Inc.
Notes and disclaimer
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All data sourced from Bloomberg unless otherwise noted.
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