There is plenty to discuss as we sit to write this article, but before we jump into our market commentary we would like to begin with a quick personal note …
We want to extend a sincere THANK YOU to each of you. We are grateful for the opportunity to invest on your behalf. In 2020 our portfolios held up well during the steepest market drops. This set us up to capitalize on the market rebound. Many of you continue to share kind words about our advice and portfolio management with other people you care about, and this has led to continued success for our firm. We’ll continue to be here for you – whether it is regarding a financial decision you face, a portfolio question you may have, or if you just want to run something by us – we enjoy hearing from you.
Investing -- An Exercise in Making Sound Decisions with Limited Information
In 2021, there are a number of events that bring the potential for strong upside, and we also have a list that could lead to downward moves in the markets.
On the positive side:
- Vaccine Impact
We see the possibility for COVID deaths to drop dramatically by late spring or early summer. If you look at the breakdown of COVID deaths by age, you will see it is heavily skewed towards the oldest amongst us. As the vaccine rollout continues, the part of the population who is most exposed to an adverse outcome will be better protected. We believe a sharp drop in deaths will warrant a broader reopening of the economy. Some governors will be quick to react to this trend, and those ‘reopened’ states will serve as a test case for the states who remain shutdown. The vaccine’s impact here will be notable.
- Government Stimulus
The Trump administration recently signed a $900 Billion COVID relief package and the incoming Biden administration is currently floating a $1.9 Trillion additional package. In the short-term, if our government continues to pump liquidity into the economy then this creates upward pricing pressure for all risk-based assets (yes, this includes stocks and real estate). Please note that we have concern around the level of government spending and debt that we continue to see. We could speak at length on the long-term implications of a spending-based policy, and we do have positions within the portfolio designed to protect against inflation. Nonetheless, additional stimulus is a positive catalyst in the short term.
On the downside:
- COVID Variants
New COVID variants can potentially impact a reopening. It would be particularly detrimental if the variant had a different spike protein, since this could bypass the protection offered by our currently available vaccines.
- Global Risks
We still have the regular list of risks that include trade frictions and other geopolitical tensions. Diplomatic issues can lead to military encounters, and these conflicts can cause heightened uncertainty. While the world appears to have a primary focus on COVID-related issues, we recognize that additional global risks can materialize at any point.
The reality is that we are accustomed to investing in a world with unknowns. Our portfolio process is well-suited to take advantage of areas where we have strong conviction while leaving us with ample ability to adjust. So, let’s take a look at the broad market valuation and then we’ll focus on some areas where we have strong conviction for 2021.
S&P500 Current Level – 3851.851
1 Year Forward Earnings Expectations – 168.152
1 Year Forward PE – (3851.85 / 168.15) = 22.91
The 25-year average PE is 16.563
The market is well above its long-term averages. What happens next? We expect the PE to trend towards its long-term average. The PE is Price divided by Earnings, so this could happen with a decline in market price, an increase in earnings, or a combination of both.
As we move through the first and second quarters of 2021, we’ll be closely watching the earnings reports. Early indications are showing a strong rebound in earnings. This is a sign that the earnings may be able to grow into the current market valuation.
Areas of Opportunity
Emerging Markets –
Over the second half of 2020, we have been building wider emerging market positions within your portfolios. There are several factors coming together to support our thesis for strong EM performance.
- COVID Spending – We reviewed the total 2020 fiscal response of countries around the world expressed as a percentage of their annual GDP and we’ll summarize the numbers here for you.
Developed Markets: Germany 39.2%, Italy 37.9%, Japan 35%, UK 25.7%, France 21%, Spain 17.7%, United States 14.2%4
Emerging Markets: Brazil 14.6%, South Korea 13.8%, Turkey 13.8%, South Africa 9.5%, India 7%, China 5.9%, Russia 3.4%, Mexico 1.1%4
Do you notice a stark contrast between the developed and emerging countries? The developed countries spent a much higher percentage of their GDP on programs to support the economy. These developed economies are net BORROWERS, which means that the debt load has increased substantially over the last 12 months. We expect this chasm to put pressure on the developed currencies, and this trend will be supportive of higher returns from the emerging markets.
- Political Climate – The Trump administration took a strong pro-American stance towards negotiation with our trade partners. This helped to strengthen the US but it also put a headwind on global trade. The incoming Biden administration is expected to implement trade policy that will be more accommodative to our various trade partners. We expect this to be beneficial to the emerging markets. We are not weighing in with a political opinion here; our role is to position your capital to benefit from expected policy and trends.
- Long-term growth story remains intact – In addition to the two catalysts above, the long-term case for a rising middle class and faster growth remains in place for the emerging markets. Current valuations in this space are attractive relative to stock valuations in the US and other developed economies. It's convenient that we get an entry into long-term growth positions at an attractive price -- plus the potential to see accelerated returns from current events.
US Commercial Real Estate –
We see an opportunity in certain commercial real estate sectors. In particular, we’re targeting areas that are still showing distressed pricing from COVID.
- We are targeting real estate positions that have seen a notable reduction in revenue due to state-mandated restrictions. We identified companies that have the potential to see significant recovery if the economy trends back towards ‘normal’. We believe these are the companies that stand to see the most price increase if the vaccine has the impact that we’re expecting.
- Our investments focus on real estate that has a long-term track record and has proven productivity during non-COVID market cycles.
- Yield on these investments is quite attractive relative to the low-interest environment we currently see. While the 10-year Treasury is 1.09%5, the yields on the three real estate positions we’ve added to our tactical models come in at 5.59%5, 5.06%5, and 10.34%5. The strong yield offers us additional return as we wait for the reopening thesis to come to fruition.
While we do have strong conviction in the above areas, we will continue to monitor the trends. If 2021 brings further government stimulus and a return towards ‘normal’ life, then we’re positioned well. If the data starts to lead in a different direction, then we’ll continue to make proactive moves while recognizing that there is sometimes a need to be reactive as well.
1: Standard and Poor’s
2: Yardeni Research, Inc
3: Standard and Poor’s, JP Morgan Asset Management
4: IMF Fiscal Monitor, JP Morgan Asset Management
5: Yields calculated based on close of business Jan 1, 2021