Wall Street loves to make predictions about the future. As we write this, most large firms are publishing their annual outlook research for 2021. They are including forecasts for GDP, employment, inflation, interest rates and even identifying specific levels where market indices will close out the year.
How many of these prognosticators do you think got 2020 right? We are pretty sure that no one got even close to correctly forecasting a global pandemic with almost 100 million infections and 2 million deaths, a 35% market crash that included some of the worst sessions since the Great Depression and 1987, followed by the fastest market recovery supported primarily by investment in large technology companies.
Does that suggest it is worthless to try and predict the future? We don’t think so. There is value in research, analysis and thoughtful predictions. Sharp investors will use forecasts as short-term guidelines about what may happen in the future based upon current facts and circumstances.
However, over time, investors must continue to monitor both sudden and gradual changes in the environment that may affect those forecasts. Furthermore, investors must recognize that although these predictions are usually based upon experience and knowledge, they are still speculative estimates rather than guarantees.
Even if, for example, virtually all large research firms declare that the S&P 500 will be 15% higher on December 31st, that doesn’t mean they are right. We could easily experience new challenges that result in violent market moves again this year.
The pandemic is far from over, and the recovery is largely based on the successful implementation of both monetary and fiscal stimulus combined with scientific progress. For all these reasons, we remain optimistic but still prepared to handle the potential for portfolio-crushing volatility, even when the masses are predicting smooth sailing and nothing but a bright future ahead.
Markets in Review
Following the market’s 35% drop in Q1, and the rapid rally off the lows in Q2, the overall market continued to grind higher throughout most of both Q3 and Q4. However, renewed pandemic fears, vaccine trial results, political and economic concerns resulted in significant volatility. The S&P 500 dropped almost 10% in September, only to rally back and then drop again almost 8% in October. In other words, although the S&P 500 ended the year up 16.26%, it was a risk-filled choppy ride.
The Dow Jones Industrial Average gained 10.17% in Q4 and finished with a 7.25% gain on a year-to-date (“YTD”) basis. As mentioned above, the technology-heavy NASDAQ Composite clearly led the overall recovery as it returned 15.41% in Q4 and was up 43.64% YTD.
Figure 1: Performance through 12/31/2020
Source: Bloomberg
In contrast to previous quarters, the best performers in Q4 were small and mid-sized capitalization companies which are very sensitive to changes in economic conditions (discussed further below). The Russell 2000 index, which includes 2000 of the smallest companies in the market, was up 30.99% in Q4 alone, and ended the year up 18.36%. Value-based investments struggled over the full year with the Russell 1000, 2000 and 3000 Value indices producing 0.15%, 2.38% and 0.25% gains respectively since January. However, the Q4 rotation from large-caps into small-caps also spilled over into value-based investing, which focuses on buying companies that exhibit quality fundamentals but appear to be undervalued. This is clear as the Russell 1000, 2000 and 3000 Value indices produced 15.58%, 32.72%, and 16.54% gains respectively during Q4 alone.
U.S. fixed-income assets overall only returned 0.67% for Q4 as yields, which move in the opposite direction of bond prices, began to grind higher from their August lows.
Small-Cap vs. Large-Cap Update
For years, small-capitalization companies, and especially those with a value bias, have underperformed large-capitalization companies. This is common in late-stage bull markets where investors are attracted to the biggest companies with the largest remaining growth potential.
This has clearly been the case over the past several years, and to some degree, even during the post-March market recovery, as large technology companies that dominate both the S&P 500 and the NASDAQ Composite indices rallied back in force.
However, it appears that this relationship is now changing. In Figure 2, we have compared the large-capitalization Russell 1000 Index to the small-capitalization Russell 2000 Index over the fourth quarter. The Russell 1000, represented in blue, has clearly underperformed the Russell 2000, represented in green – and the performance gap is continuing to grow.
This is typical when coming out of a recessionary environment and during the early stages of a new business cycle. Small-capitalization stocks have historically outperformed large-capitalization companies due to their greater sensitivity to the economic cycle. We are paying close attention to this trend as it may offer investment opportunities or be a canary in a coalmine if the relationship suddenly deteriorates.
Figure 2: Small-Capitalization vs. Large-Capitalization Performance
Source: Bloomberg
Central Banks, Monetary Policy, and Asset Bubbles
Markets are now looking for more stimulus to grease the economic skids, support employment, and help badly damaged companies. The much-needed pandemic relief that has been doled out to date has provided a temporary band-aid for a severely wounded economic and financial system. Looking back further, Federal Reserve monetary policy has provided massive liquidity support for the economy and markets ever since the 2008 Financial Crisis.
Unfortunately, Fed policy has also distorted the relationship between economic and market fundamentals and price discovery. While economic growth over the past 10 years has been anemic and sub-par, the stock market has maintained a bull market trend based on investors’ belief that the Fed backstop will continue to solve all problems. Euphoria and speculation have fueled asset bubbles across a wide swath of investable assets. These types of conditions tend to unravel and when they do, the potential loss of capital can be devastating.
Current investor sentiment and behavior remind us of the tremendous run-up in tech stocks in 1999. The pricing bubble bust turned into the “tech wreck” in which the technology-heavy NASDAQ Index imploded causing massive losses. Today’s overvaluation appears to be even more extreme than in 1999, and so the implied risk in current markets is giving us déjà vu.
Figure 3: Fed Balance Sheet vs. Market Performance Over the Past Four Years
Source: Bloomberg
Investors and the market are hooked on Fed policy support and government stimulus. In Figure 3 above, the FARBAST Index in white represents the U.S. Condition of All Federal Reserve Banks Total Assets (in essence, the Fed’s balance sheet). The CCMP Index in orange is the NASDAQ Composite Index representing the market. Every time from 2017 through December 2020 that the Fed has tried to withdraw support, the market craters as it did in 2018 and 2020.
Market price distortion has never been more evident than in 2020 as the COVID-19 pandemic shut down the economy causing the largest decline in economic activity since the Great Depression. The economic contraction caused a huge surge in unemployment, eviscerated corporate profits, but stock prices kept rising. At the time, most thought it would be reasonable for investors to expect a deep and protracted bear market.
Market indexes did fall hard and fast for a few weeks, but they recovered losses and charted new highs within months as the Fed and Government rushed to bail out the market with additional liquidity and stimulus.
Figure 4: Fed Balance Sheet vs. Market Performance During the Tech Bubble of 1999 and 2000
Source: Bloomberg
The same relationship can be seen in Figure 4 between the Fed’s balance sheet expansion and contraction during the late 1990s. Easy monetary policy leads to “Irrational Exuberance” according to Alan Greenspan, former Federal Reserve Chairman. With concerns over Y2K, the Fed expanded its balance sheet quickly in the second half of 1999 which drove tech stocks in the NASDAQ Index to an 87% gain for the year. Then it quickly reversed course withdrawing support and leaving investors out over the edge of a cliff as it were.
The tremendous bull market turned into one of the largest loss events in history with the tech bubble bursting. The ensuing bear market rout caused the NASDAQ Index to plunge more than 77% over the next two years. Just to put that kind of capital loss in perspective: $1,000,000 invested at the beginning of 1999 would have grown to $1,870,000 by year’s end. After the bubble burst, the same account would have been worth approximately $430,000.
The Fed and government can’t afford to continue printing money at the current pace without exploding the deficit to unmanageable proportions. In the prior few years leading up to the pandemic conditions of 2020, the deficit was already expanding by an unmanageable amount of about a trillion dollars per year.
With both the Fed and government throwing the kitchen sink at the imploding economy, the deficit is projected to expand in 2020 by $3.5 trillion. It may seem incongruent, if not a little insane, but we believe policy makers need to continue put the pedal to the metal to provide a large and sustained level of fiscal stimulus focused on infrastructure spending.
One of the seemingly biggest mistakes Congress made over the past 10 years was not matching the Fed’s accommodative policy with an equal measure of fiscal stimulus. The consequence of them not taking action appears evident in the anemic recovery that has led to a fragile economy and financial system. The economy needs long-term support that will only be provided by a large dose of fiscal stimulus that is focused on rebuilding economic infrastructure.
The first phase of fiscal stimulus should be a strong commitment of at least $3 trillion. The second phase of the plan should include an additional $2 trillion in spending about four-to-five years from now. This would likely get the economy growing at a rate of 4% or more over the next five years and then keep it growing at that rate or better through the end of the decade. That type of strong economic growth could heal the financial system and help pay down deficits to more manageable levels so we don’t unnecessarily burden future generations.
Looking Ahead
Focusing again on the short term, I firmly believe there is light at the end of the current tunnel. My father happens to live in Kalamazoo and drove over to the main Pfizer plant soon after the FDA approved their vaccine for emergency use. He spent hours watching them drive truckloads of vaccine from the plant to the airport and said it reminded him of when he was a child watching our armed forces preparing for battle during World War II.
Although we still have a long fight ahead, it appears we finally have the right weapons to win this war. With that in mind, we cautiously predict that we will begin to return to some degree of normalcy this year, and that unemployment will hopefully continue to improve along with GDP.
The markets are already pricing in those expectations, and it appears that a new bull market cycle might be underway as long as the Fed and government don’t leave investors hanging out over a cliff again. We firmly believe in American ingenuity, resilience, and the power of capitalism. This is why we think the right kind of long-term fiscal stimulus plan can build a virtuous economic growth cycle which will likely drive a stunning new bull market.
However, this optimism and any confidence in our own forecast is balanced with the understanding that everything can always change in the blink of an eye. We remain humble and aware that there is always a difference between thoughtful predictions and guarantees.
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IMPORTANT INFORMATION
Past performance does not guarantee future results.
The views presented are those of Steven Van Solkema and Don Schreiber, Jr. and should not be construed as personalized investment advice or a solicitation to purchase or sell securities referenced in the Market Commentary. All economic and performance information is historical and not indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product referred to directly or indirectly in this newsletter, will be profitable, equal any corresponding indicated historical performance level(s), or be suitable for your portfolio. Moreover, you should not assume that any discussion or information provided here serves as the receipt of, or as a substitute for, personalized investment advice from WBI Investments or from any other investment professional. To the extent that you have any questions regarding the applicability of any specific issue discussed to your individual situation, you are encouraged to consult with WBI Investments or the professional advisor of your choosing. All information, including that used to compile charts, is obtained from sources believed to be reliable, but WBI Investments does not guarantee its reliability. Sources for price and index information: Bloomberg (unless otherwise indicated). WBI Investments pays a subscription fee for the use of this and other investment and research tools. WBI Investments and Bloomberg are not affiliated companies.
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The Dow Jones Industrial Average (DJIA or “The Dow”) is a price-weighted average of 30 of the largest and most significant blue-chip U.S. companies.
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The Russell 2000 Index is a float-adjusted market-cap weighted index that includes the smallest 2,000 stocks by market-cap of the Russell 3000 Index.
The Russell 3000 Value Index uses the value characteristic book-to-price ratio to create a style index based upon the Russell 3000.
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