Index4th Qtr Return YTD Return
S&P 50012.15%18.40%
MSCI ACWI Ex USA IMI17.22%11.12%
Barclay's Bond Index0.67%7.51%
Consumer Price Index0.60%1.29%
January 29, 2021

Market Commentary

What a ride. After the fastest bear market in history, the S&P 500 finished 2020 up by 18.4%. Smaller capitalization stocks, as measured by the Russell 2000, outperformed larger stocks and returned 20% for the year. Small cap stocks had meaningfully underperformed on a year-to-date basis entering the 4th quarter but saw exceptionally strong performance in Q4 returning over 31% over the final 3 months of the year relative to just 12.1% for the S&P 500.

International stocks took longer than domestic stocks to break even after the drawdown in the first quarter of 2020, but finished up 11% for the year after a very strong fourth quarter. Emerging market stocks led the way abroad, returning 18.3% for the year.

Major U.S., international and emerging market indices all posted greater than 45% gains since the beginning of the second quarter.

The bond market was relatively flat for the fourth quarter as equity indices posted double digit returns. The Bloomberg Barclays
Aggregate bond index returned 0.7% in the fourth quarter resulting in a return of 7.5% for the year. This is incredible given that the yield on the index was about 2.3% to start 2020. A tremendous decline in interest rates is responsible for a big portion of the return with the 10 year U.S. Treasury Bond yield declining from 1.92% to 0.93% over the course of the year. As with most markets in 2020, the beginning and ending values fail to tell the complete story as the 10 year yield hit
a new historic low of 0.52% in August. While rates have risen meaningfully off of the bottom, it is worth pointing out that the current yield of the 10 year U.S. Treasury Bond is still well below the precrisis historical low rate of 1.37% observed in July of 2016.

After briefly trading below $0 per barrel during 2020, West Texas Intermediate crude oil closed the year at about $48 per barrel. Energy was by far the worst performing equity sector in 2020 ending the year down over 33%. Given the poor performance of the energy sector in recent years it is now the smallest sector in the S&P 500 by market capitalization accounting for only 2.3% of the index – down from over 12% just a decade ago.

Economic Outlook

The economy is healing by many key measures. Unemployment has fallen, personal income has remained elevated above pre-pandemic
levels throughout the crisis, and retail sales have surpassed their prepandemic levels. Industrial sales and production remain in an uptrend. As multiple vaccines have become available and distribution has begun, the global economy can see light at the end of the tunnel. Employment has made substantial progress concurrent with the rebound in equity markets. Some clients may recall us comparing the pandemic recession to the financial crisis in conversations when we reminded clients that unemployment actually continued to rise nine or more months into the equity market recovery of 2009. Fortunately, employment market stress has not been as stubborn in the postpandemic world since this financial crisis stemmed from a healthcare
calamity as opposed to major structural issues with the global financial system.

Many economists and others have made observations about the disparate nature of employment changes. It is possible that changes
brought about or accelerated by this pandemic will have a lasting impact on the economy. This encompasses both the types of job
openings that will exist in a post-pandemic world (think more delivery drivers and fewer waiters), as well as the demographics of the workforce (think parents who were forced or chose to stay home and teach their children when schools were closed or virtual). It remains to be seen what type of structural changes may be at work and whether or not policy changes will be needed to mitigate any negative effects.

We continue to monitor unemployment for signs of a double-dip recession. Given the recent spike in coronavirus cases within the U.S. it seems inevitable that the strong economic recovery will slow in the first quarter of 2021 until herd immunity through vaccination hopefully begins to take hold by the middle of the year. It appears that even when a peaceful transition of power in the United States could have been called into question, investors were generally willing to assume that attempts to disrupt the process would dissipate quickly and have no meaningful impact on the economy. While we are cognizant of the impact tax policy changes may have on the economy, we think it’s reasonable to assume that those changes will not be implemented during a global pandemic. Further, a narrow majority in the senate suggests that the possibility for radical changes to tax policy is less likely than moderate policy changes. It is worth noting that the possible negative impacts of potential tax rate increases may be largely offset by increased fiscal stimulus spending by the Biden administration.

Investment Strategy

Looking at year-end valuations, it is tough to make the case for robust returns from either stocks or bonds for 2021. Since the beginning of 2021, intermediate term bond yields have increased in relatively significant fashion and the yield curve has steepened, increasing the probability of positive returns from the Barclays Aggregate Bond Index for the remainder of the year. However, it is worth noting with the index beginning the year with a yield of just 1.12% it would take only a 0.2% increase in interest rates over the next 12 months to wipe out the annual yield of the index and drive the return of the bond market negative (everything else held constant).

It is notable that we are at the highest price to earnings ratio on the S&P 500 since the early 2000s. However, long time readers are aware that we believe this valuation measure should be adjusted for the prevailing interest rate environment. Even after adjusting for interest rates, however, the S&P 500 is as expensive as it has been since early 2019. With cash offering returns of virtually zero, there are not a lot of places to hide.

For now, we are retaining our modest overweight to stocks versus bonds. Admittedly this is now driven more by a dislike for bonds than true excitement about stocks. We are in the early stages of a new economic cycle and typically during this phase we would strongly favor owning stocks. There are few, if any, analogs for where we are today – coming out of a sharp economic recession but with equity valuations significantly above long-term average valuations. Monetary and fiscal policy are both likely to remain extraordinarily accommodative for the next several years providing further tailwinds for the recovering economy.

Ultimately, the implications of high asset prices for both stocks and bonds entering the year are that forward returns from today’s levels will likely be low by historical standards. There are very few years where investors receive ‘average’ returns so despite our modest outlook for long-term returns we encourage investors to remain invested and focused on the long-term. Missing out on one year of strong equity market returns can put investors in a position that makes it nearly impossible to catch up to the long-term average.

We think the cyclically-oriented “value stock” allocations in the portfolio are likely to fare well in the near future as they have done over the past few months. This is typical during the initial phases of an economic recovery. This is an area to which we increased exposure through mid and late 2020.

As rates move up, it is likely we will extend duration (a measure of interest rate risk) in high quality fixed income (perhaps even Treasuries) to protect against adverse move in equity markets. Given today’s very low treasury rates the potential upside during a period of equity market volatility is still there, even if the upside potential is much lower than has historically been the case. Inflation expectations have started to pick up which is something we will watch closely given the effect that inflation has on stocks, bonds and cash.

2020 will certainly be a year that we will never forget. While we are happy with the returns that financial markets provided in 2020, we are pleased to put 2020 in the rear view mirror. We look forward to a year of spending time with our families, with our valued clients and, with one another. Keeping our clients invested during crisis is one of the most challenging and rewarding experiences that we have. We would like to offer a sincere “thank you” for your continued trust through an incredibly challenging year.

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