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It’s Over! What Next?

Posted: Jared Jameson

Wow! What a year. A global pandemic, global recession, stock market crash, and V-shaped stock market rebound among many other things made the year unique. Coronavirus has and will dramatically change many aspects of our lives. Unfortunately, for many of us, the absence of friends and family members will be its most significant impact. The way we do business has also permanently changed. Zoom meetings will replace face to face meetings. Business travel will likely never return to its pre-COVID level. Work from home replaces long commutes to the office. And work from home can take place anywhere likely meaning an exodus from expensive, crowded cities. Many small businesses and restaurants will not survive. These are just a few of the many impacts of the pandemic.

The Coronavirus recession was statistically the worst since the Great Depression. Global stocks fell rapidly as Coronavirus spread, but, as we will discuss in this WJNotes, the decline was short-lived for many stocks.

Although we already knew it, 2020 proved once again the impossibility of predicting the future. No one predicted the pandemic this year and, even if somebody did, they would not have also predicted a huge bull market. Why do Wall Street analysts continue to engage in the folly of making annual forecasts? We wrote a recent blog about it – Click Here.

The Federal Reserve’s dramatic and aggressive action in reaction to Coronavirus drove interest rates to never seen levels. Will zero interest rates, massive stimulus, and herd immunity through a vaccine mean a booming 2021 or do markets already reflect a return to altered normalcy? Or, perhaps, are stocks way ahead of themselves? Our thoughts follow.

2020 Review

The volatility we experienced in 2020 was amazing. The market decline in February and March was the fastest ever only to be matched by a similarly rapid rebound. The following table shows returns from the beginning of the year to the height of the panic on March 23, 2020, and from the bottom to the end of the year. The total return for the year is also shown.

Needless to say, considering what occurred this year, the overall return for stock and bond markets was exceptional. Who would have guessed? No one in our opinion.

Looking below the surface, the selloff and recovery were uneven across different market sectors and industries. The following table shows the returns of some additional asset classes and other investments.

Work from home beneficiaries like growth and technology stocks did exceptionally well, while those companies impacted by lockdowns, a reluctance to travel, and high unemployment like value, energy and financial stocks struggled. Tesla had an extraordinary year. It is now the 6th largest stock in the United States. Honestly, we do not really know why, irrational exuberance maybe?

The primary diversifiers we use in portfolios also had good years. Managed futures/Trend following strategies were up 7.3% and Reinsurance was up 6.9%. The latter did well despite a record number of hurricanes and wildfires.

Overall, it was an outstanding year for a diversified portfolio. Just about everything worked. Will the gains persist?

What does zero interest rates mean for Investors?

In March and April of 2020, to stave off the coming impact of Coronavirus, the Federal Reserve cut short term rates to zero and implemented a plethora of programs to support markets and the economy. As a result, interest rates on longer maturity Treasury Bonds fell to historically low levels (and we mean very long term) as the following chart shows.

Interest rates represent the cost of money for both lenders (investors) and borrowers. Low rates are unequivocally good for borrowers like our Government or homeowner’s using borrowed money to purchase a house. Likewise, they are unequivocally bad for lenders and investors.

Low interest rates mean dismal expected returns on safe assets. After inflation, money market funds, bank accounts and most other short-term investments will lose money over time. Even longer-term bonds, like the 10-year treasury (current yield about 1.1%), will earn less than inflation. For most investors invested in a balanced portfolio of stocks and bonds, low bond returns will mean portfolio returns significantly below historical levels.

In addition, bonds and especially Treasury Bonds have been excellent diversifiers in portfolios (this year was no exception). Investors fleeing stocks buy Treasury Bonds in a “flight to safety” during panics. The increase in bond values while stocks decline has provided excellent protection for many years. But, with rates so low, the upside on bonds is now limited. Interest rates cannot drop below zero. To be clear, they can, as they have in other countries, but our Federal Reserve has ruled out negative rates as a policy tool (for now). Also, if interest rates rise because of inflation or other reasons, bond values can decline substantially. So, bonds provide negative returns after inflation, limited upside and unlimited downside, a very unappealing combination.

In our view, historically low rates also mean lower returns on a wide range of risky assets like stocks and higher risk bonds for a couple of reasons. The first reason is described by the acronym TINA. TINA stands for “There is No Alternative.” Investors buy stocks and other risky assets to try and generate higher returns because of the dismal expected return on bonds. There is no alternative. Increased demand for risky assets drives prices higher. Assuming no corresponding increase in future cash flow growth of the risky assets, higher prices mean lower future returns. In essence, the increase in price of risky assets borrows returns from the future. Low interest rates mean lower future returns on risky assets.

Investors uncomfortable using TINA have one other option. They can just spend less/save more. What happens to an economy dependent on consumer spending when investors spend less? Corporate profits drop, economic growth is subpar and, all else being equal, stock returns decline. Once again low rates result in lower future stock returns. To make the problem worse, since one of the Federal Reserve’s mandates is to stimulate economic growth, what do they do when growth is subpar? They cut rates, starting the cycle over again.

To conclude, the typical US investor portfolio of cash, Treasury Bonds, and Large US stocks will generate returns far below historic levels. Portfolios need to be adjusted to reflect this reality.

All Green Lights

It is hard to remember a time when so many signals were green for an economic boom. Zero interest rates, quantitative easing, huge stimulus already in place with more potentially to come, a potential massive infrastructure bill, and, most importantly, numerous viable vaccines leading to herd immunity and an end to COVID-19. A booming economy should be great for the stock market. Wall Street seems to agree based on everything we have read over the past couple of months. But what if markets already incorporated all the good news? What if the historic rally started in March anticipated the recovery? Not the details necessarily, but the idea that we would eventually overcome COVID-19. 2020 was a terrible year for the economy and great year for the stock market. 2021 may be the reverse.

We would also argue that in some areas of the market something beyond just a return to normalcy has been priced in. Certain market sectors and stocks are being driven higher by a new cohort of inexperienced investors who trade for free since commission on stock trades were cut to zero and have had an ample amount of free time during COVID-19 lockdowns to “play” the market. This type of investor pays little attention to fundamentals like earnings and sales. Rather they only focus on cool names and tantalizing stories about the future. This attitude is reminiscent of the tech bubble 20 years ago.

Tesla, mentioned earlier, is the poster child for market frothiness. The chart below shows the market capitalization and revenue of Tesla vs all other publicly traded auto companies. To put it mildly, there appears to be a bit of a disconnect.

The Tesla bulls argue that Tesla is so much more than a car company. They argue they will own the future autonomous vehicle market; the battery market and we suppose Mars also. They better to justify the valuation.

There are a myriad of other electric vehicle companies and technology companies in general that trade for obscene valuation levels. The math to justify the valuations implied does not compute, at least for us. Typically, this type of market “irrational exuberance” does not end well. A return to reality by the very frothy areas of the market will not likely occur without damaging the overall market, so we are paying close attention.

Some argue the entire US stock market is in a bubble. The following quote from a recently published piece from Jeremy Grantham of GMO, a fund company we invest with, expresses the concern:

The long, long bull market since 2009 has finally matured into a fully-fledged epic bubble. Featuring extreme overvaluation, explosive price increases, frenzied issuance, and hysterically speculative investor behavior, I believe this event will be recorded as one of the great bubbles of financial history, right along with the South Sea bubble, 1929, and 2000.

Mr. Grantham correctly warned about the Japanese bubble in 1989, the Tech Bubble in 2000 and the real estate bubble in 2008. He was early in his warnings for all three, but ultimately, he turned out to be right. As he would admit, because bubbles can go on much longer than anyone expects, it can be very costly to abandon an investment strategy in anticipation of the bubble bursting. Rather it makes sense to protect portfolios where appropriate, emphasize undervalued areas, and remain conservative to take advantage of opportunities after the bubble bursts. How are we positioning for a low growth economy, low expected returns on stocks and bonds, and a potential bubble? Our strategy is as follows:

  • Rebalance when appropriate. Rebalancing is selling winning investments and buying losers. For example, in March 2020, we aggressively sold bonds and bought stocks. The trades added materially to portfolio returns this year.
  • Substitute alternatives like managed futures and reinsurance for bonds. These types of alternatives offer higher returns than bonds but still provide diversification benefits.
  • Increase credit exposure in the bond portfolio. We currently own high yield bonds and lower rated securitized credit to generate higher returns in the bond portfolio, but we must be careful about the level of exposure because credit increases risk of the overall portfolio. If our credit investments continue to appreciate as they have, we will reduce the position to reduce risk.
  • Invest in areas of the stock market that have underperformed and offer more compelling opportunities like value stocks and foreign stocks.

All these strategies we hope will add value beyond a typical stock and bond portfolio as they did in 2020. We look forward to helping you achieve and maintain financial security in 2021. Thank you for placing your confidence in us.

Please call into our upcoming virtual luncheon on January 28th. We will discuss 2020, our outlook in more detail and the implications of the election results. To RSVP, please email Farrah at

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