Q4 2020 Commentary

It was an absolutely unprecedented, unpredictable and remarkable year for equity markets.

Stocks began the year at price multiples that had only been reached twice in history: first during the tech bubble and then very briefly in early 2018 (ahead of a significantly volatile year).  Valuations at these levels had always been followed by lower prices, weak-to-negative long-term returns and above average risk (both short and long-term).

Accordingly, we began the year positioned very conservatively across all strategies.

We did not anticipate the global spread of COVID-19. What we did anticipate was the fact that any interruptions to the bull market would likely be larger and more dramatic than average.  We strongly believed that the market would provide us with future entry points at lower prices.

It was not long before fallout from COVID-19 led to the fastest decline from record highs in market history, with the S&P 500 falling 34% in just 23 trading days. 

All of our strategies bought heavily into the weakness. 

Despite perceived risks, there were plenty of reasons to take on additional equity exposure back in March.  From a pure price perspective, the decline brought multiples back to their most reasonable levels since 2018.  From a pandemic perspective, there was historical evidence that pandemic-driven economic weakness tends to be brief – implying that markets were likely overreacting.  Finally, it was clear that massive combined response from the Federal government and central banks would, at a minimum, eventually inflate asset prices. At best, these actions would serve as an effective stimulus bridging the gap from early shutdowns through normalization and beyond. 

By the end of the first quarter, markets had rebounded significantly from their lows, but the S&P 500 was still down 20%.  

The rebound continued, largely unabated, through the end of the year.  Markets, having already recaptured record highs in August, put together a remarkably strong fourth quarter, leaving all of the major indices with significant gains for the year. There was a large performance divergence among the indices. The Nasdaq managed to climb an astounding 40%, while broader indices posted more muted gains. The S&P 500 gained over 16%, while the Dow only rose 7%.

Throughout the year, our focus remained on managing risk.

This has been a theme of ours amidst high equity valuations. We have had a very conservative bias the last few years, refusing to chase assets to record highs.  Despite repeatedly returning to high cash positioning, we have been able to participiate in markets through multiple significant corrections and buying opportunities.

Looking forward, though we seem to be on the cusp of putting a generational risk event  behind us, in some ways we find ourselves in largely the same situation we started 2020 – markets are overvalued by most historical measures, and we are responding by once again defaulting to a conservative positioning.

Unlike 2020, which began amidst record high corporate earnings and the lowest unemployment rate in over 60 years, the world is beginning 2021 trying to climb out of an economic hole.

Q4 2020 earnings will likely be 9% lower than Q4 2019 earnings.  Q4 2020 GDP will likely be at least 1% below Q4 2019 (including stimulus).  The employment:population ratio is more than three percentage points below the start of 2020 – sitting at its lowest level since 1983. Job growth once again reversed course in December, and weekly jobless claims continue to come in at recessionary levels.

There are, of course, plenty of silver linings. The effects of massive monetary and fiscal stimulus have done more than just inflate the values of risk assets.  Getting cash directly into the hands of Americans has pushed retail sales to new record highs, and easy monetary policy has helped fuel a massive housing boom. We just passed another round of stimulus, and there is almost certainly another massive round on the way under the next administration.

Looking only at continued stimulus and easy monetary conditions, you might think that remaining exposed to stocks would be a positive game plan.  On that data point alone, we would not disagree, but there is a limit to how much stocks should be worth in this environment.

We cannot put a firm number on the reasonable price for equities in this unprecedented scenario. We acknowledge that the combined monetary/fiscal stimulus likely justifies above-average equity valuations, perhaps, even, the highest sustainable valuations in history. That is a risky, but reasonable bet.  But stocks are not just sitting a hair above previously sustainable levels, they have blown right through them

The only other time stocks rose to valuations this high, they eventually fell 35% lower (and more than 50% off of their peak).  A return to 2017 valuations (at a time of an organically booming economy with low interest rates and massive corporate tax cuts in the works) would imply at least a 12% fall from these levels.  A return to the previous sustainable multiples would require a fall of more than 30%.  A return to average worthwhile valuations would require a decline of nearly 60%. We do not anticipate a 60% decline in equity prices, but those are the risks we must acknowledge as we navigate this market.

Wishing you a happy and prosperous New Year,

Robert B. Drach

Drach Advisors LLC