Fourth Quarter 2020 Key Takeaways
Last year was both volatile and difficult in many areas of our lives, yet economically global stocks were up 16% in 2020. U.S. stocks did a bit better. During the dark days of March, with pandemic fears rampant and the global economy falling off a cliff, very few (if any) would have predicted this year’s outcome for stocks. Despite being a cliché in investing, the benefit of “staying the course” in times of volatility once again proved to be prescient.
As I flash back to my self-supported bicycle trip across the U.S. in 2014, there were times when we became disoriented. The prescribed route on the map often looked difficult versus a route that we could visually identify that looked favorable. That was a difficult journey, and our emotions sometimes convinced us to stray from the recommended course of action. Over and over we made poor decisions that tacked on additional miles to an already arduous day. We quickly developed a mantra for the trip: “When in doubt stay on the route.” Investors in today’s volatile environment would be well served to follow similar advice when their emotions try to convince them to stray away from traditional time-tested investment strategies.
In 2020, just about all asset classes performed well. In addition to double digit returns from stocks, fixed-income and core investment-grade bonds gained a strong 7.6%, benefiting from falling rates as investors sought low-risk assets earlier in the year. Inflation-protected government bonds performed even better. This is unusual as the interest payments were very meager, but falling rates lift bond prices.
In a challenging and chaotic year, our client portfolios performed well. In fact this is the second straight year of strong returns, and the cumulative result is reflected in healthy year-end balances in our client portfolios. But as always, we caution against too much optimism. Experience has taught us that investing is rewarding in the long term but can feel like riding a roller coaster. Nevertheless we are optimistic that our portfolios will perform well in the next year as the prior year headwinds may be turning into tailwinds. The core question is how much of the potential tailwinds of economic growth (post-COVID-19) are already reflected in the optimistic stock prices of today.
For 2021, the likelihood of widespread vaccine distribution supports the case for an economic recovery beginning in the second or third quarters. Central bank monetary policy is almost certain to remain very accommodative for at least the next year or two. And government fiscal policy is also likely to be stimulative, especially given our recent political outcomes – with “free money” falling from the sky directly into your bank account. This macro backdrop should be supportive of equities and other financial risk assets at least for 2021.
Projecting out over a five-year horizon, U.S. stocks continue to look expensive based on historical measures, but not necessarily so given the relative low to extremely low bond yields. Non-U.S. stock markets, emerging-market stocks in particular, have a much higher five-year expected return than U.S. stocks. If the U.S. dollar continues its recent decline, U.S. investors in international assets could receive a double win as foreign stocks are lower in comparable price, and when the dollar falls, foreign investments go up.
Of course, we must continuously assess the risks. In the next few months, there could be a sharp economic slowdown from pandemic-induced lockdowns and potentially inadequate supplemental fiscal relief. And the current extreme investor optimism leaves the market vulnerable to disappointment. Longer term, two big concerns continue to be China and the specter of inflation. It’s important to note that although our prediction is for an economic recovery, our portfolios are built to be resilient across a wide range of potential scenarios.
Fourth Quarter 2020 Investment Letter
In our first quarter 2020 letter back in April (which feels like an eternity ago), we recognized that we were living through an incredible period of history. The pandemic weighed heavily on us then as it does today. But this quarter, we look back at what we’ve endured and lay out our investment outlook for 2021 and beyond. While many risks remain, the effective vaccines that are starting to be distributed provide a real light at the end of the tunnel.
We said in the first quarter that we would get through this crisis and that things would improve and recover. Financial markets recovered first, experiencing both their quickest decline and rebound on record, despite the significant global economic contraction. Economies have made great progress too but are not back to their preCOVID-19 levels yet and may not be for another year or two. On the health side, despite the approval of several effective vaccines, the authorities warn us that we may be in for dark days this winter before the vaccines can be
widely distributed to the general populace. This may set back economies and markets in the near term and keep us isolated and sheltering in place in some cases. But we expect that 2021 will see the end of the pandemic, and our society can then follow markets and the economy in bouncing back as well. In the meantime, our wish remains the same as it was in April that you and your loved ones stay safe and healthy.
This year was a tragic one. Yet global stocks were up 16.3% for the year. U.S. stocks did a bit better, with large caps up 18.2% and small caps up 20.0%. Developed international stocks
gained almost 10% and emerging-market stocks gained over 15%.The comforting full-year returns mask the incredible volatility and stress investors faced earlier in the year. Stock markets around the world were down 30–40% for the year by March 23, the year’s low point.
From there, stocks skyrocketed into year end. Amazingly, the major large-cap indexes were all up over 65% from their lows, and smaller-cap U.S. stocks have nearly doubled since then.
During the worst days of March with pandemic fears rampant and the global economy falling off a cliff, very few predicted this year’s exceptional performance for stocks.
Moving on to fixed-income, core investment-grade bonds gained a strong 7.6% for the year, providing positive returns both during and after the market crisis period. In typical fashion, early on in the year Treasuries and high quality corporate bonds benefited from falling rates amidst a deflationary shock. Interest rates have risen modestly since the positive vaccine news in November, but they are still generally much lower than they were at the start of 2020.
Looking Ahead to 2021 and Beyond
The vaccines, easy financial conditions, and stimulative fiscal policy are all reasons for our optimism for the economy, the markets, and our society overall as we look ahead. The likelihood of widespread vaccine distribution supports the case for a cyclical economic recovery beginning in the second and third quarter of 2021. Central bank monetary policy is almost certain to remain very accommodative for at least the next year or two. And fiscal policy is unlikely to be restrictive and could be stimulative, depending on political outcomes. This macro backdrop should be supportive of equities and other financial risk assets, at least for the next year. U.S. stocks have high absolute historical valuations. Expected five-year annual returns are still only in the low single digits. But U.S. stocks don’t look expensive relative to extremely low bond yields.
In our view, non-U.S. stock markets, emerging-market stocks in particular, are more attractively valued and have much higher five-year expected returns than U.S. stocks. We also anticipate the U.S. dollar to fall in value as our government continues to be on a spending spree. Like the old Frank Sinatra song suggests, “there’ll be pennies from heaven, so be sure your umbrella is upside down.” If the dollar declines, U.S. investors in non-U.S. stocks will earn an additional currency return on top of any equity returns. But returns typically come with a cost called risk; i.e. emerging markets can be highly volatile at times.
The Risks in Our Outlook
As always there are numerous risks to our economic outlook. Unexpected shocks can happen at any time, whether a jump in inflation, domestic political dysfunction, geopolitical conflict, or trade disputes. Financial market history teaches us to expect the unexpected and expect to be surprised.
Over the next few months, there is a real risk of a sharp economic slowdown from pandemic-induced lockdowns and, potentially, inadequate additional fiscal relief for households, small businesses, and state and local government budgets. The current extreme investor optimism also leaves the market vulnerable to disappointment. But given the positive macro and investment backdrop, we would likely view any financial market drawdowns as temporary. One thing stock market investors have demonstrated this past year is their ability to look past temporary difficulties and to focus on the long term. Emotional investors get caught up in the short term and are at risk of making disastrous decisions.
Looking out longer term over our five-year tactical horizon, the big risks we are watching are the specter of inflation and China.
Inflation is a lower concern at this point, but the risk is not zero. Rising demand stemming from spending unleashed after the pandemic could coincide with a supply side constrained by the retreat of globalization to instigate an inflationary spiral. Therefore we have included an inflationary defense in most portfolios.
Turning to China, we are focused on the risk and opportunity it presents because of its outsized influence within the emerging markets. China has handled the pandemic relatively well, but its stock market has also been one of the best-performing ones in 2020. We wouldn’t be surprised to see stocks pull back there, especially as China reins in excesses and reduces stimulus. (After all, according to the International Monetary Fund, China is the only country expected to have generated positive GDP growth in 2020.) We also expect trade and technology conflicts to continue. China has demonstrated this past year that it will strongly disrupt actions by individual corporations if they come into conflict with the government. Overall and longer term, we remain bullish on China and emerging-market stocks while at the same time recognizing their elevated risk.
Our portfolios are well positioned for a cyclical recovery from the global pandemic, but our positioning always incorporates a wide range of potentialities. We think in terms of multiple plausible scenarios, not in single outcome or all-or-nothing bets. Diversification can position your portfolio to take advantage of a multitude of outcomes but will also fall short of any one outcome that is known to be the most favorable (in hindsight).
Portfolios can have good overall returns and achieve your retirement goals with a proper financial plan, but if you cherry pick one known outcome with the benefit of hindsight, diversification can leave you wanting more. Should a less sanguine outcome occur, we have investments in the portfolio that can offer downside protection.
Also, we are prepared to prudently, but opportunistically, respond as events unfold as we did in 2020.
The market has always exhibited dramatic mood swings, whipsawing investor sentiment, and 2020 was no exception. As in a healthy marriage, it’s wise to ignore mood swings that occur from time to time and focus on the wholesomeness and richness of a long enduring partnership. We recommend for investors to ignore the crowd’s actions completely. As we closed our first quarter letter we recommend to “stay the course.” While it’s a cliché in the investment business, that advice proved to be profitable again this past year.
Here’s to saying goodbye to an unfortunate year that we all are eager to leave behind and to welcoming a hopefully brighter 2021. We wish everyone a healthier, happier, and more prosperous new year.
We thank you for your continued trust in us.
Ron Dickinson, CPA, CFP®, MPA-Tax
P.S. Once again, we appreciate the large number of referrals we have been receiving from our clients. We are honored that you consider us worthy of being introduced to your family, friends, and neighbors.
[Financial Planning and Investment Management Services offered through Dickinson Investment Advisors, Registered Investment Advisor. Statistics and market information provided by Litman Gregory Advisor Intelligence.]