Monthly Outlook: December 2020
Stock market indexes are making new highs and many stocks are higher today than they were pre-COVID. Why? Because, you know, everything is awesome! Except that they’re not. Stock markets could hardly be more disconnected from reality and seem to be pricing in a very optimistic and return-to-normal future. We’ve had 270,000 COVID deaths in the U.S. this year and the virus is still unchecked as of today. Twenty million people lost their jobs initially this spring and although 10 million people are back to work, that leaves 10 million people still unemployed, which is still a recession-level 7% unemployment rate. Here in Colorado, like most states, we’re in “Code Red” with restaurants open at 25% capacity and other businesses, especially leisure and hospitality, are struggling to stay afloat. According to Standard & Poor’s, the S&P500 earnings in 2019 (pre-COVID) were $139/share or 23x price to earnings. With COVID, and 3 quarters of earnings reported in 2020, so far, we’ll be lucky to see S&P500 earnings of $93/share. That’s down 33% from last year, which resonates with most of us observing the real world. Then why is the S&P500 at even higher prices than 2019 with 33% less earnings? Because Wall Street analysts predict that 2021 will bring $143/share, even higher than 2019. Really? Even with a vaccine or three hopefully coming in Q1 2021 for some people, many businesses will be shuttered or restricted for half of 2021, unemployment will stay high but falling, and many people on Main Street are going to continue to struggle. But on Wall Street, everything is awesome – for now.
Short-run vs. Long-run
In the long-run, valuations and fundamentals dictate future returns for stocks. In the short-run, however, markets are driven by emotions, particularly the oscillation between hope and fear. Especially since the U.S. elections one month ago, investors are on optimism over-drive. Massive, continued stimulus from both the Fed and Congress is surely on the way, we’ve heard of at least three promising vaccines, and, besides, we’re tired and just want 2020 to go away. The number of stocks trading above their 200-day moving average is at a 5-year high. Inflows of money into stock mutual funds hit a 20-year high. According to Sentiment Trader, optimism is at the highest since 1983. You know what they say about everyone being on one side of the boat? Peak optimism is exciting and lures retail investors into the market. But it’s more often an indicator of a topping market.
What about valuations and long-run implications? The “Buffett Indicator” or Total Market Cap to GDP (value of all stocks divided by the total economy) has a 92% correlation to subsequent 12-year stock returns. That’s remarkable and worth looking at, I’d say. Today, the TMC/GDP is at the highest in over 90 years, similar to peaks in 2007, 2000, and even 1929. Each of those peaks led to 50% declines for stocks followed by years of slow growth and recovery. Again, valuations are only good at predicting very long-term returns and don’t predict how we get there.
Performance Chasing and Buy & Hold
Which is better, three-year steady annual returns of +8%, +8% and +8% or exciting-but-volatile returns of +24%, -24%, and +24%? The first turns $1,000 into $1,259 and the second turns $1,000 into $1,168. Some investors have invested heavily into Big Tech stocks in 2020 and are enjoying out-sized returns. It’s tempting to pile on and chase performance or move to managers that won this year with big positions in growth stocks. But will Big Tech be the repeat winner in 2021? History suggests probably not. Chasing performance is a losing strategy. This year, we’ve performed more like that first manager with good returns but not exciting Big Tech returns. Managing for steady growth and for downside protection will see you through to meet your goals over the long-term. Further, a buy-and-hold strategy or one that insists that the portfolio always be 100% invested in “something” with little or no cash from time to time is likely to suffer losses in the next downturn. In bear markets, even “good stocks” go down. Given the irrational exuberance of emotions in the market and the over-valuation of fundamentals, right now, more than ever, is the time to use a tactical allocation strategy (like our iFolios strategy) that is designed to capture steady growth and has a sell discipline to provide protection.