In the first newsletter of the year, we always make some broad, and sometimes bold, statements about the state of economy and the market, as well as some predictions that inform our current portfolio construction.
The remainder of the year we explain where we missed the mark on this forecast. Wall Street guys are often wrong, but never in doubt.
On this date last year, I wrote:
“If there is a fear to contend with, it could very well be a fear of the market getting too far ahead of itself if price growth continues to outpace earnings growth by a significant margin.”
It is like Déjà vu all over again.
I went on to conclude:
“The market is feeling much better about the economic outlook heading into 2020 than it did heading into 2019 when recession fears were prominent. That sentiment has manifested itself in the recent outperformance of the value stocks, which should continue to resonate if the relatively upbeat economic sentiment does.”
I could change the dates and call it a day. We are back to where we were exactly one year ago, at least as far as market sentiment is concerned.
We believe that the combination of the COVID vaccine rollout coupled with a larger than expected fiscal stimulus package and the eventual economic reopening will spark a robust economic rebound in 2021.
There is nothing bold in that statement, in fact, you have probably been hearing that from many market commentators. But what they are missing, or underestimating is the upside surprise of consumer spending due not only to the pent-up demand caused by the pandemic, but also the psychological factors of celebrating a shared victory over a hated adversary.
We see an enormous “COVID Peace Dividend” coming in 2021 which we model based on consumer spending patterns after the Allies’ WW1 victory in Europe in November 2018, as well as conquering the “Spanish Flu” pandemic of 1918-1920. To be sure, there was an uptick in consumer spending after the Allies defeated the Central Powers in WW1, but the spending party really got started after we defeated the Spanish Flu in 1920. It was that spending that ushered in the “Roaring 20’s” with its joyous and decadent celebrations. After WW2 we also saw a huge spike in consumer spending which enabled the economy to avoid recession from the rapid fall in industrial production of wartime machinery.
But do not confuse good economic conditions with a robust market outlook. Much of the euphoria and anticipated gains from exiting the pandemic have been pulled forward and presently reside in high market multiples, but we should see decent gains as the U.S. consumer powers us beyond these present expectations.
In this note, I will discuss the health of the all-important U.S. consumer, the fiscal and monetary support underpinning the consumer and the banking system, market valuations, the outlook for volatility, growth vs value stocks, and the outlook for interest rates and the bond market.
Finally, I will discuss whether Bitcoin belongs within an investment portfolio.
Health of the U.S. Consumer
U.S. consumers had largely unlevered their personal balance sheets heading into 2020 which when coupled with the fiscal relief of the March 2020 CARES Act helped tremendously with respect to their ability to survive the economic shutdown caused by the pandemic.
Now, with additional fiscal stimulus on the way the economy has a tremendous amount of liquidity and a healthy increase in personal savings. In just the past several months U.S. consumers have added over $1 trillion to their personal coffers. This dry powder will ultimately find its way into the market causing not only higher asset values, but also higher inflation. We will discuss this higher anticipated inflation when we turn our attention to interest rates and the bond market.
Now that Democrats control Congress, higher spending including direct support for state and city budgets will now be infused into the economy. A much-anticipated infrastructure spending bill has been promised, as well. Some of this spending will be offset by higher taxes on corporations and high net worth individuals, but the net will result in higher fiscal deficits. The state and local aid will benefit our municipal bond investments which I will discuss in the fixed income discussion later in this note.
The wealth redistribution of higher taxes on high-net-worth individuals puts money into lower income households who have a much higher propensity to spend this incremental income which will also create some inflationary pressure. In short, the Federal Reserve will get exactly what it has wanted, higher inflation rates.
It is no secret that the Federal Reserve will monetize governmental spending through Treasury bond issuance and maintain a zero-interest rate policy well into 2023, or beyond. The Fed also continues to buy individual securities at the long end of the maturity spectrum and added $120 billion worth of these repurchased securities to its balance sheet in 2020.
Additionally, this monetary support will remain as the economy is currently going through a soft patch due to the partial shutdown of parts of the economy due to the current spike of COVID infections. The last labor report showed a 140,000 drop in nonfarm payrolls due to the 342,000 drop in restaurant and bar employment due to the forced closures. This soft patch will not spiral into recession, and we do not believe that the economic shutdown will turn into anything close to what we experienced last Winter/Spring.
Market valuations might appear to be stretched as compared to historical standards, and a recurring question is whether the market is poised for a major correction. For certain high growth stocks that benefitted due to the pandemic, I would be concerned if I were an investor in these firms. Peloton (PTON) is an example of one such highflyer. As you know, PTON sells a popular line of internet enabled home fitness equipment headlined by their stationary bicycle. In 2021 they are forecast to have Earnings Per Share (EPS) of $0.40. They are trading today at $154 which yields a Forward Price/Earnings ratio of 385. As the economy reopens, many folks looking to exercise are going to go back to the gym. After all, misery loves company, and we are starved for personal interaction taken away from us by COVID containment efforts. Now, in 2021 that Peloton bike is going to remain useful, as, say, a drying rack for your wet laundry. It also has a nice cup holder for your car keys. Accordingly, market valuations are stretched in certain segments of the economy, but perfectly reasonable and actually cheap in other cyclical and economically sensitive sectors.
In 2019 Earnings per Share (EPS) was flat, and in 2020 they were a disaster, but markets were up in both years. If you consider the price/earnings multiple, that means that for over two years the denominator has dropped, and your numerator has increased. You can see why we are sitting at historically high valuations. Now, in 2021 we are going to need to grow into and earn those high valuations. That should not be too difficult given the reopening of the economy, but high valuations do represent a risk factor and a source of increased volatility in the market prospectively.
Value vs Growth
There is a well-known value manager in town that is in an investment circle I frequent, and I have been listening to his admonishments about investors not investing in value to their imminent peril. That banter has been going on and on for over a decade. Today, due to the higher forecasted nominal growth and the unprecedented valuation spread between value and growth stocks he may finally be right. We are moving to a more equal balance between value and growth stocks in 2021.
Yield Curve & Fixed Income Strategy
The short end of the yield curve is anchored in the belief that the Federal Reserve will not be raising its Fed Funds Rate for the next several years. However, the mid-to-long end of the yield curve will be rising due to the expectation of higher growth and inflation discussed previously. Against that backdrop of generally increasing interest rates, high quality credit spreads (the difference between the yield on a corporate bond and a similar maturity Treasury bond) should tighten into an improving economy. We also like Treasury Inflation Protected securities (TIPs) to hedge potentially higher inflation.
We like municipal revenue bonds as the Democrats are sure to include state and local aid in their next fiscal relief package which bolsters these credits. Even before adjusting for these municipal revenue bonds tax exemption, they offer greater yield than comparable taxable securities.
Additionally, with tax rates for high-net-worth investors potentially increasing, tax exempt municipal bond credits look even more attractive. Finally, for taxpayers with greater than $1 million in taxable income, President Elect Biden has proposed to increase taxes on these investor’s dividend and capital gains to the same tax rates paid on ordinary income. This makes municipal bonds look better still.
Finally, corporations have been scrambling to go to market with debt deals before higher rates set in, and they have added over $50 billion in new corporate debt issues during the last 90 days. This is a clear indication that investors are positioning for higher inflation and interest rates prospectively.
First, we like financials due the steepening of the yield curve and improving economy. Banks generally borrow short-term and lend long-term and will do well as the difference between these short and long rates increase. We are also investing in stocks in the travel and leisure segments of the economy to take advantage of our desire to get out of the house and travel. Cybersecurity and clean energy have also been high on our list. We will remain committed to our core Information Technology stocks as they continue to be fundamentally sound. Finally, foreign markets and currencies are still much cheaper than the U.S. and may have the most to gain from a widespread rollout of vaccinations and global reopening.
Now, recovery is never smooth, and we expect periods of elevated volatility as we experience unforeseen surprises which implies higher levels of portfolio diversification will prove important as ever.
Does Bitcoin Belong in an Investment Portfolio?
The short answer is “not presently”. It is still a speculative trading asset that has rocketed higher based on the belief that central governments are in a race to debase their currencies which increases the potential for an alternative currency to emerge.
However, there is no central bank support for this alternative currency, and its value trades wildly based on the ever-changing mood of the small and younger investors who played an important part in the rise of Bitcoin to these unsustainable prices. Evidence that the increase was driven by these “Robinhood” investors can be seen in the huge increase in call option buying in less than 10 option contract amounts. These small option contract sizes are the domain of the small investor in the option market. Additionally, there has been a surge in Over the Counter (OTC) trading activity which caters to zero commission brokers such as Robinhood. OTC dealers pay for order flow which provides an income source to these no-commission brokers.
Finally, there is a fixed number of available coins in the market that when coupled with the elevated demand for this alternative currency results in a classic supply and demand imbalance leading to higher current prices.
If you like gambling, Bitcoin is your trading asset of choice. As long-term investors, we will leave these coins to the Las Vegas folks.
John P. Swift, CFA®, CPA
Chief Investment Officer