The Prevailing Market Narrative
The prevailing narrative this year is one of hope and some mounting fear over what many believe to be extreme market valuations in major sectors of the equity market. Most of the financial talking heads are talking up a market pullback, and they are right. There will be a market pullback for the simple reason that most market participants have been conditioned to expect it. They believe it is coming, and they will jump at shadows to get out of the market at the least provocation.
But in 2021 the market has one more year of a free pass. Almost everything is setting up in favor of equity investors this year if they could only demonstrate the nerve to not join the “deer in headlights” crowd.
Monetary and fiscal policy favor equity investors. COVID vaccinations are ramping up, and it is the beginning of the end of the cold & flu season in the Northern Hemisphere. Corporate earnings are surprisingly strong, and there is a tremendous amount of cash that will be coming into the market from a variety of sources I will discuss later.
There are sectors of the market that investors should avoid. I will discuss these, as well as address the longer-term pressing questions of how the exit from historically low interest rates will look, as well as what are the risks associated with all this governmental spending. These are important questions; the kind of questions that concern me over the mid-to-longer term.
But fear not, 2021will be decent to investors if you just keep the faith that the combination of fiscal spending and monetary stimulus will provide a free pass for another year.
The Case for Equities: Monetary Policy
The market continues to believe that there is no alternative for investment other than equities. The Treasury futures market indicates that the 10-year Treasury Bond will be trading hands at the end of 2022 at just 1.85% yield versus the current yield of 1.3%, and the Federal Funds rate is predicted to stay near zero until 2024. Accordingly, we face an interest rate outlook and bond market anchored to a zero-interest rate monetary policy. Against that backdrop fixed income investments are not attractive, and the market will continue to believe that there is no alternative but to invest in equities.
The Biden Administration is pushing a $1.9 trillion fiscal stimulus package. The market believes that a deal will be done at about half of that number, but fiscal spending will be supportive of the equity market.
COVID vaccinations are quickly ramping up and the CDC sees the United States reaching the vaccination milestone indicative of reaching herd immunity from this insidious disease this summer.
Corporate Earnings Continue to Surprise on the Upside
The 2020 fourth quarter earnings reports have been tremendously good; historically good. When the dust settles on the quarterly earnings announcements, we will have seen the second highest difference between actual and forecasted quarterly earnings results. Interestingly, the best “beat the estimates” quarter was the quarter that preceded it, 3Q20. Analysts continue to be overly conservative with their estimates.
But can you blame them for their pessimism heading into 4Q20? Life during the last quarter of 2020 was not pretty by any stretch of the imagination. COVID infections were on the rise as we entered winter and the cold & flu season in the Northern Hemisphere, and jobless claims were going in the wrong direction. We witnessed a contested Presidential election and complete chaos in Washington. Analysts were understandably conservative in their earnings estimates, and they were very wrong.
How wrong? Fourth quarter earnings for the S&P 500 grew year-over-year by 2%. Think of that for a moment. You are comparing 4Q19 before the COVID pandemic hit the U.S. and the world outside of China with the 4Q20 and earnings grew year-over-year. Now, if you took the earnings growth of Apple, Microsoft, Amazon, Alphabet (Google), and Facebook out of the equation that result is no longer true, but last I looked all five of those stocks are in the S&P 500 (and in our core portfolio). Their results count.
Another supportive factor for equities is the forecast for large cash inflows into equities. Surveys suggest that stimulus recipients will direct a larger portion of their future stimulus checks towards investments. Next, there is a historically high amount of cash sitting idly in low-interest rate money market funds, over $5 trillion presently. Some of that money is going to find its way into the market. Stock buybacks, which went to near zero last year, will rebound towards previous levels which increases demand for stocks which, in turn, increases prices. Finally, the weakness of the U.S. dollar will attract foreign buyers of U.S. stocks.
A Sector to Avoid: High Valuations in Some Technology Sectors
We find that newer companies competing for business in the cloud, financial technology, and artificial intelligence sectors to be so highly priced that they remain non-investable especially when you consider the high volatility and inflation risk which will hurt technology earnings.
We have been closely following attractive and disruptive firms in these sectors such as Snowflake (SNOW), CrowdStrike Holdings (CRWD), Zscaler (ZS), Cloudflare (NET), Trade Desk (TDD) and Okta (OKTA). The least irrationally priced stock in that bunch is Okta (OKTA) who provides single sign-on and identity verification and protection services to over 6,500 cloud services. Think of them as a security checkpoint and gatekeeper to the cloud. Their stock sells at 47 times 2021 projected sales. That is sales, not earnings. Very few, if any, of these cloud disruptors have earnings. So, you must evaluate them based on a price-to-sales basis. And on that basis, or any other basis, we find these stocks presently non-investable, but we will keep watching and waiting for our opportunity to invest in one or more of these businesses.
How Will We Exit Reliance on Low Interest Rates?
Global markets have become addicted to low interest rates and exiting this zero-interest rate environment will be messy and unpredictable. Like the addicted gambler or alcoholic, getting your life back to normal and beating addiction is extremely difficult.
Once we started inflating the financial system with a torrent of cash, you must continue to feed the beast or risk plunging your economy into a deflationary spiral, recession or worse if you take the stimulus away.
Now, you can grow your way out of this low-rate addiction, but our global economic output is a function of population and productivity growth. On the first measure, demographics are not on our side. Annual population growth in the U.S. is 0.5% and declining, and it is near zero across Europe and China. It is negative in Japan.
Productivity growth is hindered by policies around the world that have created value destroying companies through systems of inefficient capital allocation (I am looking at you, China). Labor productivity growth comes from increases in the amount of capital available to each worker, the education and experience of the workforce, and improvements in technology. The best way to create sustainable improvements in labor productivity is to focus on better and more accessible education. We can achieve our maximum potential for productivity gains only when barriers to getting a great education for all our citizens are eliminated.
What are the Risks Associated with all this Governmental Spending?
As we become more reliant on governmental spending, the government’s share of the overall economy will rise crowding out private investment in the process. Higher governmental share of the economy has historically resulted in less productivity gains and inefficient capital allocation (see last section). Less productive economies are less prosperous, and as a higher percentage of the population becomes reliant on the government to make ends meet, we slip ever closer to a centrally planned economy and more socialism. Considering the history of socialism and economic performance, in the long-term this is the wrong recipe.
We need to get back on our own two feet, and that starts with getting vaccinated against the COVID virus. Let us take care to get our seniors and other at-risk populations into a clinic to get their shots. In most cases, getting your shots has been frustrating and difficult. Be persistent and patient, and above all, keep working towards doing your part towards achieving herd immunity and getting our global economy back to self-sufficiency free of the need of governmental fiscal stimulus.
John P. Swift, CFA®, CPA
Chief Investment Officer