The St. Nicholas Viewpoint: 2021 Annual Outlook
by Tim Cebulko CFA/CFP, President, Chief Investment Strategist Jan 15, 2021
Markets across the globe continued to surge in the fourth quarter, improving upon the blistering pace they achieved in just the prior quarter. The extent of the moves was again surprising given the uncertainties evolving from accelerating Covid infections, vaccination rollout doubts, political fallout from the elections, and the re-instatement of regional and international shutdowns. We get that the market is a discounting mechanism, sometimes very accurately reflecting the state of the economy 9 to 12 months in advance, but the timing and magnitude of the moves is puzzling. If we buy into this discounting hypothesis (and we always have), we could logically forecast a huge economic explosion in the first quarter of 2021, given that the monstrous stock market moves actually began within a couple weeks of the March 2020 lows. Needless to say, this is certainly not our actual forecast.
It’s very evident that any economic recovery will be slow-in-coming given the current condition of the economy and the legitimate prospect that the consumer will continue to remain holed-up for months to come. Please don’t misconstrue where we are coming from – the introduction of vaccines from several companies in such a short time borders on the miraculous. Historically, the fastest vaccine development for any particular malady approached four years. Four years…and we’re already rolling out the initial vaccination programs just ten or eleven months after the virus was initially discovered! Again, quite miraculous.
Still, we have to accept the reality that the rollout of the vaccine program is in its infancy and we can already get a sense of just how long it will take to vaccinate enough citizens in order to reach herd immunity. It’s a pretty good guess that the majority of the US will not receive the vaccine by the end of the first quarter. And, let’s not forget that there are two required doses for each individual, and those doses need to come at least one month apart. If it sounds like a logistical nightmare, it is…but be assured that it will get done. We feel like the market is discounting an unrealistically early recovery…kind of like 330 million people showing up on a Friday and being fully vaccinated and ready to go back to work (and to the malls, and the cinemas, and the airports, and the amusement parks, and the cruise ships, and even the then fully-opened restaurants) on Monday. A dream scenario, but unrealistic.
No, the reality is that the rebound will be fairly slow, with the likelihood that we see very little of it (if any) in the first quarter. Remember too, that the US needs a global recovery for any predicted economic boom to be lasting, and that’s even further down the road. If you think vaccinating 330 million people is a challenge, try 7.7 billion…and that includes many, many countries that just don’t have the financial wherewithal to vaccinate its citizens. All of this on top of the fact that the US has a big change in political leadership ahead, and that the actions and implications of that consequence present a new wave of unknowns. Regardless, we vow to remain resilient. While it is too soon to accurately predict the onset of any type of economic recovery, we feel confident it will happen by at least the second half of the year if not sooner. The magnitude of any future rebound can only be measured after-the-fact, and it’s certainly always possible that the market surge of the past nine months may be overestimating future economic strength. Only time will tell on that one.
Fourth Quarter Performance Review
As far as major markets were concerned, there was no bad place to be last quarter. Even bonds had another positive quarter, despite near-zero rates for months. All equity markets – foreign and domestic – posted double-digit quarterly returns. Global markets fared a bit better for the quarter, with Emerging Markets leading the way, up almost 20%. Japan wasn’t far behind, up 18.4%, and both China and Developed International increased just over 16%. Full year returns better reflect the severity of the virus impact, with much lower returns across the board. Emerging Markets had the best 2020 returns at 18.3%, followed by Japan’s Nikkei at 16.0%. Developed International markets were up just 7.8% for the year and China’s Hang Seng Index actually declined 3.4% for the full year. Domestically, quarterly returns ranged from a low of 10.7% for the DJIA to 15.4% for the NASDAQ, but annual returns were distributed along a much broader range. Leading the way for 2020 was the tech-heavy NASDAQ, up an unbelievable 43.6%. More rational were the total returns of the S&P 500 at 18.4% (S&P Price-only was up 16.3%) and the DJIA up “only” 9.7%. Regardless where any of these indexes fall on the return spectrum, they are all impressive given they represent world economies that experienced full and partial shutdowns for almost the entire year. On the Fixed Income front, we may have seen the last positive annual return year for bonds for a bit, so bond investors should relish in the positive quarter of 0.8% and the full-year return of just under 9%.
The St. Nicholas managed equity composite was up nearly 13% for the quarter, resulting in YTD average returns over 27% – more than 1100 basis points above the S&P 500 price change. Add one more very big relative performance year to continue to add to our exceptional long-term record of relative outperformance. We will repeat as usual that the composite is an average of accounts, so individual returns will vary depending on account structure (every account is individually-managed and tailored to each specific client), cash flows, and the length of time with our firm. We will also take this opportunity to repeat that our chosen benchmark is the S&P 500 Price-only Index given that the total return number reflects the daily re-investment of dividends into proportional shares of over 500 stocks – a function that is simply not duplicatable by individual money managers. No matter the benchmark, St. Nicholas clients remain comfortably ahead, proving that we possess and apply a consistently successful stock selection process.
We’ve stated in prior letters that the Federal Reserve Bank and its underlying intentions are not a mystery in any sense of the word. The Fed has been very vocal in their expansive monetary stance and continues to express their intention to leave rates unchanged for what may be years to come. The economy is recognizably on wobbly legs and the path to recovery remains shaky. They have set the estimated GDP growth for 2021 at 4.2%, but iterated that much of that could occur in the second half of the year. Rates are effectively at zero percent and they confirmed in their December meeting that not only would rates remain untouched, they would continue to enhance market liquidity through the bond purchase program. Again, not a secret. It is clearly evident that absolute rates can not go below zero (negative interest rates can be affected through other means, but we’ll leave that particular bridge uncrossed for now). Logically, then, the only way to continue to enhance liquidity would be through bond-buying, thus allowing more money to funnel its way into the banking system.
As a quick tutorial, The Fed controls liquidity through monetary policy. Liquidity is needed to make money easily available. Easily available money means that banks have plenty to loan and can therefore presumably spur economic growth. Whether this happens efficiently is up to the lending banks and the borrowing consumers, but it most assuredly can’t happen if liquidity is not there. There is a very strong argument that if banks aren’t readily lending and/or consumers and businesses aren’t readily borrowing and spending, then the excess liquidity gets used up by investors and helps fuel higher stock prices. This condition is sometimes used to justify higher stock valuations given that earnings models often use current interest rate levels to discount future earnings (It’s a complicated financial equation/process, but all you really need to know is the discount rate is part of the denominator and simple math tells you a lower denominator makes the overall value higher). So, for now, we can thank the Fed for much of this stock rally.
Regardless, excess liquidity flowing into stocks only becomes problematic if earnings can’t keep up or if alternative investments (think bonds) offer more competitive returns (not gonna’ happen with bond rates anywhere under 3 or 4%). Still, at some point, there will be much stronger consumer demand, and the excess liquidity will be used for spending rather than investing. Again, not necessarily problematic for stocks given that the liquidity is now funneled into the economy and therefore fueling earnings growth that allows earnings to catch up with stock valuations. Call it the financial “Circle of Life” if you will.
The Equity Markets
We’ve talked about the absence of valuation metrics in previous letters and it is important to repeat that, for the most part, the valuation issues that first surfaced in the second quarter of last year still remain. As a reminder, we’re talking about the inability to value stock prices based on earnings because either earnings can’t be adequately estimated, or (worst case scenario) earnings have completely disappeared. There is a wealth of other issues related to the metrics used in the evaluation of stock prices, but the bulk of them are earnings-related. Basically, without accurate earnings estimates, stock analysis is mostly guesswork. Admittedly, earnings estimates in general were not all that reliable pre-Covid, but for most of 2020, most estimates were literally dart tosses. The bad news is that not a lot has changed. It’s still nearly impossible to know if/when earnings start growing and how long it will take to get back to normal.
The good news is that the intuition that led our decision-making for 2020 is the same intuition that inches forward somewhat blindly into 2021. If that doesn’t sound like good news as stated, we’ll rephrase. Our stock selection discipline has successfully endured (with accurate estimates) since we first opened our doors in 2004. Pre-Covid, that discipline left us with an established core of names that possessed strong valuations and visible earnings growth. When the visibility of that earnings growth blurred last year, valuations fell back to other quality-related metrics that allowed most of those names to decline less initially and rebound stronger than the market, with most even advancing to newer highs. Our valuation model led us to good names and our intuition carried us the rest of the way to the best relative performance year we’ve ever had. That sounds like good news.
We’ve already heard our share of market predictions for 2021, and many of them forecast the demise of growth in favor of value stocks; they expound tactics like ‘sector rotation’ – selling stocks in successful industries for sectors yet to catch-up; they strongly push for historically underperforming sectors like banks, energy, and deep cyclicals; and, there’s a growing majority that say to completely abandon the big tech winners of 2020. While we can’t summarily dismiss any of these strategies, we can explain why we will not be forging down any of those paths. As a reminder, the basis for our discipline is GARP – Growth at a Reasonable Price. While GARP stocks do indeed exist in each of the suggested strategies, their numbers are few. The reasons the numbers are few is that GARP requires earnings growth, something most of the aforementioned approaches lack. Value stocks – which generally always include banks, energy, and cyclicals – are typically stocks with higher dividends that are, for some reason, cheaper or ‘on sale’. They’re clearance rack stuff – a ‘scratch-and-dent’ sale if you will. The reasons they are on sale vary but include concerns like earnings disappointments, low/no earnings growth, distressed businesses (like oil), or highly cyclical business swings. It’s not entirely accurate to throw a blanket over the whole bunch, but the gist of these strategies is this: get out of stocks that have worked very well and move into those that haven’t caught-up yet in the hopes that they will.
It is not unreasonable to expect some degree of rotation. Indeed, it is logical to conclude that there are many stocks that have yet to benefit from a recovering economy. What’s being forgotten however, is that many of these stocks’ moves (if they materialize at all) will simply be a return to prior levels. And, while it would be nice to be a perfect market timer/sector rotator and capture only these moves, it’s just too hard to separate the winners from the losers in such a short window. Still, the bigger problem is that once (if) these prices return to previous levels, what have you got left? The answer is the same old clearance stuff with sub-par earnings growth and predictability. We’ll stick with our known earnings growers thank you. Yes, we may underperform for a quarter or two while others sell their Apple to buy Chevron, but in the end Apple (and the other quality growth names we own) continues to grow earnings at a double-digit pace for at least the next five to ten years. Yes, Chevron holders might win the six or nine months, but Apple owners rule the decade. And the previous decade. And the one before that. Our GARP approach has a very long and proven performance record through all types of markets and economies and we see no reason to abandon it for a few quick and/or questionable gains.
We hate to be overly repetitious, but the fixed income story simply doesn’t change much going forward. In fact, expect essentially the same bond market rhetoric to get artfully repeated for at least the next three or four quarters, and possibly well into 2022. Regardless, that doesn’t mean that there won’t be action along the yield curve. The Fed has recently gone so far as to temporarily raise their target inflation rate from the long-standing level of 2%. They admit that this becomes a moving target going forward, but that the flexibility in the desired levels is acceptable given the recent history of sub-2% inflation. This has ongoing implications for the yield curve. With a higher inflation target they now have the ability to leave short-term interest rates near zero for a very long time, the argument being that money can continually be fed into the economy without the fear of spiking money-supply inflation. This means the short end of the yield curve will remain essentially stationary.
However, the expectation remains for a gradual strengthening in the economy. If you remember your basic Economics class, you know that as the economy gets stronger, demand improves. And, void of any level of instant equilibrium, higher demand outpaces supply. If indeed the economy naturally seeks equilibrium (as it truly does in the long term), then that can happen under two conditions: an increase in supply, or a reduction in demand caused by higher prices. Owing to the latter, we’ll see upward pressure on prices, thus causing higher inflation expectations and putting upward pressure on the longer end of the yield curve. Such a scenario would call for a steepening of the yield curve where short rates stay put and long rates increase. But don’t get excited yet bond fans…we’re talking a modest increase in longer rates that in the short run won’t really present much opportunity to increase income. That means we see the ten-year note going from around 1% to maybe 1.5%. Would you really want to go out ten years to lock-in 1.5%? We think not, but will continue to look for opportunities to maximize income with shorter maturities until we see a better window for higher rates.
Our guess is that a survey of annual outlook letters from economists and money managers would show at least half of them beginning with “Good Riddance 2020”, or something along those lines. We passed going that route not because we’re not happy that the year is behind us but because 2021 has basically become an extension of 2020. Translated: not a lot has changed. We still have COVID-19 to deal with. We still have social injustices that haven’t been corrected. We still have millions out of work, businesses shut-down, and a frail economy. The political turmoil remains – the names have changed but the infighting continues. When they write the history books of the future (if it can ever be agreed what the correct history will be), 2020-21 will be but another of the hundreds, if not thousands, of difficult periods that our country has managed to navigate. And, as history has proven, most of these events, although critical to the long-term evolution of society and the United States in general, were incredibly unpleasant for those who lived through them. We are all part of that history and unfortunately, we cannot alter the past, but we can continue to hope for a better future. We’ve still got a long tough road ahead of us, but we’ll never get there if we lose hope. Keep the faith people – better days are still to come.
 Based on a composite of fully-discretionary equity-only portfolios representative of our primary equity management style. This composite only includes stock portfolios that have been managed solely by Tim Cebulko since inception. Composite returns are not independently audited but have been verified internally and are believed to be reasonably accurate representations of actual account returns. Composite returns are gross of management fees and are dollar-weighted. Past performance is not intended to be a guarantee of future results.