The St. Nicholas Viewpoint: Mid-Year Outlook 2020
by Tim Cebulko CFA/CFP, President, Chief Investment Strategist July 16, 2020
First Quarter Performance Review
As far as market volatility is concerned, technology has proven to be both a benefit and a curse. The instant (and unreliable) news environment in which we live combined with programmed trading conducted in milliseconds has resulted in volatility that we’ve never seen before. Get used to it folks…it ain’t going away. We saw record-breaking declines at the end of the first quarter, followed by record-breaking increases in the second quarter. One-thousand to two-thousand-point days were common. Ordinary and typically boring blue-chip stocks saw repeated days of 5% to 10% moves, while high-flying tech and growth stocks saw multiple swings at levels twice that high. While energy, airline, and cruise-ship stocks are still down 70%-80%, massively expensive growth stocks like Netflix, Nvidia, and Chipotle are up 100% from their March lows. The real hi-fliers – untouchables like Zoom Video, and Tesla – continue into the stratosphere, skyrocketing over 300% this year alone. None of these moves can be logically rationalized, and much remains to be seen how all types of stocks react as this pandemic-related crisis continues to rely on exaggerated and sensationalized news to influence already distorted stock prices.
Exaggerated or not, we’ll take the quick rebound as it stands. Much like the universal performance-related negatives last quarter, we experienced universal positive performance across the board in the second quarter. Unbelievably, even after a nearly 20%-plus second quarter, almost all major equity indexes are still in the red for the first six months of 2020. The best quarterly numbers come from US markets, with NASDAQ exploding up almost 31%! The S&P 500 and the Dow Jones Industrial Average also shot up, increasing 20% and 18.5%, respectively. Year-to-date June 30th, NASDAQ is the only major equity index in positive territory, with an increase just over 12%. For the same time period the S&P 500 is still down 4% while the DJIA remains down almost 8.5%. Overseas we saw the best quarterly performance from Emerging Markets, with the MSCI Emerging Markets Index up 18%, followed by Japan’s Nikkei up 17.8%, Europe up 15%, and China’s Hang Seng Stock Index up only 3.5%. Year-to-date returns remain in negative territory for all of these foreign markets, but Japan leads the group down only 5.8%, followed by Emerging Markets (-9.7%), Europe (-11.1%), and China (-13.4%). In spite of short rates already dropping to zero before the quarter began, bonds continued their rally into the second quarter, up around 3% and stretching YTD returns into the 5%-7% range.
As expected, St. Nicholas clients fared much better than the markets as a whole. Quarterly returns for our managed equity composite were close to 24%, pushing YTD returns over 500 basis points above the S&P 500 price change. More importantly, the long-term relative performance cushion continues to grow, with our 15-year returns nearly tripling the index. Obviously, the composite is an average of accounts, so individual returns will vary depending on account structure (every account is tailored to the specific client and individually-managed) and the length of time with our firm. Regardless, the end result is that we are achieving what we set out to do – treat each client as an individual and beat the markets while we are doing it. That may sound trivial, but it’s not an easy task given that 75%-80% of equity managers underperform their benchmarks annually and almost none of them have done it with any level of consistency over the long-term.
The Fed not only continues its massive expansionary actions, it has indicated that it expects interest rates to remain near zero for not only the balance of this year, but likely for most of 2021 as well. We suspect that the 2021 comments are merely a tease to maintain calm and not realistically based on economic expectations for next year. In reality, it is extremely difficult to predict economic growth so far out, especially given that that the spectrum of outcomes is still very wide. Economic growth in 2021 without a Covid vaccine will look extremely poor, especially if there is a seasonal resurgence of cases next spring. On the other hand, the introduction of a vaccine is a complete gamechanger, and the economic boom from a year’s-long pent-up demand could be steep enough in magnitude and long enough in duration that Fed-induced monetary influence may indeed be needed to regulate the pace of growth.
In any case, the Fed remains unprecedentedly accommodative today, and will continue to be for at least the balance of this year. The combination of Fed monetary ease and massive fiscal policy infusions creates the thin string of hope from which our economy – and our financial markets – currently dangle. The Fed continues to support the fixed income markets, maintaining its bond purchases, but transferring its influence to the corporate side of the market. The Fed’s balance sheet – a reflection of the bond buying it has conducted this year – has ballooned to over $7 trillion and will undoubtedly continue to climb. Such massive monetary actions would normally be just cause for inflation fears, but so far, we don’t see the warning signs. For inflation to be fueled, all of this “cheap” money needs to work its way into the economy, causing increased demand to push prices higher. This hasn’t happened yet given that consumers still appear to be huddled (some by force, some by choice) into the safety of their homes, and that banks – the true faucet that feeds this cheap money into the economy – are refusing to lend more and are instead using this excess liquidity to build their balance sheets.
The Equity Markets
Unfortunately, the valuation problems in the equity markets remain. As a matter of fact, the record-breaking rise in the markets this quarter only exacerbated the valuation exaggeration. Last quarter, we noted that we had a severe problem discussing equity valuation metrics because most of the ones we look at involve stock price, earnings, or earnings growth. All three of these financial measurements continue to be severely distorted, so rational evaluations of stock price valuations are still nearly impossible. Perhaps the biggest issue lies with earnings. For virtually every stock in every industry, earnings estimates are nearly impossible given the broken economy. Without earnings estimates, there is no base, and without a base amount of earnings, growth projections are impossible. Even with a base, earnings estimates would be nearly impossible. It might be possible to come up with scenario-based estimates – one number assuming no virus resolution, and one number supposing a vaccine – but that would not only be confusing, it’s still mostly guesswork.
Presently, this makes equity-valuation quite difficult, and so now much of our analysis is quality-based, history-based, and to an extent momentum-based. We like the last method the least, especially given that ‘momentum’ is a demand-based measure that gives pretty much zero consideration to valuation. Even worse, momentum can shift on a dime as many non-St. Nicholas investors will find out once a vaccine nears and rationales begin to normalize. By example, it was certainly possible to make money on Clorox stock after buyers pushed it up because everyone was buying bleach and disinfectant products to defend against the virus. Momentum buying pushed a normally blasé stock up 35%, but what happens the day we get a vaccine? The stock tanks and you’re left holding a 5% earnings grower with the PE of a tech stock.
The recent market calamity has only strengthened the legitimacy of our long-term stock selection discipline. The metrics that we used pre-Covid left us with high-quality companies with fairly visible growth rates in varying economic conditions. The fact that some of them have attracted momentum buyers is not bothersome because when the momentum buyers start chasing something else – and they will – we’re still left with reasonably-priced stocks with visible double-digit earnings growth. The price and earnings distortion has had little effect on what we own, but it has admittedly put a crimp on valuing new names. Regardless, our ‘buy list’ is usually pretty static in any environment, so we have no issues working amongst the list of St. Nicholas stocks as it currently exists. When the time of reasonable valuation metrics returns, we’ll plug in our technique and continue as if no interruption existed.
Reminder/Update – Good News for IRA Investors
Two recent law changes by Congress will directly impact St. Nicholas clients and involve RMDs (Required Minimum Distributions). First, The SECURE (Setting Every Community Up for Retirement Enhancement) Act increased the age at which RMDs are required to begin from 70.5 to 72. If you are already over the age of 72 and taking RMDs, this change will not affect you. The Act is effective January 1, 2020, and has no grandfathering provisions, so if you turned 70.5 in 2019, you must still continue RMDs even though you’re not yet 72.
The CARES (Coronavirus Aid, Relief, and Economic Stability) Act, signed into law on March 27th, was designed to provide up to $2.2 trillion in virus-related aid. The Act’s material RMD change was the complete elimination of the RMD requirement for 2020. If you have not yet taken your 2020 RMD, you are free to skip it this year. In doing so, you not only preserve the value of the IRA, you would also reduce your taxable income for 2020. The IRS has also recently announced expanded rollover relief for those already taking RMDs this year, allowing for distributions all the way back to January 1, 2020 to be rolled over through August 31, 2020 without running into issues with the 60-day rule or with the once every 12-month IRA-to-IRA rule. This means most distributions that were thought to be RMDs in 2020, but then waived by the CARES Act can now be undone and rolled back into a retirement account by the end of August 31, 2020. For many of our clients already taking forced RMDs, this could mean material income tax savings for 2020. Any time you can defer taxes and spread them out over a longer time frame, it is generally worth considering. Please contact us immediately if you are interested in rolling back any 2020 IRA distributions by August 31, 2020.
Bonds continued their rally through the second quarter, and at this point, are still outperforming stocks year-to-date. In spite of the pleasantly positive returns that we’ll probably end up with in 2020, bonds at this point appear to have little left to offer. And, while no one likes the volatility and downside that comes with stocks, we’ll suggest that the biggest investment impediment going forward now rests with bonds. Now that fixed income liquidity has returned to historically reasonable levels, bond prices more adequately reflect true valuations. This is bad news because true valuations mean bond prospects look pretty dim for the foreseeable future. Investors need to go as long as 4-5 years before seeing yields above one percent, and most of those issues involve companies in struggling corporate sectors (energy, finance), or municipal bonds from states with collapsing budgets (too many to name). Paying so much for average-to-below-average quality and getting so little in yield is reason enough for us to maintain higher fixed income cash levels and let patience guide us to higher yields. The other option is using income substitutes in the form of dividend-paying stocks – which we are indeed doing for clients that fit the risk profile – but this doesn’t come without increased price risk and most bond investors prefer the patience route.
How long will we have to wait for yields to improve? That’s a great question and unfortunately, we do not have a solid answer. However, recognizing that the primary driver of this bond rally has been the Fed with all of its accommodative purchasing, we know that will eventually cease – and possibly reverse. The speed at which that happens will be a function of their observations on Covid and the actual turning point in economic growth – a point where growth will be explosive and sustainable for at least several quarters. Unfortunately, that turning point doesn’t happen without eradication of the virus and that only happens with a vaccine. Still, once we hit that point (3…6…9 months from now?), the Fed will be done. They’ll keep interest rates at zero for a while, but the bond buying will stop completely, and slow selling will begin. That’s when rates start to reverse, and that’s when patience is finally paid off.
We have to admit that the stock market moves took us by surprise – not that they happened, but that they happened so fast and with such great magnitude. We’ll admit as well that we have some concern that they happened with such ease. There seems to be little patience for information absorption anymore – react on the news; react instantaneously; and, react with great conviction. Unfortunately, as we continue to witness, the “news” today is almost completely unreliable at first pass. We could rationalize such a knee-jerk reaction (both down and up) in a scenario where we discover the virus, we recognize its potential, we combat that potential, and we solve the problem. The problem is that we are back to where we started as far as the stock market goes, but we are there without the solution, we have limited knowledge of its potential, and we are still combatting the problem. We are there without a return to the historically successful job market we had entering 2020. We are there while no US state has returned to 100%, and many states are still in nearly complete shutdowns. We are there well before the economy has shown any realistic signs of sustainable recovery. And, more concerning, we are there in the midst of a cultural upheaval whose resolution can not be resolved with a vaccine.
Cultural change can take years…decades. Historically, even minimal change comes slowly and we appreciate the view that for some, change really hasn’t come at all. Circumstance leaves the US in a very delicate position, and as investors, we should be concerned. The United States is exposed on several fronts right now, and at this point it wouldn’t be difficult to collapse one of those fronts. Such a collapse could reverse market trends and result in a more extended recovery. We’re not predicting any such scenario – just recognizing the weakening façade. Still, at this point, we remain hopeful but cautious.
 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.
P.S. We would like to remind clients that all of our written Policies and Procedures are available upon request at any time. We are also required to notify clients of the availability of our regulatory Investment Advisor Brochure/Form ADV on an annual basis, so please contact us at 904-470-0102 with any requests.