The St. Nicholas Viewpoint: Third Quarter 2020 Outlook
by Tim Cebulko CFA/CFP, President, Chief Investment Strategist Oct 14, 2020
We will begin with the subject that is forefront in everyone’s mind – the election. I’ll start by restating that I’ve never believed in market-timing and never will. In the past, St. Nicholas clients have taken whatever the elections gave us and managed through it. As is typical, calls for a market collapse are routine in election years, especially when there is a change in administration. Historically, although there are small rallies and sell-offs the week of the election, huge moves pretty much never happen. Please keep in mind that this is not the first “the-world-will-collapse-if ‘so-and-so’ gets elected” circumstance. Indeed, there have been Presidential election-based market crash expectations throughout the history of the US. Most recently, there were dire stock market predictions when Bill Clinton was running the first time in 1992 – his win was followed by a 230% market increase over 96 months. In 2008, the consensus for the stock market was “bad news” if Obama won, and although the market did indeed decline by 12% in the first two months, the markets eventually increased 148% in his 8 years. Finally, nobody initially thought Trump would win in 2016 and many were calling for apocalypse if he did. Post-election, there was no initial negative move in the markets and they continued to rally and be up over 50% in 45 months even after the massive Covid-related decline this year.
As far as Congress goes, rarely has one party controlled all three (The White House, the Senate, and the House of Reps) and when they have, it’s usually not for long. Interestingly, the last time(s) a new President carried a majority in both houses was Clinton in 93-95, Obama in 2009-11, and Trump in 2017-19 – but those lasted for only one 2-year congressional term each and appear to have had little effect on the markets short-term or long-term. The lesson: guessing what the market’s going to do based on who’s in the White House and Congress simply doesn’t work, and we therefore don’t try it with client accounts.
Regardless, St. Nicholas is well-positioned for a weak market if another one ensues – our performance this year is a reflection of that. We didn’t drop near as much as the market did at the March bottom, and we’re over 800 basis points ahead of market indexes (on average) as the recovery continues. 800 bps is a HUGE positive relative performance gap – especially in this dangerous market. We will be similarly well-positioned for any potential Oct/Nov weakness, without losing upside potential no matter the outcome. It’s guaranteed that we won’t know the outcome on election night, and it will likely take weeks for a final outcome to be announced. Be prepared for above-average volatility during that time. We do not plan on raising any material levels of cash pre/post-election and would never recommend an election-based market-timing roll of the dice in client accounts.
Second Quarter Performance Review
Despite September market weakness, equity markets still finished with very strong returns for the full second quarter. Domestically, NASDAQ continues to lead the pack, up 11% in the quarter and over 24% YTD. The S&P 500 Stock Index turned in an 8.5% quarter, but is only up 5.6% YTD. Trailing the group is the Dow Jones Industrial Average, up 8.2% for the quarter but, surprisingly, still down roughly 1% for the year. Overseas markets aren’t fairing near as well as their US counterparts. For the quarter, the best place to be was Emerging Markets, up 9.5%, followed by developed Europe up 4.8%, Japan up 4%, and China’s Hang Seng down 4%. For the nine months ending September 30th, all overseas markets remain in the red. Emerging Markets are down 1%, Japan’s Nikkei down 2%, Europe down 7%, and the Hang Seng down nearly 17%. We’ll suggest that the relative return differences between US markets and the rest of the world are accurate reflections of not only the relative maturity of our economy, but also a statement on who’s got better control over the pandemic. Finally, bonds took an expected breather in the quarter, based mainly on the fact that the Fed has used all of its rate-cut bullets, and there is little-to-no bond price movement. Bonds returned only about a half of a percent for the quarter, leaving YTD returns in the 6% to 8% range.
Quarterly returns for the St. Nicholas managed equity composite were close to 11%, pushing YTD returns near 13% – over 800 basis points above the S&P 500 price change. Obviously, the stellar performance thus far in 2020 continues to widen the long-term relative performance gap, with our inception-to-date returns more than tripling the price increase of the S&P 500 since 2004.[1] 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) and the length of time with our firm. Our goal has always been to beat the markets while offering individual attention to each unique client, and we feel that we are excelling in both areas. Given that 75%-80% of equity managers underperform their benchmarks both short and long term – with most using cookie-cutter approaches – we think all of our clients should be very satisfied and we would like to thank all of you for your continued loyalty.
A Must-Read for Bond Investors
We’ve moved the bond commentary to the beginning of our letter because we have some very important considerations to share with those clients that have fixed income exposure. Bond markets this year have placed many fixed income investors in a nasty Catch-22. On the plus side, the economic shutdown combined with the severe and likely long-lasting actions by the Fed (cutting rates to zero and promising to leave them there for possibly several years) have produced fantastic bond market returns this year. As it presently stands, year-to-date bond returns impressively outpace equity returns, and still have a pretty fair chance to lead all major asset class returns by year-end.
The catch is that the massive rate cuts have left yields at basement-bottom levels unless or until the economy experiences explosive growth, or inflation finally becomes problematic. Neither of these scenarios have much of a chance of happening in at least the next 18 months. This means bond prices have no more room to go up from extremely overbought levels. Normally, the response is “no problem…we’ll just ride it out by collecting coupon income”. Unfortunately, that’s not going to happen either, given that income yields are very close to zero as well, and this extreme exists throughout what is now a very flat yield curve.
For those who might appreciate a bond market primer, the “yield curve” is a graphic depiction of bond yields and maturities, with yields along the Y-axis and years-to-maturity along the X-axis. The normal shape of a yield curve is upward-sloping, reflecting the typical risk/return relationship: the more risk one takes (the further out one invests), the more return (yield) one should receive (reflecting the ”reward” for assuming more risk). Today’s flat yield curve is not realistically upward-sloping by any measure, meaning no matter how long the maturity, there is almost no difference in yield. In numerical terms, a 2-year Treasury yields 0.15%; 5-years gets 0.35%; and, 10 years will pay you 0.77%. So, you not only make almost nothing, you get little reward for extending maturities. The other danger is with price – it takes very little movement down in a bond’s price to easily eat-up the tiny income yield you are earning. We’ve used this analogy before, but we liken it to stepping in front of a steamroller to pick up a nickel – you’ll likely beat the slow-moving destruction, but if you only get five cents, why bother?
In summary, it is a terrible time to be a fixed income investor…very easily the worst we’ve seen in decades. There’s just no yield worth chasing, and we are not risking our client’s money by doing so. We are letting bond calls and maturities remain in cash for now. Patience will keep your principal safe. Occasional opportunities from temporary fear or price weakness will allow us better entry points into short-term bonds and/or bond funds. Also, those of you willing to take more risk might want to talk to us about using dividends from safer/higher quality stocks as a temporary alternative, but again, that does not come without greater price risk. In the meantime, cash reserves will be larger than average, but rest assured, those reserves will also remain protected from bond price declines that are certain to come and that are certain to be sizeable.
The Fed
The interest rate bullets in the Federal Reserve’s monetary policy gun have all been spent. Interest rates can not be lowered any further (although zero percent is only a symbolic target and negative rates are always a possibility). The Fed still has the ability to conduct open market operations (buying bonds on the open market to infuse more liquidity into the banking system and economy) and it continues to do so. Beyond this, the Fed has also signaled that while it is doing as much as it can from a monetary standpoint, fiscal stimulus is still going to be necessary to nurse a very delicate economy until a vaccine becomes available and the pandemic slows and eventually ends. Specifically, the Fed minutes reflect that “The path of the economy will depend significantly on the course of the virus. The ongoing public health crisis will continue to weigh on economic activity, employment, and inflation in the near term, and poses considerable risks to the economic outlook over the medium term”. Clearly the Fed understands that it can only do so much, and that the resumption of normal economic growth can only happen when the Covid pandemic is fully extinguished.
The Equity Markets
Despite a slower September, stock prices continue to hold their own, and in some sectors, have continued to rise into and through October. However, it is important to understand the true health of the stock market. The market rally since the bottoms hit back in March has not been a rising tide that lifts all ships. Realistically, most ships remain in port, with industries like energy, airlines, and entertainment still in dry-dock. This year’s returns have been incredibly concentrated amongst just a few sectors, and we’ll use the S&P 500 Stock Index as an example.
Obviously, anything even remotely connected to stay-at-home or Covid protection has soared, and we won’t list those companies specifically. Many of these stocks are doomed to become laggards once the pandemic ends, and are therefore not worth chasing. Apart from these one-off successes, this market is led by technology stocks and this is mainly because the pandemic has not only not cut into tech business, it has more than likely accelerated tech growth forward by several years. This is very apparent when dissecting index returns. The top five stocks in the S&P 500 are up an average of 33% YTD. Most of you could easily guess those five, but they are Apple, Microsoft, Amazon, Facebook, and Alphabet (Google). Not surprising, the other 495 are still down an average of 25%. Keep in mind, we are speaking in terms of averages – obviously, there are many of those 495 that have positive returns as well, but those returns are overwhelmed by the sheer number (and size) of negative returns. And, speaking of negative returns, 40% of the stocks in the S&P 500 are still in bear-market territory, down 20% or more YTD.
This is still a very ugly stock market, and the numbers just stated above are a fair explanation for the “Wall Street doesn’t reflect Main Street” cries we continue to hear. However, in fairness to the winners, their valuations are an expression of the confidence in their future successes, and unfortunately, the valuations in most of the other 495 stocks also reflect the lack of confidence in their recoveries. In short, technology is where the growth is and that’s why those stocks continue to be return leaders. It’s now worth mentioning the happy coincidence for St. Nicholas clients is that our portfolios have always been positioned for the most visible growth in good times or bad, and we own most/all of those top five names in all of our managed equity accounts in sizeable positions.
Finally, a quick word on valuation metrics: “non-existent”. Not a good word if, like us, you’re in the business of stock-picking. Still, it’s only fair to let our clients know that the overall lack of economic visibility has pretty much destroyed the accuracy of valuation inputs for our normal stock evaluation process. This road block has existed since the first quarter and will continue to be the prevailing condition for many stocks for months to come. What exists today is a good example of the “garbage-in/garbage-out” doctrine that has always defined the myriad of poor valuation and mathematical considerations. In short, the reliance on our historical model as an accurate predictor of individual stock performance has been diminished. Not to worry… we have three solid arguments to support our continued success: One, the “garbage” remains consistent for most inputs for all players, so this levels the playing field. Everybody has to work with the same numbers no matter how distorted or questionable they may be. Two, because we had better visibility entering this crisis, our “garbage” is cleaner and easier to pick through. And, three, our model is only a small part of the process, and the largest component in the process – intuition – remains. Model or no model, Tim Cebulko has been making the ultimate decisions that have resulted in material historical outperformance, and Tim Cebulko endures successfully in that role. This last argument is not haphazard conjecture included solely for the purpose of nurturing ego, it’s simply a very important truth that should be shared when extreme market conditions like today’s exist.
In Conclusion
It’s a bit more difficult to sum things up this quarter, especially given Covid unknowns and the fact that in less than three weeks, the election will be over and we’ll start getting rid of some of the political unknowns that may be either propping up the market or perhaps holding it back. While we assume that the Presidential election outcome will take some time to confirm, we should at least have an official count before our next letter. We are big believers that the economy influences the election more than the election influences the economy, and we’re hoping that eliminating the election unknowns will actually provide some stability to the markets. Yes, elections bring about change and change impacts markets, but regardless of all of the election outcomes, the key to the markets will be the sustainability of the recovery from the pandemic shutdowns, and the discovery of a vaccine will go a long way in determining when and how that happens.
[1] 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.