Wealth Matters Newsletter - January 2021

Common themes in nearly every conversation I’ve had with clients, friends, and family over the last month were relief and hope: relief that 2020 was coming to an end and hope that 2021 would offer the possibility of returning to some semblance life of prior to the pandemic.  Unprecedented may have been one of the most over-used words in the English language to describe 2020, but so too would many of its synonyms.  In fact, users of the website Dictionary.com voted “unprecedented” as the People’s Choice 2020 Word of the Year (narrowly beating out “pandemic”).  A global pandemic, the swiftest bear market in history, and swiftest bear market recovery in thirty years, economic lockdowns of varying degrees, massive economic and physical stimulus, new levels of discord in Washington, and the fastest vaccine development in history were just a few of those “unprecedented” markers.  Patient investors were handsomely rewarded in 2020, a reflection of massive stimulus and the promise of vaccines bringing an end to the economic hardships experienced by many.  Can markets deliver again in 2021 or has much of the “hope” already been priced-in?

In order to build a framework to answer that question, we must first consider whether or not stocks are overvalued or undervalued.  Investors attempt to determine a stock’s value in a myriad of ways, but most generally involve attempting to forecast future earnings or cash flows and discounting or adjusting those forecasts by some factor that reflects the time-value of money (a dollar today is worth more than a dollar tomorrow).  In its simplest form, investors might use the 10-year U.S. Treasury yield as the discounting factor.  At year-end, the 10-Year U.S. Treasury yield was 0.925%; at its low during 2020, the yield was 0.318%.  With interest rates so low, the current value of future earnings or cash flows is higher than during a “normal” interest rate environment; the Federal Reserve indicated throughout 2020 its intention to provide accommodative monetary policy (think low interest rates) until employment regains its pre-pandemic footing.  By many estimates, this low rate environment may be with us for several more years, based on the Federal Reserve’s employment targets.  Already low interest rates, and the likelihood that low rates stay for longer, provide a backdrop of support for higher stock values.  

The other component to this measure of value is the estimate of earnings or cash flows.  The associated impact on corporate earnings as a result of the pandemic was very much industry and company specific.  Industries dependent on in-person consumer behavior (think travel and leisure, as an example) have been severely, negatively impacted when compared to those industries that do not require an in-person experience (think online shopping or video streaming services).  This is one factor that played a role in the severity of the sell-off in the spring of 2020; many companies were immediately negatively impacted by government mandated closures, which immediately caused investors to rethink future earnings and cash flows.  It also played a role in the stock market’s swift recovery – the fiscal and monetary support that was enacted provided some basis for estimating earnings and cash flows more favorably.  Expectations for improving earnings, particularly in the hardest-hit industries, have been building.  This was visible in the stock market’s performance during the fourth quarter of 2020, as the “stay home” stocks that led the market’s higher for much of the year were surpassed by their more economically-sensitive counterparts.  Small cap stocks, as measured by the Russell 2000, saw a return of 31.37% during the fourth quarter 2020, versus the 12.15% return of the S&P 500 and 15.63% return of the NASDAQ Composite over the same period.

We are cautiously optimistic for 2021.  Interest rates are likely to remain favorable and vaccinations continue to be rolled out, which should permit consumers to revisit old behaviors safely.  Savings rates in the U.S. hit historic levels in the spring and remained high throughout the year – some of those savings consumers have amassed may be released back into their spending plans.  Resumption of spending and in-person activity would improve earnings and would likely result in improved employment figures, creating a “virtuous cycle.”  These optimistic assessments are not without risks.  Vaccination rollout has been slower than originally anticipated, as the logistical challenges of such an immense undertaking have been made visible.  Congressional elections are still not finalized (as of this writing) and the results could have a real, short-term impact on markets.  As was highlighted in our fall edition of this newsletter, full Democratic control in Washington would make it easier for President-Elect Biden to impose tax or regulatory changes that could reduce profitability.  Small businesses, which have been the backbone of job creation in the U.S., still face prolonged economic uncertainty.

Markets can continue to deliver in 2021, but we need some hope to become reality.