Market Update - The Uneasy Recovery
The equity markets in much of the developed world continue their upward rally.
2020 had been a highly turbulent and stressful year for the financial markets, to put it mildly.
We have witnessed one of the most severe market collapses in recent memory, with the S&P500 dropping <red>-34%<red> from its February highs before recovering swiftly on stimulus and vaccine optimism . As of yearend 2020, the Canadian TSX rose <green>+2.16%<green> . In the U.S, the S&P500 is up <green>+16.20%<green>, while the DJIA rose <green>+7.23%<green> .
The 2020 stock market crash was unique in that it was triggered by a global pandemic. As such, it was a novel threat that Wall Street was wholly unprepared for. The financial markets started the year being relatively optimistic and calm. However, as Covid-19 ultimately made its way across the world and into North America, panic began setting in. The market experienced several big selloffs in March as investors fled for safety. The DJIA dropped <red>-7.79%<red> on March 9, <red>-9.99%<red> on March 12, and <red>-12.93%<red> on March 16 .
The financial market crash signaled the beginning of the Covid-19 recession that sent many economies reeling. The U.S economy posted its sharpest economic contraction on record during the second quarter of 2020 . The recession was driven largely by a forced shutdown of economic activity, affecting both demand and supply. The downturn hit some industries such as travel, hospitality, and oil particularly hard. The year saw an unprecedented oil market crash that sent crude prices into the negative territory briefly, partly a result of Covid-19 shutdowns and partly because of OPEC+ disagreements .
The selloff on Wall Street largely stopped as central banks and governments started taking drastic actions to support the economy. Central banks around the world acted with extraordinary swiftness and resolve in response to the unparalleled threat posed by Covid-19. In the world’s largest economy, the U.S Federal Reserve pledged to keep interest rates near zero while buying up bonds to ensure there was adequate liquidity in the markets. The U.S Congress also passed a $2.2 trillion stimulus package to further bolster the economy in late March. This was followed by a $900 billion stimulus package in December . These drastic government and central bank actions were adopted all over the world, from Canada to the European Union to Japan . As a result of such actions and due to progress on the coronavirus vaccine, the market entered a new bull market in April .
We started 2020 being rather conservatively positioned. Back in January, we warned our investors that the market was vulnerable to a major correction. We saw slowing earnings, an inverted yield curve, and stretched market valuations as reasons to be cautious. As a result, we allowed our portfolios to build up a cash cushion at the beginning of the year.
This proved to be a prudent move. Although it was the coronavirus pandemic that ultimately led to the market panic and selloff, any shock to the system would have left investors equally vulnerable. However, as the market panicked and investors sold off everything they could and bought toilet paper, we saw good value in equities and began to buy.
We quickly took our cash positions down and bought many of the stocks we’ve been watching for months and years. We have done the necessary research on these stocks but had not yet bought them due to their high prices. The market panic gave us a good entry price on many of them. Some examples of the stocks we bought on your behalf include Bank of America, Visa, Apple, RBC, and others. We take the long term view when investing your money. We believe the attractive valuation, strong economic moat, high returns on equity, and long term growth prospects on many of these names make them attractive investments that could drive superior risk-adjusted returns.
In 2020, nearly all the portfolios we managed were able to outperform the market and post superior returns relative to the TSX index.
Before we talk about our thoughts on the market for the New Year, we must caution investors against market forecasters. Each year, hundreds of economists and experts gather together and try to predict how the market might move in the upcoming year. We believe this is highly speculative and unreliable, and we must warn investors that it is not our practice to forecast such things. Rather, we look at the market from a fundamental perspective, and invest based on our views of the attractiveness of each security we analyze.
Looking at the market right now, there is no denying that many asset no longer look like a bargain. There are also some who see evidence that we may be in a bubble. For instance, investors are once again bullish, driving down cash positioning, which is helping push equities to new highs . Furthermore, the IPO market is once again red hot, which could indicate an overheated market . More worryingly, they see that a long term value indicator of the S&P500, the Cyclical Adjusted Price Earnings (CAPE) ratio, has reached a level surpassing that of the 1929 highs . To explain, the CAPE ratio was invented by Yale Economist, Robber Shiller. It divides the share price by the average earnings over the past 10 years, to even out the effects of the economic cycle. When the ratio is high, it could indicate an overvalued market.
In isolation, the above arguments may suggest a market bubble. However, looking at the whole picture helps us reach a different conclusion. For one thing, the US Federal Reserve and other central banks have cut interest rates down to zero, and they are expected to stay low in the foreseeable future. This, combined with unprecedented fiscal stimulus support, makes equities highly attractive vs. other asset classes, such as the low yielding bonds and cash. Further, one of the weaknesses of the CAPE ratio is that it does not account for the discount rate used to value stocks. A stock’s fundamental value is a function of both its future earnings power and discount rates. For example, a high discount rate leads to a lower stock valuation, and vice versa. Currently, the discount rates used to value stocks are at historic lows, thus making stock valuations attractive when taking all things into consideration.
This does not mean that we like all stocks. There are many individual stocks that we would avoid. However, it does suggest that all in all, although equities do not look as cheap as they did 6 months ago, there isn’t much justification that U.S equities are in a bubble.
The coronavirus pandemic still proves to be a source of uncertainty in 2021. Lockdown measures have been reintroduced in many parts of the world . However, with viable vaccines being deployed across the world, we believe an economic recovery is highly likely . Granted, there will be volatility in investments, and the selloff in certain individual stocks will undoubtedly rattle investors from time to time. Nonetheless, as long as we continue to believe in the underlying companies and their management, we deem it prudent to remain invested in them and to ignore the volatility. We encourage our clients to think long term and ignore the short-term price fluctuations as long as fundamentals are supportive.