360 Private Wealth Management: 2020 Fourth Quarter Investment Commentary and 2021 Investment Thinking Framework
The 2020 Rearview Mirror – 2021 Crystal Ball Edition!
Anyone who has been to my office has seen these objects on my desk; a rearview mirror from a 1974 GMC ¾ ton truck and a crystal ball… This image is from a picture I took. You may also have heard me suggest that I refer to these two devices often in my daily work… I use them as props and metaphors for the challenges I face as an advisor and the challenges you, as clients, contend with in trying to build wealth and maintain financial security. Metaphorically speaking, the rearview mirror gives me detailed info on everything that has happened as far back as I care to look… On the other hand, the crystal ball has been on my desk for well over ten years now. As hard as I stare into it, it has failed to provide me with any useful insight or prescience I can use in guiding my clients in their search for financial well-being. All I ever hope to be, over time, in my work here, is approximately right in my advice and actions. I take no credit for any exceptional results we achieve, when they happen from time to time, above the “approximately right” benchmark… Anybody who would is either a charlatan or a fool. Life has taught me that…
So welcome to the “2020 Rearview Mirror – 2021 Crystal Ball” edition of our ongoing market updates!
Looking back and looking around now…
2020 was an interesting year to say the least. I didn’t think rushing to get a year-end commentary out this year was as important as waiting for some of the events earlier this month to play out. The political events earlier this month in the U.S. were significant. The change in government there will likely have a bearing on the performance of different sectors of investment markets in the U.S. and elsewhere going forward. I thought it might be better to wait for some of this to play out and then pen some notes that might help put 2020 into perspective, while providing some guidance for investment decisions in the year ahead.
This time last year, Canada announced its first case of COVID-19, the mysterious new virus which had gripped parts of China, which was quickly showing up in countries around the world. In the weeks and months that followed COVID-19 quickly turned into a pandemic, triggering a global shutdown and the worst economic crisis since the Great Depression. And yet, by the end of the year, investment markets around the world markets had recovered beyond expectations.
Last March, all eyes were on the S&P 500, S&P/TSX, Nasdaq, and MSCI EAFE Indices as they fell approximately 34%, 37%, 30%, and 34%, respectively. Every broad investment market downturn in history has led to an upturn at some point, and this time was no different – except perhaps the speed at which the drop and rebound occurred. The S&P 500 closed at the end of 2020 with a record high price index, up 16.3% year to date, and the S&P/TSX, Nasdaq, and MSCI EAFE year-end price indices were up 2.2%, 43.6%, and 5.4%, respectively.
These numbers are impressive and at least a bit puzzling, considering the pain being suffered by societies and the broader economy over the course of the year. In fact, the markets and the broader index performances highlighted above don’t tell the real story.
As 2020 drew to a close, many parts of the world were under some form of lockdown, healthcare systems were under strain, and many businesses, especially smaller companies, were on the verge of going out of business. There is no doubt the social, health, and business environment created by the COVID-19 pandemic created business winners, especially in the essential consumable, tech, and healthcare sectors. However, for every winning business sector, there was a sector, and thousands of individual businesses, which suffered significant losses as the grip of the virus wore on.
Indexes are constructed of businesses from all sectors. What happened was businesses and sectors that gained most from the pandemic gained the most in the indexes in 2020. In fact, the winners in the pandemic have gained so much in value that they literally washed away declines of the most adversely affected businesses and effectively carried the broader indexes higher. In some cases, the valuations achieved by some of the biggest darlings of the past 12 months have no connection to reality, current or projected. Some valuations are even nonsensical. The fundamentals don’t add up. The result is distortion in the indexes where there is, in effect, if one can picture it, a barbell with 20 smaller five-pound plates on one side and two, fifty-pound plates on the other. You have a few so-called “mega-tech+” pandemic-winner companies from a valuation perspective countering the impact on the index of the many companies that did not benefit and, in many cases, were hurt by the pandemic. Here in Canada, we have come to call this phenomena the “Nortel” effect (or, more recently, the Blackberry effect) on the index in question, when the index becomes incredibly lopsided.
This has happened before, the most significant example being the markets leading up to and in the very early months of the new millennium, tilted to internet and tech stocks. Investors and talking heads all said, “this time it’s different”! It was the age of day-trading. Investors ignored fundamentals and traded on momentum, otherwise known as the “greater-fool” investment philosophy. The greater-fool investment philosophy follows the mantra of “no matter what I pay for this investment today, someone is sure to pay me more tomorrow!” Fundamentals? Who cares? The power of the web has now added fuel to this investment philosophy. A whole new cohort of retail investors is willing to invest on this basis. It ended quite badly that time, as it has time and time again before that. Will this time be different??? Maybe, but not likely.
One very interesting extension of the ‘greater fool investment philosophy” is presently playing out in the recent valuation run-ups occurring on heavily shorted stocks. The increases in prices on these stocks is the result of “quasi-organized” groups of retail investors targeting large investors (i.e., hedge funds) holding large shorts on companies with poor future prospects. Shorts effectively make money when target stocks fall in price. For the record, we do not practice this strategy because of the heightened risk associated. The short strategy involves effectively “borrowing” stock from existing shareholders and then selling the stock at the current price, waiting for the stock price to fall, then buying the stock back and returning it to the source. The difference is profit.
A number of high-profile investors have made extreme amounts of money using this strategy over the years. They are not always well-regarded in the market but they are an effective part of making sure companies do their best for their stakeholders (shareholders). Historically, poorly managed companies have risked being hurt by investors using a short strategy. The current situation has turned the tables on investors using the short strategy, effectively creating something called a “short-squeeze” where short investors are forced to buy stock at much higher prices than where the short was established to cover losses. One very recent example of things going wrong in this space involves a company called GameStop and the once very successful hedge fund, Melvin Capital. Melvin Capital incurred multi-billion-dollar losses in closing out its short position in GameStop. The traders on the other side of the trade made significant profits. We will have to wait to see how, and even if, this phenomenon continues. There are rumblings the U.S. Securities and Exchange Commission is now investigating online chatroom activities where these strategies are being hatched and organized. In the meantime, there is a move by many short-sellers to reduce their short positions or risk an attack by the retail chatroom crowd.
The momentum trade, this time, is being driven, at least in part, by the massive injection of liquidity on the part of governments and central bankers. Not all of the money sent out was spent on essentials. A recent survey by the Federal Reserve Bank of New York on the use of COVID-related stimulus payments from the U.S. government suggested as much as 65% of the COVID-related payments received over the last 12 months were NOT used for day to day living expenses. Rather the $$$ was saved or used to pay down debt. At least some of the money being saved is finding its way into investment markets. The result is stimulus money is driving part of the markets’ moves these past several months. It is notable for investors that the new U.S. government’s first move has been to send additional new COVID “relief” money to households. Given that development, it would be reasonable to expect the momentum trade to continue here in the short term, unless some new negative reality emerges with the virus…
In the last quarter of 2020, we got some good news in the form of vaccines, which seemed to be providing resistance to the COVID-19 virus. Emergency use filings have brought us a couple of vaccine options that are already being manufactured and administered. It is likely several more promising options will soon follow. The hope is that we can finally come out of lockdowns and isolation and return to some form of normal. It would be reasonable to expect the massive amount of liquidity injected into households and the economy will fuel a pretty significant surge in global economic activity as we emerge from the COVID economic fog. This should allow all businesses to benefit, but especially those in sectors most adversely affected by COVID as we venture out again, returning to offices and going to restaurants and entertainment venues, and as we travel and stay in hotels and resorts.
Thoughts about the rest of 2021 and beyond…
We see 2021 being a pretty good year for economies around the world, barring any new negative news regarding new variants of COVID and the inability to adapt our responses. Economic activity should gain momentum as the year progresses and vaccinations increase. In fact, investment markets are counting on it. Any hiccups along the way could cause markets to give back some of the gains made since the bottoms endured in the spring of 2020.
The areas we need to be wary of are the very sectors that enjoyed a lot of success in 2020; sectors like tech, health care, and even some essential consumable firms; especially those tied to the virus’s effects on day-to-day life and working and playing at home.
The areas where opportunity may present itself will be in the broad range of companies who will benefit most from vaccination and a return to normal.
We see relative strength in the Canadian dollar. It is trading at 79 cents U.S. as I write. It would be reasonable to expect to see it remain close to this level or even, maybe, inch a bit higher as oil prices likely improve with economies opening up and demand continuing to improve. There is an effort on U.S. lawmakers and central bankers to keep the USD at lower than historic valuations to boost domestic economic activity and dissuade companies and consumers from buying products and services offshore.
We believe more significant inflation may emerge again in 2021 and beyond. This would be a reasonable expectation, given the amount of liquidity pumped into the economy in 2020 and again early this year. It may take a year or two, but I can see inflation moving closer to the top of the Bank of Canada’s target range (3%). The rub may be that increases in inflation will happen quicker than increases in interest rates on savings accounts, GIC’s and other fixed-income investments. The result could be hard on households holding large portions of their $$$ in these sorts of instruments. The effect of such an environment is that the $$$ they have invested in these sorts of investments will be that the real value of the investments (the value after tax and inflation are applied) will actually go down, even after adding any interest earned… Not a great prospect.
This is not a time to sit on the sidelines but a time to make calculated investment decisions. And if the markets do pull back at some point early in 2021, we need to remember what happened last year and be ready to take advantage of any investment opportunities that emerge.
The bottom line? As always, know your risk capacity. Diversify your holdings across asset classes and investments, in line with your risk capacity and need for cash and income. Regardless of what some recent media stories might suggest, the market is not a casino!
As always, if you have questions about the markets or your investments, we’re here to talk.
David J. Luke, CFP, RFP, CLU, CH.F.C., CIM | Financial Advisor
360 Private Wealth Management | Manulife Securities Incorporated
Unit 1 – 25 Scurfield Boulevard, Winnipeg, MB R3Y 1G4
Main Office 204.925.5868 | Direct 204.925.2073| Fax 204.925.2263 | Toll Free 844.688.3656
This publication is solely the work of David Luke for the private information of his clients. Although the author is a Manulife Securities Advisor, he is not a financial analyst at Manulife Securities Incorporated (“Manulife Securities”). This is not an official publication of Manulife Securities. The views, opinions and recommendations are those of the author alone and they may not necessarily be those of Manulife Securities. This publication is not an offer to sell or a solicitation of an offer to buy any securities. This publication is not meant to provide legal, accounting or account advice. As each situation is different, you should seek advice based on your specific circumstances. Please call to arrange for an appointment. The information contained herein was obtained from sources believed to be reliable; however, no representation or warranty, express or implied, is made by the writer, Manulife Securities or any other person as to its accuracy, completeness or correctness.