Insights & Thoughts

4th quarter commentary

Who’d a Thought?

Dec 1, 2020 | Quarterly Commentary

Despite all the terrible news from this past year, the U.S. stock and bond markets ended at all-time highs fueled by the largest government stimulus program in history and optimism that the economic shutdowns will soon be over. The S&P 500, Dow Industrial Average and NASDAQ all finished at record highs. Bonds prices also did well as a result of the Federal Reserve’s zero interest rate policies.

The S&P 500 gained 18.4% while the S&P 400 MidCap index advanced 13.7% and S&P 600 SmallCap index rose 11.29%. There was a clear distinction based on size within the stock market as larger companies faired better than smaller ones. In fact, many of the biggest companies actually saw their businesses benefit from the lockdowns. This was especially true for the largest names in the tech industry. As we had mentioned earlier, six companies now dominate the S&P 500 (Apple, Facebook, Google/Alphabet, Amazon, Microsoft) and make up a quarter of its value. It’s little wonder that index did so well.

On the surface it seemed counterintuitive that the markets would behave this way in light of the near complete shutdown of the economy for so many months. The question that many investors have is why and is this sustainable? The answers to both of these questions lay in the data. Because the biggest component of GDP is consumer spending, it’s worth a closer examination of those trends.

The pandemic led to the sharpest economic contraction in modern history. GDP dropped 33% in the second quarter alone which sent stocks tumbling 34%. By June, tensions eased and workers returned to work virtually. This meant that overall disposable income rose as people traveled less, dined out less and had fewer activities. It appears people used much of that disposable income to pay down debt and spend on bigger items.

What we’ve seen in the last few months is a massive resurgence in durable goods spending. These are items such as electronics, home improvement related spending and auto sales. As a result, manufacturing and industrial production has strengthened significantly in the second half of the year. Because the stock market is always forward looking, we can largely attribute the stock gains to these data points.

The winners and losers in the pandemic can be seen in the sector performance within the general stock market. The big winners were technology and consumer discretionary sectors while the losers were energy and real estate. There was over a 50-percentage point difference between these two groups.

These trends give us hope that we will continue to see gains in 2021. The vaccine rollout is in full swing and should allow more mobility in society. This will hopefully lead to a more even recovery across the economy. There aren’t likely going to be big gains in the best performing sectors from last year, but the stragglers should play catchup. For this reason, we think small and mid-cap stocks will fair better in 2021. Value stocks may have a good year too.

Interest rates are still a concern for us. Prior to the pandemic, interest rates were finally beginning to normalize after the financial crisis. The Fed was finally making headway in unwinding its bond portfolio it had accumulated via quantitative easing in 2008-2010. Those same policies were used again to prop up the economy but were expanded to include a broader range of bonds that they would buy. The Fed is now in competition with other investors in much of the bond market. Their buying essentially puts a floor under market prices and limits the yield investors earn. Generating income has become a serious problem for retirees and other traditional bond investors such as insurance companies and pension funds. This directly impacts the amount of money needed to retire on and the ability of institutional investors to meet their pension and cash flow obligations.

The Federal Reserve is in a tough spot. Many investors need higher rates but the government is going to have a hard time servicing its expanding debt (now almost 28 trillion). Every 1% increase in rates will cost the government $280 million more in interest per year. We’re probably 3% below normal now. Deficits matter and spending is the problem.


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