At the end of 2019, no one predicted that the unemployment rate would hit its highest level since the Great Depression and most Americans would struggle financially; US national debt would cross $27 trillion, an increase of almost $5 trillion; GDP would shrink 3.5%; average wages would decline but household incomes would increase, thanks to government stimulus checks; yet the stock market would hit new highs, delivering a double-digit rate of return(1).
The economy and, by extension, the securities markets have been supported by the friendliest financial conditions in US history including: a negative real rate of interest, liberal fiscal policy, business subsidies, stimulus checks for most individuals, and a ballooning Fed balance sheet used to buy treasuries, agencies, and now corporate bonds.
People were fearful of what might be. As is usually the case, however, more things could happen than will happen. We certainly did not predict that 2020 would unfold as it did, but did comment in Q1 2020, when fear was near its peak that:
“…the world isn’t coming to an end. The impact on the Nedgroup Investments Global Flexible Fund is largely a mark-to-market exercise in the midst of the most unsettling series of events that many of us have ever experienced.”
Market returns are never average
Investors typically anchor to the average annual market return, while disregarding that the actual annual returns vacillate tremendously around that average.
Ironically, people will one day look back at 2020 and see a year that delivered a market return of approximately 2x the long-term average. There will be less attention paid to the market having declined approximately 34%, only to then rebound approximately 67%(3). That’s comforting in a way as it suggests that this unusual year was not really so abnormal.
Investors focus on average annual stock market returns without often appreciating that the stock market never returns the average. Long-term equity returns are achieved with significant variability around the mean. The MSCI ACWI Net Return Index has returned an average of 6.1% over the past 20 years, but in only three instances were the returns even within 2% of the average. In 65% of the cases, the returns were more than 10 percentage points higher or lower than the average, with a 77% spread between the best and worst years (34.6% in 2009; -42.2% in 2008).
A COVID-free world?
The pendulum swung hard to the downside in March 2020 and has subsequently swung even harder to the upside since those market lows. That happened sooner than we expected. Far be it from us to say this rebound was overdone, but there’s little question that the markets are pricing in a COVID-free world.
In comparison to trailing indicators, large-cap US stocks (S&P 500) trade at 22.3x forward earnings at year-end, 45% higher than the 20-year average. Larger market cap companies based outside the U.S. (ACWI ex-U.S.) trade less expensively at 16.7x, although still 25% higher than its 20-year average(6). These higher valuations can, in part, be supported by lower interest rates and the higher growth rates of many businesses. However, ~12% of the S&P 500 now trades at more than 10x sales – its largest percentage and more than during the dotcom bubble. Only time will tell if it is truly different this time, but it has always been dangerous to utter those words during previous periods of market exuberance.
Mind the gap…!
It's interesting to see how people find solace in different industries in which they have little grasp of the economics, let alone what might be the right price to pay. Momentum, more than understanding, drove the Nifty 50 in the 70s; Oil stocks in the 80s; Tech stocks in the 90s; Diversified industrial stocks and certain financials - like General Electric and Bank of America in the 00s; and now back to technology and healthcare stocks today(7).
This has led to a clear bifurcation in the market with a widening gulf between the haves and have-nots – as pronounced as we have ever seen it. The valuations of many “haves” are too rich for our blood and are less likely to deliver reasonable returns over time, despite many high quality businesses in the mix. The lower valuations of the “have-nots” can often be appropriately justified by the secular challenges these businesses face. As price conscious investors, we focus on the cohort in between. Much of the oxygen in the room has gotten sucked up by those stocks that have been “working”, leaving the share prices of many good businesses gasping for air.
Navigating through uncertainty
Grounded in the philosophy of not paying more for an asset than we believe it is worth, our true north remains bottom-up security selection. We evaluate the risk/reward of each of our investments over a three to five-year period, and innately believe that anything less is speculation. As risky as investing in stocks appeared at the March 2020 lows, particularly with regard to the financial, travel, and aerospace sectors, we would argue that higher stock prices today, all else equal, translates to greater risk.
We therefore expend the bulk of our energy and capital on those businesses that we believe offer secular growth, good returns on capital, have operators who are either owners or function with an owner mentality and, finally, trade at prices that should allow for an acceptable rate of return over time.
Price may not matter over the short-term, but it certainly does over the long-term. The Nedgroup Investments Global Flexible Fund’s portfolio will hopefully continue to prove that point. What was a bad year in March 2020, turned into an above-average year by December; emphasizing how noisy short-term performance can be for long duration assets. From a valuation perspective, we believe the Fund is well-positioned for future performance, although more relatively than absolutely. And we have available liquidity that will allow us to capitalise on future opportunities.
Although we don’t like losing money, we can’t forget about making money. This balance between capital preservation and appreciation must always consider the macro environment: the sovereign desire to inflate, the continued low interest rates, and the negative real return on cash. Given that setup, if we can continue to be successful with our equity security selection, then we should run the Fund more invested even if that may involve greater volatility.
We will continue to pay closer attention to how things might unfold over time, rather than to emphasise any moment in time.
(1)The MSCI World Index returned 15.9% (USD) for the 2020 calendar year while the S&P 500 gained 17.8% (USD) for the same period. Source: Morningstar
(2)Source: Bureau of Economic Analysis. Data is from March 2020 through November 2020 and compared to the same time period in 2019.
(3)Source: Bloomberg. As of December 31, 2020. The ‘market’ statistics noted refer to the S&P 500 Index.
(4)Source: Bloomberg. As of December 31, 2020.
(5)Source: Factset. As of December 31, 2020. Data is represented by the respective indices in the charts.
(6)Source: J.P. Morgan Asset Management, Guide to the Markets. Slide 55. As of December 31, 2020.
(7)Nifty 50 was an informal designation for fifty popular large-cap stocks on the New York Stock Exchange in the 1960s and 1970s that were widely regarded as solid buy and hold growth stocks, or "Blue-chip" stocks.
(8)Source: Bloomberg. As of December 31, 2020.