As far as financial assets are concerned, 2020 was a banner year. Not so much for everything else. There is no need to rehash the challenges that we all faced last year – it is onward and upward from here!
The S&P 500, which is an index of 500 stocks weighted/ranked by the size of each constituent, returned 18.4% for the year 2020. That’s because the index is dominated by a handful of megacap technology stocks. The equally-weighted S&P 500 was only up 10.9%…a difference of 7.5%! It is remarkable that a handful of mega-cap tech stocks can carry an index of 500 stocks to such an outperformance of its equally-weighted self! Value stocks were a different story as they barely budged. The Russell 1000 Value, an index of large company value stocks, only increased 1.4% for the year. Gold rose 25.4%, the 10-year Treasury bond returned 10.6%
If one truth about investment markets became evident in 2020, it was that a tanking economy can be great for asset prices, especially the stocks of super-speculative and money losing businesses. This is because of the countercyclical nature of Fed intervention and the price-distorting effect of interest rate manipulation and Fed bond-buying. And it is also magnified by the short-term opiate-like effect of huge increases in debts and deficits. Lost on traders, whose focus is on positioning for the next few days, is the drag on future economic growth and the prospect for inflation that such massive debt potentially brings to our economy.
What does this mean for the future and for long-term oriented investors?
When reflecting on investment markets and thinking through appropriate strategies for chaotic times, it is important to remember that cycles and reversion to the mean happen. There are cycles that can be observed everywhere in nature, as well as in investment markets. These cycles can provide us a framework so that we’re not taking the wrong risks at the wrong time.
Cycles give us a reference in how to carry on because we learn from the past. The earth rotates on its axis once every 24 hours. It revolves around the sun once a year. Seasons change predictably, tides go in and out, and the moon waxes and wanes with predictable regularity. Comets come and go, as do ice ages, monsoons, animal migrations, cicadas, and even musical compositions have cycles – a pulse and a verse-chorus pattern.
Human biology has its own repeating patterns as does human emotion, which in turn drives behavior. And it are these very emotions cause investment prices to ebb and flow as depicted in the chart below.
Granted, without efforts by the government to eliminate periods of price declines, these patterns would probably be more predictable, but certain patterns underneath the market itself can help guide our positioning.
As I have mentioned in previous letters, growth stocks have outperformed value stocks since 2007 (the longest period ever recorded). But this growth-value preference waxes and wanes over ten- to twenty-year cycles. It has cycled six times since 1960 (as the chart on the next page indicates). The chart is about 5 years old, so it is at a much more extreme point today where growth has outperformed value, which is precisely why we favor value-type stocks. We believe there is very little risk in value stocks, and extreme risk in the high-flying tech stocks – mostly due to price distortions resulting from government interventions, cheap credit and an incentive to speculate.
Value Stock – Growth Stock performance relationship
(rising line depicts value stocks outperforming growth)
Also, at an extreme is the outperformance of equities vs. commodities (chart below). The relative performance also follows long cycles and if we look at how depressed energy and resource stocks are compared to the euphoria and record high valuations seen in tech and growth type stocks – the sentiments are polar opposites. Today is an opportunity for those that don’t own resource stocks to own some, and for those who own high-flying tech stocks, to get rid of them and reduce their downside risk – a lot.
At the present time, it is generally accepted that there is no (or very little) inflation. However, when one considers the effect of microscopic interest rates and the astronomical amount of capital now needed to fund a low-risk retirement, inflation has been off the charts.
To explain: Let’s assume that one wanted to invest their retirement savings by rolling 6-month CDs because they didn’t want exposure to credit risk, interest rate risk, or market risk. The average 6-month CD during the entire 1990s paid 5.24%1. If one could live off of $52,400 per year (average) for ten years (in 1990s dollars), they would have needed to accumulate $1,000,000 investable assets by the beginning of retirement in 1990. Fast-forward the clock to 2010, if one retired in 2010, they would have needed $20,154,000 to earn the same income because the average 6-month CD rate for the period 2010 –2020 was 0.26%2.
While we haven’t seen a huge increase in general prices (although this is debatable), what we have seen is a massive inflation in the amount and types of risks that people need to assume to maintain their standard of living. The necessity for assuming more risk is a form of "cost" and challenges the idea that there has been very little inflation simply because price increases have been modest. The "inflation" of today is in the amount of risk that needs to be assumed by retirees relative to the retirees of 30 years ago. This is precisely what the zero interest rate policy of the Fed has achieved – it has absconded from retirees by forcing them to take undue risk, and handed that benefit to stock market speculators and private equity purveyors.
Recently, famed investor Jeremy Grantham said, “The long, long bull market since 2009 has finally matured into a fully-fledged epic bubble.” He goes on to say, “Featuring extreme overvaluation, explosive price increases, frenzied issuance, and hysterically speculative investor behavior, I believe this event will be recorded as one of the great bubbles of financial history.” He compares this period to the South Sea bubble, the 1929 market crash, and the dot-com boom of 2000.
I don’t bring this up to alarm you, or to suggest that people should go to cash or any of that. In fact, Grantham mentions a good place to be right now is in value stocks and emerging market stocks, both of which we own. I believe the bubble is in the prices of today’s market leaders and in private equity, not the investments that have been depressed for a decade. So those people who simply own “the market” will likely suffer, because “the market,” as defined by the S&P 500, is dominated by risky high-flyers. This is what happened after 2000 – the S&P was flat for 10 years.
If stock prices decline, the Fed will certainly intervene to try and stop it, and the dollar will weaken, and, if the economy grows, inflation may begin to rise. This is a scenario that very few are expecting and that is not priced in. Going forward, there is a strong likelihood that yesterday’s losers will be tomorrow’s winners and vice versa. That is simply the way of it in markets and we are ready.
We believe that our investments do not carry a huge amount of long-term downside risk since many of them are already out-of-favor, ignored and get little-to-no press. It is the folks who are currently loaded up in popular high-flying technology and stay-at-home stocks who should be worried. We have always maintained that the best way to invest is to ignore benchmarks and simply work to earn high risk-adjusted average annual returns. The key word being "risk-adjusted," which means to avoid permanent losses. And that, in turn, means not overpaying and avoiding bankruptcies. We feel strongly that over the long run, with this focus we will significantly beat many benchmarks and carry less risk no matter what the Fed does or doesn’t do.
Thank you for considering Highgate Securities Investments to help meet your investment goals. We can be reached at 303-968-1230, or by email at firstname.lastname@example.org. We are happy to perform a no-obligation, objective portfolio evaluation for you.