INVESTMENT ENVIRONMENT1
Source: Orion Advisor Services, AlphaGlider
Equities markets exited 2020 with incredible strength. Foreign markets led the way in the fourth quarter with emerging markets up 19.7% and developed markets up 16.1%. US equities, which had been among the strongest performing national markets this year, was up a massive 12.0%. The broad US fixed income market was up 0.7% during the quarter, led by higher risk issuers.
Emerging markets also led global equities during the full year (+18.3%), narrowly edging out US markets (+17.8%). Developed foreign equities markets lagged despite its respectable 7.8% return. It was a great year for fixed income. The broad US fixed income market up 7.5%, with longer duration paper leading the way.
COVID-19 continued to play havoc in the fourth quarter, killing approximately 150,000 Americans. For the full year, approximately 350,000 Americans died from the virus. The combination of cold weather driving people indoors, poor compliance with masking requirements, and an increase in gatherings during the holidays drove US daily cases and deaths to all-time highs in December. But hope arrived just before Christmas with the rollout of the first vaccines. The US may be able to reach herd immunity as soon as this summer, but it will likely be until 2022 before the majority of the world gets to this level.
Source: Youyang Gu/@youuanggu
Joe Biden decisively won the US presidency in November’s free and fair election. And with Georgia’s January runoff complete, Democrats control both houses of the legislature. However, this control is somewhat tenuous, with a reduced majority in the House and a narrow 50/50 split in the Senate (Vice President-elect Kamala Harris breaks any ties). Regardless, January 20th will bring a sea-change to the domestic and international affairs of the US.
For investors, the outcome appears to be fiscal Goldilocks — enough Democrat control to get a larger fiscal plan passed (e.g. $2,000 stimulus checks, longer extension of emergency jobless benefits, more state and local government aid, infrastructure spending), but not enough Democrat control to raise tax rates on US corporates. Biden is expected to reengage the US with its closest trading and defense partners, as well as with vital international institutions and agreements such as the North Atlantic Trade Organization (NATO), the United Nations (UN), the World Trade Organization (WTO), and the Paris (Climate) Agreement.
Although not as much of a trade protectionist as Donald Trump, 2021 Biden appears to be more so than 2009-2016 Biden, when he when was as the VP under Barack Obama. We don’t expect trade relations with China to improve anytime soon, nor do we expect the US to try to join the Comprehensive and Progressive Agreement for Trans-Pacific Partnership (TPP-11), a trade agreement that Obama and Biden helped spearhead.
On the topic of global trade agreements, China pulled off two important deals with close US allies during the fourth quarter — the Regional Comprehensive Economic Partnership (RCEP) which includes many of the countries signed up to the TPP-11, and an investment agreement with the European Union (EU). The Trump administration lobbied its allies against joining these agreements, but to no avail. Biden’s administration will have its work cut out for it to try to reestablish the coalition of like-minded countries to counter China’s growing economic, political, and military power.
In December, numerous US government agencies and as many as 18,000 companies learned that Russian government hackers had breached their computer networks for most of 2020. The Russians pulled off their massive intrusion by inserting malware into popular network management software sold and supported by SolarWinds, an Austin-based software firm. It will likely be many more months before the magnitude of the intrusion is known and the malware removed from these computer networks. Trump has not yet retaliated against Russia, but Biden has indicated that he will once in office.
With little time left on the clock, the United Kingdom (UK) and the EU agreed to the terms of their future trading relationship which started January 1. The relatively “hard” Brexit avoids tariffs, requires the UK to comply with the EU’s environmental, labor, and social standards, and forces Northern Ireland to follow most of the EU’s rules to avoid the need for a hard border with Ireland, an EU member. Freedom to work and live between the UK and the EU comes to an end, but the UK is now allowed to strike its own trade deals, albeit from a weaker negotiating position than when they were part of the EU. Missing from the deal is the treatment of financials services, a large and important sector for the UK economy. The consensus of economists’ projections on the deal’s impact on long-term GDP levels are approximately -4% (Source: OBR). There are growing calls in Scotland to leave the UK for the EU as a result of Brexit.
2020 was tied with 2016 as the hottest year on record, extraordinary given that 2016 featured a super El Niño event while 2020 had a modest La Niña. Munich Re, the large European reinsurance company, said that 2020 weather-related events killed 8,200 people and destroyed $210 billion in property. Nearly half of this property damage occurred in the US ($95 billon), a result of a record number of named Atlantic storms and the largest wildfires recorded in the western US. The last six years are the six warmest in recorded history.
Those who can make you believe absurdities, can make you commit atrocities.
— François-Marie Arouet (Voltaire)
PERFORMANCE DISCUSSION
Despite being underweight equities during a strong risk-on period, AlphaGlider strategies held their own against their respective benchmarks in the fourth quarter — most of our strategies were within 90-95% of their benchmarks’ appreciation. For the full year, the ratio was close to 90%.
During the fourth quarter, our strategies were helped most by their overweight exposure to emerging market equities (SPDR Portfolio Emerging Markets, SPEM,2 +16.5%; iShares ESG Aware MSCI Emerging Markets, ESGE, +18.9%) as well as Singaporean equities (iShares MSCI Singapore, EWS, +17.7%). Although our underweight position in US equities held back performance, much of what we did own in this asset class did well relative to the S&P 500 (+12.0%), such as all-cap (Vanguard Total Stock Market, VTI, +14.8%; Vanguard ESG US Stock, ESGV, +13.9%), value (Vanguard Value, VTV, +14.6%; Nuveen ESG Large-Cap Value, NULV, +13.3%), and technology (Fidelity MSCI Information Tech, FTEC, +13.7%). Against our fixed income benchmarks, we were helped by our large exposure to inflation-protected Treasuries (Schwab US TIPS, SCHP, +1.7%; Vanguard Short-Term TIPS, VTIP, +1.4%). Our mortgage-backed securities detracted from our performance (Vanguard Mortgage-Backed Securities, VMBS, +0.3%). In a testament to the broad based strength of most asset classes this quarter, we did not own a single fund that declined during the quarter.
As in the fourth quarter, AlphaGlider strategies benefitted during the entirety of 2020 from their overweight positions in emerging market equities (SPEM, +14.6%; ESGE, +18.6%), all cap US equities (VTI, +21.0%; ESGV, +25.7%), US tech equities (FTEC, +45.9%), and inflation-protected Treasuries (SCHP, +10.9%; VTIP, +5.0%).
Our strategies’ biggest detractor during the year was its sizable underweight exposure to US equities — the S&P 500 was up 17.8% for the year. Our developed foreign market holdings all fell short of their global equity benchmark, MSCI ACWI (+16.3%): Singapore (EWS, -8.5%), Europe (Vanguard FTSE Europe, VGK, +5.5%), and developed markets (SPDR Portfolio Developed World ex-US, SPDW, +9.9%; iShares ESG Aware MSCI EAFE, ESGD, +8.2%) and real estate (Vanguard Global ex-US Real Estate, VNQI, -7.2%). Our US value equities also disappointed (VTV, +2.3%; NULV +0.4%). On the fixed income side we were hurt by overweighting short duration during a period of falling interest rates, and by our mortgage-backed securities (VMBS, +3.8%).
OUTLOOK & STRATEGY POSITIONING
The COVID-19 pandemic inflicted massive destruction to both human life and economic value throughout the world in 2020, and will no doubt continue to do so until we get control over the virus. Yet here we are, sitting on diversified portfolios that appreciated in the double digits last year. We all know that the stock market isn’t the economy, but they are linked, especially over the long-term. There have been some positives for the market as a whole (e.g. multiple massive monetary and fiscal stimulus packages) and for some sectors of the market in particular (e.g. the pandemic accelerated digital trends), but the combination of record high US stock market valuations, the steep fall in economic activity, and the recent surge in frenetic speculative activity has me concerned that we are in the late stages of an investment bubble.
I’ve been a professional investor for nearly a quarter century, which has allowed me a front row seat to the bursting of two large investment bubbles — the ’99/’00 dot-com and the ’07/’08 real estate bubbles. Looking back on the months and years leading up to the apex those two episodes, it became clear that valuations in certain sectors were becoming stretched and that the market’s perception of risk and reward was being skewed. My colleagues and I had active debates about when, and how, we should reposition our portfolios, torn between riding our hot hand or ducking into safer and cheaper stocks. We worried that we could blow up our investors if we overstayed our welcome in the bubble stocks, but also that we could fall behind our competitors if the bubble continued to inflate. Either outcome could get you fired, so the stakes were high.
While I’m no expert in game theory, it was clear to me that the system incentivized us, as well as our competitors, to stay invested in the bubble stocks, even as it became obvious that they were grossly overvalued. It takes years for a bubble to form but it doesn’t take too many quarters for an underperforming fund manager to be shown the door. Laggard managers who want to keep their jobs need to at least rejoin the pack, so it’s only natural that they abandon their portfolios for ones that either look like the pack’s (i.e. their benchmark index) or like the leaders’ (i.e. loaded up with bubble stocks). Of course this only causes the bubble stocks to go up further, and causes their valuations to deviate even further from fair value. When the stock market bubble eventually bursts, the funds' investors get burned but their fund managers keep their jobs. Why? Because most of the competitors also burned their funds’ investors. Safety in numbers. Herd mentality is a survival tactic for an underperforming manager. But what’s good for the managers is not always good for the managers' fund clients.
I also observed that fund managers who were early into bubble stocks also tended to hold on to them too long. I think there are many reasons why this happens. One is that it’s only human nature to let success go to your head, or to grow attached to your winners. Another is that the fund manager has a particular investment style or asset class preference (e.g. growth, value, momentum, commodities, emerging markets, tech, etc.) and they tend to stick with it regardless of valuations and the investment cycle. Either way, they ride the bubble stocks on the way up, and they ride the bubble stocks on the way down. It’s the rare manager who can sell the stocks that got them to the top.
Another thing I learned from my front row seat was that it is much easier to identify an investment bubble than it is to call its peak. Identifying a bubble is done by weighing objective valuations against a set of reasonable projections for the asset. Predicting a bubble’s peak, however, is about reading the psychology of the market for which there are no numbers. It’s also a short-term prediction by definition, and predicting any short-term market move is basically a crapshoot. I sure don’t have a crystal ball into calling the peak, but the two previous ones I experienced went out with a bang. Right now we seem to have several of these:
Tesla (TSLA): It was trading at 3x sales a year ago. It now trades at >30x. It’s market cap is roughly equal to that of Toyota, VW, Daimler (Mercedes), GM, BMW, Honda, Fiat-Chrysler, Ford, Nissan, and Subaru, combined. Tesla’s revenue is only 2.2% of these automakers.
Source: StockCharts.com
Bitcoin: Tough to put a value on a cryptocurrency, but I struggle to understand how the market suddenly thought it was worth 300% more over the period of less than four months.
Special Purpose Acquisition Company (SPACs) & Robinhood: These two investment vehicles weren’t invented in 2020, but they did explode onto the scene this past year. Investors desperate to invest in the next big thing dived into SPACs, otherwise known as “blank check companies”. These asset-less shell companies raise money from investors in an initial public offering (IPO) on the promise they’ll go out and acquire/merge with one or more operating companies, usually private ones. Over $80 billion was raised by SPACs during the year, nearly ½ of all funds raised by in IPOs, and up from only $13.5 billion in 2019. Millennials got their first taste of investing with Robinhood, an app that looks like Candy Crush, celebrates trades with confetti, and offers up the chance for a high yield checking account to users who tap the app more than 1000x a day. It also sells their clients’ order flow to the highest bidders so that they can front run the clients’ trades. In December the Securities and Exchange Commission (SEC) fined Robinhood $65 million for misleading its clients on its shady sales tactics. Like in the late 1990s, there appear to be many newly arrived investors being lured in by banks and venture capital.
Source: US Dept of the Treasury, AlphaGlider
Real Treasury Rates: Exiting 2020, all durations of US Treasuries and T-bills were trading with negative real rates. This happened as a result of aggressive price-insensitive buying by non-market players (e.g. the Federal Reserve) and the persistence of inflation. Two years ago you could by a 10-year Treasury and expect to get 1% above inflation (i.e. real return). A year ago you could get a slight positive real return. Now you’re falling behind inflation by a little over one percent a year, for the next 10 years. Greedy and overconfident private investors aren’t the only players behind this investment bubble — governments are also driving it.
Shifting back to the overall US equity market, I think the following four charts accurately capture the extreme valuations that concern us:
Price to Sales: What you pay to for a dollar of revenue. 25% higher than the peak of the ’99/’00 dot-com bubble, 60% higher than the peak prior to the ’07/’08 real estate/global financial crisis. Higher operating margins and lower tax rates justify paying a bit more for a dollar of revenue (more profit and cash flow per dollar of revenue), but we expect we these to revert back toward the mean going forward.
Source: Yardeni Research
Hussman Equity Risk-Premium Model: A modification of the cyclically-adjusted price to earnings ratio (CAPE, Shiller PE) which divides current price by average historical, inflation-adjusted earnings. Chart shows the very strong correlation between CAPE and future long-term returns (12 years in this case). Current CAPE is suggesting -4.9% annual nominal returns for the next 12 years—that’s a total 45% decline! This level occurred two other times last century: just before the Great Depression and during the late 1990s, during the dot-com bubble.
Source: Hussman Strategic Advisors
Market Cap to GDP: The value of the equity market relative to the value of the economy as measured by gross domestic product (GDP) — also know as the “Buffett indicator”. 25% higher than the peak of the ’99/’00 dot-com bubble, 67% higher than the peak prior to the ’07/’08 real estate/global financial crisis. Like with price to sales, a premium is justified by current high operating margins and low tax rates, but we expect we these to revert toward the mean going forward.
Source: Longtermtrends.net
Market Cap of US vs Rest of World: The value of the US equity market relative to that of the rest of the world, as measured by MSCI indexes. Performance leadership went back and forth between the US and the rest of the world’s stock markets from the 1950s until the ’07/’08 global financial crisis. Since then, the US has dominated. The US market now trades at a significant premium to rest of world — we expect reversion to the mean.
Source: Longtermtrends.net
Famed economist John Kenneth Gilbraith once said, “We have two classes of forecasters: Those who don't know — and those who don't know they don't know.” Well, we are definitely in the camp of those who don’t know. The future is unseeable, so the best we can hope for is to increase our odds at being on the right side of a trade. Fortunately there are analytical tools that have been able to do that, but they are only helpful over longer time periods, such as 7-15 years. All of the previous charts show metrics that have proved useful over longer time periods, most notably the CAPE valuation metric (see Hussman Equity Risk-Premium model two pages earlier). It takes takes patience and discipline to successfully execute investment strategies with these analytical tools, both from the fund manager as well from the fund manager’s client.
The apparent investment bubble we are seeing in US equities and global bonds didn’t appear overnight, and thus our current portfolio positioning has been in place for some time. We’ve slowly reduced our exposure to the asset classes we’ve seen grow overvalued, shifting into more reasonable, and sometimes downright attractive, valuations elsewhere. We have no clue as to how long or how far this apparent investment bubble will expand, but frankly, we’re okay with that. We’ve got our eyes focused on the horizon, using our well established valuation tools to steer us to our clients’ long-term return goals.
As a reminder of where we stand, the AlphaGlider investment strategies are:
- underweight US equities where we find valuations to be extremely high
- overweight foreign equities where we find generally fair to attractive valuations
- overweight gold and inflation protected Treasuries, and short on duration in our fixed income allocations to protect ourselves from rising rates and inflation