It is hard to believe how things have changed in a year. This time last year we were just starting to experience the true impact the COVID-19 virus would have on our lives. In writing our Q1 Market Commentary last year, it was in the midst of a 15-day nationwide, or almost nationwide, lockdown in an attempt to “flatten the curve.” We had experienced a 34% decline in the S&P, we were just starting to get our bearings in the new Work From Home world and we here at CWM we were hard at work rebalancing portfolios to take advantage of tax loss harvesting while positioning for what was anticipated. We were also monitoring & evaluating the events that were unfolding globally, and trying to peek just a little into a very uncertain future. In preparation for writing this quarters commentary, we took a look back the commentary for this time last year. Even with a healthy dose of realism, boy were we a little naïve.
A year later we are only just starting to come out of the fog. Restaurants are still at limited capacity. We at least had the Masters Tournament in April with a few spectators. Dr. Fauci is still trending in the news though now he and 200 million other Americans are either fully or partially vaccinated. And right when we were starting to get comfortable with cryptocurrencies, now we are all googling what on earth a Non-Fungible Token, or NFT, actually is.
Lucky for us, the markets in their efficient wisdom, knew these brighter days were to come. As of March 31, 2021, the S&P 500 clocked its largest one-year price increase in more than 80 years at over 78%*. To give that some context, after the 2008 financial crisis, it took the market a little over 25 months to get to that point. If we look back further following the 2002 tech bubble, that same price increase took 46 months or almost 4 years!
As we know, much of the S&Ps gains last year came from a small subsect of the market. Growth stocks, particularly tech growth stocks lead the charge. If we take out just the Big 6 (Facebook, Amazon, Apple, Google, Microsoft and now Tesla) the S&P’s 18% performance in 2020 drops to 10%. All things considered, 10% is nothing to sneeze at, but if we delve deeper, we saw 200 of the 500 companies that make up the S&P500 finish in the red at the end of last year**. Much like the economic recovery, the rebound was not as widely felt as the headlines would lead one to believe.
Continuing its upward trajectory of last year, the S&P was up 6.2% in the first quarter of 2021. If 2020 was the year of the tech stock, 2021 is starting to shape up as the year for value. After a much maligned 10 year period of underperformance compared to Growth, value stocks are finally making some head way. As of March 31st, Large Cap Value has outperformed Growth by 10.4%. Mid and Small Cap Value are also in the groove out performing their Growth counterparts by 12.5% and 16.3%, respectively^. What’s encouraging is that since the March lows, both Mid and Small Cap Value have outperformed Growth Mid and Small Caps, by about 10%. This makes sense as the reopening of the economy will benefit smaller companies. In the past few weeks, Growth has made a resurgence but we are still Value tilted in the portfolios as their current PEs compared to their 20-year averages are significantly more attractive. Where
Growth is trading at on average over 2x its 20-year average PE, Value on average is trading at just 1.25x^. As expected, sectors like Energy, Financials and Basic Materials, that often lead during the early stages of recovery posted 30.67%, 13.01% and 11.27% returns since the beginning of the year. Technology lagged all others posting just 1.94% so far this year.
As the global campaign to vaccinate people worldwide progresses, international markets also saw positive returns in Q1. The developed international market was up 3.5% with emerging markets trailing at 2.3% for the quarter. In relation to domestic stocks, we are also maintaining a slight overweight to international, with a pretty healthy allocation to Emerging Markets. This is primarily an organic result of our emerging market position doing so well in 2020, and our belief that emerging markets as an asset class are poised to do very well as the global economy comes back online and as the dollar weakens. Again, if we look back at the history books, we know Emerging Markets were the best performing asset class five years in a row between 2003 and 2007, followed closely by developed international and then domestic small cap****.
As much focus as the equity markets have received, it seems like everyone is even more engrossed on what’s happening to fixed income or bonds. Particularly, what the effect of inflation might have on yields. Despite the Fed’s continued insistence that it would not raise rates for the foreseeable future, the bond markets (a notoriously fickle and cynical bunch) aren’t buying it, as the Barclay’s Agg dropped 3.4% in Q1. It was appearing, for a little while at least, that bond investors were testing the Fed as Treasury yields started to rise. But the sell-off of these government bonds, pushing prices down and yields up, wasn’t coming from domestic holders, but were concentrated during the Japanese trading sessions, with additional selling coming during the London trading sessions. An astute analyst finally identified that Japanese commercial banks were selling off their US Treasuries ahead of the end of the Japanese Fiscal year on March 31st, because the Nikkei posted its greatest performance in decades and banks didn’t need the income from these bonds^^. This sell-off had a domino effect as we saw both bond and equity markets wobble a bit in late March. As the Japanese fiscal year has come to an end, things have stabilized a bit and we are already seeing Treasury yields come down, with the 10 year now below 1.6% after peaking at almost 1.75%.
Even though we can explain the rise in Treasury yields to an extent, we may be starting to see some slight inflationary pressure with more to come. The latest personal consumption expenditure deflator (the Fed’s preferred measure of inflation) showed a 1.5% year-on-year increase in January. This is well below the Fed’s new target of an average of 2% inflation. This means that the PCE inflator could rise beyond 2% for a period of time before the Fed might take action. It is certainly reasonable to assume that we will see this level of inflation as early as the second quarter of 2021, particularly with stimulus checks now hitting bank accounts, but the theory that the economy will start overheating as people buy more than they need to in an effort to avoid tomorrow’s high prices seems, at least for the time being, a little far-fetched. That sort of destructive inflation is something we will be keeping an eye out for if it appears the Fed isn’t going to shut off the tap of easy money once the economy has fully recovered.
Given the uneven nature of the recovery and the Fed’s dual mandate of price stability and full unemployment it will be interesting to see how the Fed responds. As recently as his March 17th comments, Fed Chair Powell seems to be placing more emphasis on full economic employment, particularly among demographics that were hardest hit during the down turn. Based on the Fed’s stated key indicators and where we are in relation to those marks, it may be a while before the gaps start closing. Despite the Fed’s continued insistence that it will be making decisions based on the data, the markets are still taking a wait and see approach. Rising inflation, even in the slightest in Q2, will continue to fuel the market’s extrapolation of rising rates beyond where we will probably see them go. Whether the markets will eventually believe Chair Powell remains to be seen.
Make no mistake. We are still battling the spread of the virus. While investors were rewarded in 2020, and handsomely so, many Americans remain out of work, businesses were shuttered and lives turned upside down. Though some days it feels like its two steps forward and one step back, it’s a welcomed change to see the world begin to reopen. You might be planning to see loved ones you haven’t seen in over a year, plan that vacation you had to cancel or maybe its just a night out with friends at a local hangout. Whatever your plans are for 2021, I’m sure you, like us here at CWM, will have a new found appreciation for just having the ability to do these things again.
I want to continue to thank everyone who we have had the honor to work with. We know, as always, there is a lot of work to be done and we are honored to do it on your behalf.