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The Brave Report: Market Commentary for January 2021

Click here for .pdf version of this report: The Brave Report-January 2021

What just happened?  This wraps up one of the craziest years on record, both as a country and for the stock market.  We have seen the country (and world) deal with an unprecedented situation and the market has somehow remained resilient, with some areas of the market seeing record returns.  There has been a very uneasy disconnect between the Main Street economy and the stock market, but this disconnect is not without reason.  As we start the new year (albeit on a very crazy note) we will have to start to dissect how much of this economic damage is permanent and how quickly we can get back to normal, whatever that ends up being.

I wrote most of this commentary prior to the events of January 6th so it is not mentioned. I do not see them having a major impact on anything I discuss below; however, I will add one thing. Hopefully, these embarrassing events act as a springboard for unity amongst our politicians and they are able to finally believe that there are things that are broken in this country and the only way to fix them is to work together. The divisiveness in the country has been growing for years but most of our leaders were blind to it or even culpable in its creation. Often it takes a boiling over to wake the masses up to hard realities. Hopefully, this is that moment for our politicians and they are able to put political ambition aside to do what’s best for our country.  We saw glimpses of it as they certified the electoral votes and spoke out against the violence, but much work remains. If we can see some unity and cooperation there is no reason the market rally we are seeing cannot be justified and continue.  Let us remove the mantra that “if you don’t agree with me then you are wrong” from our political lexicon.  Businesses operate in this fashion and use disagreement as an opportunity for growth. Politicians need to do the same.

Market Overview

The markets followed through on their strong November to finish the year even higher.  The Dow and the S&P 500 both gained more than 3% on the month and the NASDAQ surged 5.6%.  This brings the final 2020 totals to 7.25% for the Dow, 16.26% for the S&P 500 and an amazing 43.64% for the NASDAQ.  What makes these return numbers even more impressive is that at the lows in March, the Dow and the S&P 500 were down 30% and 27% respectively and the NASDAQ was down over 17%. It is not surprising that the tech-heavy NASDAQ was the big winner on the year as the pandemic forced the acceleration of technological adoption and innovation by consumers and companies alike. One of the big questions going into 2021 will be how much of the economy will revert back to old ways once the pandemic is over and how much will be permanent.

For the month of December, the rate complex was quite stable, trading in a relatively narrow band throughout the month.  We saw a slight steepening of the yield curve but the 10-year treasury spent the majority of the month yielding in the low 90 basis point range.  While December was quite tame, if we zoom out and look at 2020 as a whole, we saw quite a different story.  With the onset of the pandemic back in the first quarter we saw rates on the 10-year drop from near 2% all the way down to 0.4% before stabilizing and slowly rising to current levels.  An increased need for continued monetary easing and the desire of the fed to keep rates low until the economy can recover should keep rates relatively low as we work our way through 2021

Crazy Year: 2020 marked one of, if not the craziest years I can remember since I started in the business more than 16 years ago.  The pandemic torpedoed an economy that came into the year in very stable shape.  We have never seen the type of short-term economic damage that we have seen over the last 10 months.  The country was brought to a standstill, businesses were shuttered, and leisure and travel activities were all but erased throughout the spring.  There will be years and years of Monday morning quarterbacking to discuss what the proper response to the pandemic should have been, both from a health standpoint and an economic standpoint, but that won’t change the fact that real longer-term damage was done to the economy.  It will be years till we fully understand the full breadth of the damage, but one just must walk down the street in any city or town to see dozens of closed businesses. Some will return, but many will not and coming out of the pandemic we will see a very different business landscape.

With all this doom and gloom, especially on the small business side, the stock market showed a different kind of resilience.  After a sharp selloff in the spring, the market rebounded rapidly to finish the year in very positive territory, especially in the tech-heavy NASDAQ. This was also in the face of a continued trade war with China and one of the most contentious elections in history. As a casual observer, the disconnect between the Main Street economy and the stock market doesn’t make sense. However, there are a number of factors that helped to prop up the stock market and allow it to reach new highs:

  • Timeframe: I have discussed this in past reports but one of the major differences between small businesses and larger corporations is the time frame they operate on. Small businesses are looking out a quarter to maybe a year or two. They often operate on much thinner margins and with a lot less operating capital.  A larger, publicly-traded company often has the luxury of planning over a longer time frame.  The way their stock is valued is also based on a much longer time frame. When we look to value a stock, we are typically discounting their cash flows for the next 10 years back to today.  Because of this, a quarter or a year is only a small percentage of their stock value. This year, after an initial selloff, we saw investors start to take a much more long-term approach. They began to ask themselves, how will this interruption in business today impact their cash flow five or ten years in the future? The answer was often that it won’t, and in some cases (which I will discuss in a second) it will actually have a long-term positive impact on cash flow.
  • Technology and corporate efficiency: One of the major things we saw as the pandemic unfolded was the adaptability of companies and their workforce.  This was primarily driven by technology and the increased adoption of technologies that increase efficiency, allowing workers to maintain productivity throughout the crisis. From a stock market standpoint, we saw this shift directly manifest itself in some individual stocks. Zoom is the easy example as remote meetings became the norm. Many technologies that were in their infancy when the pandemic hit are now the norm in the world of doing business. In my opinion, this is the more impactful long-term shift for companies.  This increase in efficiency due to the adoption of technology will allow them to grow faster and become more profitable as we move past the pandemic.  Expenses will drop as unneeded travel is cut and companies will have better access to talent as employee location becomes a non-factor. These increases in efficiency and profitability can’t be overlooked as we assess stocks moving forward.
  • Government intervention: The greatest factor in the continued resilience of the markets is the role the government and the Fed in particular have played throughout the pandemic. While I agree that stimulus has been slow to roll out and that much more is needed to help small businesses, the actions of the Fed helped to stave off what could have been a historic collapse in the stock market. Outside of just dropping interest rates to historic levels, they became a backstop for almost any company and a lender of last resort to help prevent credit markets from imploding.  They also infused trillions of dollars of liquidity into the markets (both on the credit and stock side) to ensure markets were still able to operate efficiently and prevent and panic. The impact of these policies, many of which continue today, cannot be overlooked.  As historians look back, I believe these actions will be credited with preventing another great recession.

With all of this considered, there are definite valuation questions that need to be asked moving into 2021. Not all companies are going to come out of this pandemic as winners and there are a number of companies that have rallied well past even the most optimistic projections for their fundamentals. The current market earnings multiple is well above historic averages and currently sits at one of the highest levels in history. However, it is difficult to assess what an appropriate market multiple should be considering the underlying rate environment and the earnings unknowns coming out of the pandemic. Rates have never been this low and a low-rate environment would lend itself to much higher earnings multiples than are ordinarily seen. I would stress caution with many of the high-flying names but do not think we will see a market-wide valuation correction until the fed changes its stance on rates.

2021 Outlook: With 2020 behind us, we can now look forward to 2021.  There are a number of variables that will drive the markets as we move forward.  The most obvious one being the pandemic and how quickly we can roll out the vaccine and put an end to the restrictions that are handcuffing businesses.  From a health standpoint, I think things will continue to get worse until we reach a critical tipping point of vaccinations.  When this happens could be a driving factor in how the market performs and what kind of continued stimulus we get from the government.  Additionally, as I said last month, how far investors can look into the future will be the determining factor in the pandemic’s short-term impact on the markets.  If they can continue their long-term focus, we should be able to see some constructive growth.

Outside of the pandemic, the new administration and the fully democratic house and senate will be the focus of these markets, especially over the next few months.  I have discussed the election at length in previous reports. We now have some answers but also still some unknowns. We enter an environment where one party controls the presidency and both branches of congress. We will see some short-term volatility as investors digest and understand what policy initiatives will be prioritized.  As a short-term catalyst, this new government dynamic means that more aggressive stimulus is much more of a reality.  I expect one of the new administration’s first tasks will be passing a massive stimulus bill to help bridge the gap from now till the vaccine is rolled out and to make up for the delays we have seen over the past few months.  This should mean larger stimulus checks to individuals and I would guess additional support for small businesses, both in the form of a new PPP program and tax relief.  This should be a positive catalyst for the markets and provide some light for those most impacted by the pandemic.

After the initial stimulus, I expect the focus to be shifted to other spending initiatives, most notably a massive infrastructure bill.  This will serve to fix some of our crumbling infrastructure but also add additional stimulus to the economy as it works its way out of the pandemic.  Going into the Trump presidency this was largely seen as an easy bipartisan initiative, but it never came to fruition.  With the new makeup of congress, I expect this to get pushed through quickly.  This again should be a positive catalyst for the markets.  It could lead to a slight rotation from some of the highflyers into more economically sensitive sectors so this will definitely be something to keep an eye on if you are sitting on names that have run up over the past year.

After this, we enter an area of unknowns.  With the Democrats holding most of the power, there has been a fear that some of the more progressive far-left policies could become more of a reality. This would be viewed negatively by the markets.  This includes increased banking regulation, higher taxes on the rich and corporations and much higher welfare spending.  While there will definitely be a major policy shift from the outgoing administration, until we get full clarity over what initiatives are real priorities it is tough to handicap the market impact.

I think the initial spending initiatives will help to support the markets in the short term. With the unpredictability of Trump behind us, we should also be able to remove one of the major day to day risks to the market as it doesn’t seem that President Biden will be tweeting market-moving information every day. Beyond that, we will have to see how progressive Biden is willing to be.  Will he attempt to placate the far left or try to be more of a unifier, reaching across the aisle to get things done?

Strategy Commentary

To close out the year my Tactical Macro portfolio gained just shy of 20%, outperforming the market by a few percentage points. This is with a much-reduced risk profile than the overall market as the current equity allocation is only 70%.

Over the month, I held steady with my overall allocation. I had planned to increase some of the equity allocation but with the uncertainty about the runoff in Georgia and an expectation that Trump would become a bit unpredictable as he left office, I was comfortable holding course. With the democrats flipping the senate I will be monitoring any short-term volatility to try to add to some places that I am underweight.

I continue to maintain my overweight to technology. While I do expect some profit-taking as there is some rotation to some more economically sensitive sectors, I think technology will still be highly represented in my portfolio.  If anything, I will be looking to add to some sectors that could benefit from increased government spending and a potential infrastructure bill.

I had been adding to some emerging markets positions, especially in China. However, I have paused this as government crackdowns in China on some of its major technology companies have added some increased headline risk to the region and created a sense of unpredictability.  I am comfortable maintaining my current international exposure.

I continue to prefer a larger cash position to a full fixed income allocation.  Rates are at the high end of their trading zone since the start of the pandemic. While they have jumped slightly to start the year I am comfortable with my current exposure.

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