…the “Wall of Worry” we wrote about in last quarter’s Economic & Market Commentary. In the U.S., the S&P 500 Index increased 12% (price appreciation plus dividends) during the quarter, rising 68% from the March 23rd low. For the year, the index returned 18.4%, which is 11% above the February 19th, pre-pandemic high of 3,394. These results are phenomenal on a stand-alone basis, but even more pronounced in light of the S&P 500’s 31.5% return in 2019.
International stocks, as measured by the MSCI All Country World Ex-U.S. Index, outperformed their U.S. counterparts in the fourth quarter, returning 17%. For the full year, non-U.S. stocks increased more than 11% (price appreciation plus dividends) an impressive figure in light of their 22% return in 2019.
The returns listed above are impressive, yet our country is deeply divided politically, COVID-19 cases are on the rise and social tensions remain high. These factors leave many wondering why stock prices are rising, and why there is such a disconnect in sentiment between Main Street and Wall Street. Within this context, and based on many calls we have received from clients throughout the year, we thought it would
be helpful to provide our interpretation of why stocks have performed so well amidst this dislocation.
For starters, it is important to keep in mind that stock prices reflect investors’ expectations of the future.
Rising stock prices tend to signal improving expectations for economic growth and rising corporate profits. Rising stock prices can also be a signal of improving visibility (i.e. higher conviction) and falling market volatility. Finally, in that stock prices are discounting the future, interest rates come into play as a pricing mechanism; the lower interest rates are, the more investors are willing to pay for future earnings.
Along these lines, three major positives occurred during the fourth quarter. First, and regardless of the
outcome, the consumation of the presidential election eliminated a major source of uncertainty and angst. Next, third quarter earnings (reported during the fourth quarter) were generally much better than
investors expected. Finally, the fourth quarter saw significant, positive surprises on the COVID-19 vaccine front. The elimination of uncertainty around the election, combined with rising expectations for the resumption of economic growth in light of third quarter earnings and effective COVID-19 vaccines ready for distribution through 2021, supported rising expectations in the quarter.
As mentioned above, persistently low interest rates – and the Federal Reserve’s (Fed) stated desire to keep rates low – were another factor likely contributing to strong fourth quarter equity performance. Low rates stimulate economic growth (or at least that is the hope) and increase the relative attractiveness of stocks versus other asset classes. This “Don’t Fight the Fed” theme, which we also discussed in last quarter’s Economic & Market Commentary, stands true today. That was our message last quarter, and our view remains unchanged.
We are cautiously optimistic on the potential for stocks to continue climbing the “Wall of Worry” as we look out to 2021. Numerous risks abound: uncertainty around the new administration’s fiscal and tax policies, persistently high COVID-19 cases and new strain of the virus, delayed fiscal stimulus, difficult international trade relations, etc… the list goes on and provides plenty of fodder for the bears. However, most importantly, we see light at the end of the tunnel in the global battle against COVID-19. Two highly effective vaccines have received emergency use authorization by the FDA with another having been approved in the UK. Distribution of these vaccines has already begun. Beyond the obvious benefit to
humankind, moving on from this dark period means corporate profits are set to improve.
According to Empirical Research Partners, more than 75% of the decline in corporate profits in the wake of the pandemic came from the energy sector (as demand plummeted), the financial sector (as increased loan loss reserves decreased bank profits) and the dramatic decline in travel and leisure spending. With this dynamic in mind, assuming continued pandemic progress, we are optimistic that corporate profits will continue to recover through 2021, and see a distinct possibility for 2021 earnings, in aggregate, to exceed 2019’s level. Should this recovery in earnings happen, we would not be surprised to see the level of the S&P 500 Index continue to increase as the economy and corporate earnings catch up to and then drive stock prices higher.
Another factor contributing to our optimistic outlook for stocks is the Fed’s policy. It has made clear – through words and actions – that interest rates will remain low for the foreseeable future. This policy should help with the resumption of economic growth. Low rates also provide some cover for stock valuations as equity dividend yields and free cash flow yields look quite compelling relative to near-zero
yields on U.S. government bonds. Bears point to stretched Price to Earnings (P/E) multiples as a reason stocks are overvalued. We agree that P/E multiples look high on current depressed earnings levels. If earnings recover as we expect, P/E ratios do not look that stretched to us, especially given the current interest rate environment. While contained to a few areas, we acknowledge that there are pockets of
euphoria (e.g. recent IPO price action) found in today’s equity market that remind us of the 1999-2000 period. We are vigilant in watching areas of the market and assets that we believe may exhibit a price bubble. While these assets are more volatile and at risk of drawdowns in price, we do not see them as posing a risk to the stability of equity markets overall.
Looking beyond 2021, we remain optimistic about stocks generally and continue to express this view in our clients’ portfolios – with varying degrees of emphasis based on client-specific factors such as risk tolerance and investment time horizon. As we all learned quite painfully with COVID-19 this year, many risks and pitfalls can be difficult to predict. We are also mindful of the potential for higher tax rates, ballooning federal debt, and rising inflation. As a result of the risks we know – and those that we do not
– Howland Capital’s Investment Committee is focused on investing in equities of high quality businesses with durable competitive advantages, secular growth tailwinds, proven management teams and demonstrated track records of strong cash flow growth. We believe these types of securities are most likely to outperform the market over the long-run and are better positioned to weather whatever the market has in store as it tentatively ascends the “Wall of Worry.”