2020 ended the year with a bang. This was likely from two things; strong returns from the financial markets and most of us slamming the door on 2020! Stocks ended the year on an upbeat note despite the economic headlines and persistence of COVID 19. The Wall Street Journal coined the market move as “The Everything Rally,” as most investments recovered from the lows in March. Stocks, bonds, houses, Bitcoin, and even baseball cards saw a surge in interest and price appreciation this year. This quarter saw the market rally broaden out. Smaller companies and the international markets outperformed the S&P 500 for the first time in several quarters. Diversification paid off as we closed out the year.

Stocks continued their strong performance on the back of another surge in the technology sector. This was spurred by several successful and high profile initial public offerings like AirBnB and DoorDash. There were 158 stocks among the largest 1,000 stocks in the US that posted 50% or better performance for the year. There are corners of the market that are experiencing some euphoria. Markets also responded favorably that the election has come and gone and vaccines were approved. Removing uncertainty has improved investor confidence.

Investment Strategy

We remain positive on stocks but are also realistic that markets have had a strong performance over the past two years. Our expectations are stocks should have a good 2021, but are not expecting a third year of double-digit returns. We are fully invested at this time and have a slight overweight in stocks. Our thinking in overweighting stocks is because the expected returns of holding cash and bonds are low, given the historic low rates we are seeing. This by no means is a significant “bet” as we have only increased our stock allocation by 5%. Our portfolios remain diversified and we have been careful not to overweight growth stocks. We are optimistic about value, low volatility, and international stocks. All three areas should perform well if earnings growth rebounds and we see a modest amount of inflation in 2021.

Outlook

Our positive outlook is centered on forecasted economic and earnings growth, healthy corporate cash holdings, and a consumer that is in their best financial shape in decades. Expectations for 2021 and 2022 look strong for the US and global economy. As vaccine rates rise and herd immunity is reached in the second half of 2021, a return to “normal life” should help the economy. Companies are expected to post strong earnings growth compared to 2020 results but, more importantly, are expecting to surpass earnings from 2019. Corporations are holding a record level of cash on their balance sheets. This is a result of many companies taking advantage of low interest rates and borrowing money over the past year. We expect companies to look for acquisitions and start to buy back stock. Both of these are positive for stocks in the near term.

Consumers are in their best financial shape in years. A vaccine, a stimulus check, and pent-up demand to do something different than the past year should serve as a spark for spending. Savings rates have surged for most individuals in 2020 because money spent on many activities have been limited. Additionally, credit card balances have dropped significantly since March 2020. There is a lot of dry powder in savings to be spent or invested in the coming year. The Federal Reserve remains supportive to the economy and markets with its lower for longer policy on interest rates. We have written about this in our last Viewpoints, and our thoughts have not evolved much on this topic.

As we said in our investment strategy section, we are optimistic but realistic. Some risks need to be considered. The economic recovery and vaccine rollout is not going to be smooth. These two items are linked in our minds. We expect there to be negative headlines and bumps in the roads, with sporadic lockdowns to continue until we reach herd immunity in the second half of the year. This will create periods of volatility for stocks.

Our next risk factor is the market valuation. The S&P 500 is trading at 22.3x forward earnings. This is well above the historical average (16.5x) but below the 27.2x seen during the 2000 market peak. To expect to see additional expansion in the market multiple is going to be tough. Things can always get more expensive, but this shows how critical it will be for earnings growth to be robust to see valuations levels drop to more reasonable levels. Should we be selling because the broad market is expensive? We don’t think so because valuations generally are a poor predictor of returns over the next 12 months, meaning if stocks are expensive, it does not usually correspond with a sell off in the next year. Rich valuations do usually lead to lower average returns over the next five years.

Investor sentiment has bordered on euphoric towards the end of this year. Investing since the March lows has seemed “easy” because everything has gone up. There is a saying that price (or performance) is sentiment. If things go up, investors think they will continue to go up in the near term and vice versa. This can cause surges in and out of the market as sentiment shifts. While things have been “easy” in most of 2020, any market weakness could be exacerbated by a shift in sentiment. Just like in periods of market sell-offs, it is as important to stay disciplined in our asset allocations and not let emotion interfere with our investment decisions.

We would like to close out this Viewpoints with a graph that we find helpful and help frame some perspectives. This is a graph of the S&P 500 returns for the past 30 years with the low point seen each year. In most years, you can see positive returns and most years see a sell off of at least 10% or more. Volatility is something we expect ahead and drawdowns are to be expected along the way.

Disclaimer: The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing.

US Market Viewpoints: December 31, 2020