Putting 2020 In Perspective
As advisors, we manage portfolios so long-term plans can become reality. Whether accumulating assets or using a portion of investment earnings to meet cash-flow needs, we seek to skillfully negotiate all investment environments so you regularly move forward.
We carefully define financial objectives and, where appropriate, prepare sophisticated financial models that project future portfolio values – not just your ending value, but also the value at intermittent points along the way. We call this staying on schedule. It is similar to football and progressing towards the next first down. The goal is to always have a manageable distance to get to the next line to gain and a new set of downs.
Our investment process is steady and methodical. We seek to prudently seize opportunity and avoid unwise risks. There are times to throw the long pass and other times when you button it up and patiently wait for better opportunities. These are just two of hundreds of decisions that will be made over the life of your portfolio. Each one builds on the one before. All contribute to its overall value. Some will appear brilliant. Humbly, others not so much. Our goals are to build consistent, high-quality, absolute returns, avoid devastating losses, and keep you on schedule.
An Unlikely Rally
2020 was particularly challenging because the investment risks were enormous and the potential for large, damaging losses great. Yet, faced with high valuations, lower profits, and massive unemployment, equity indexes surprisingly posted strong gains. In reality, these gains were primarily centered in a smaller number of growth stocks such as Apple, Microsoft, Amazon, and Google. Without them propping up market averages because of their weightings, equity returns were far less impressive.
The challenge with growth stocks is not the quality of these companies, but rather the prices being paid to own their shares (valuation). Currently, it costs nearly double the normal price to own their future earnings. This not only makes them susceptible to a major price correction, but when excesses grow this large and then correct, it can take many years for prices to recover. The last time valuations got this “irrationally exuberant” was in the closing days of the tech-stock bubble when the S&P 500 dropped about 50%. Then, it took more than a decade for prices to get back to where they were before.
Over most of the last decade, we’ve placed a strong emphasis on growth stocks, as they represent a large majority of the holdings in the S&P 500. We believe this contributed to high-quality returns that generally put our clients ahead of schedule and, to use our football analogy, in short-yardage situations. As price excesses began to build to less-tolerable levels, we started to reduce exposure to these stocks because their valuations made them especially vulnerable to a meaningful price correction and, if history is a guide, meager returns over the next 10 years.
We further reduced our positions last March in anticipation of the economic fallout associated with the pandemic. At the time, valuations remained on the expensive side, so selling seemed like the prudent option. Surprisingly, growth stocks rallied from those levels, so our timing was far from perfect. Now we seem to be back in familiar territory. Valuations are even more expensive today, a 40% drop in the price of growth stocks could happen at any time, and the long-term outlook for their returns continues to be challenging. So, it could be that we weren’t wrong – just early in our decision.
Staying on Schedule
A key consideration in making our decisions to become more defensive was our desire to keep you on schedule. In modeling equity returns, we assume a 7% compound annual growth rate in our financial projections. This becomes the scheduled return we strive to regularly achieve so you can reach your goals. Looking at last year in this context provides important perspective.
Figure 1 illustrates two scenarios. Scenario 1 is similar to the path we are on. It assumes little to no return in the first year while waiting for the odds to turn in your favor (e.g., playing conservatively when you have bad field position). In this case, a 7.8%/year return is then required for the remainder of the decade to be on track. In contrast, Scenario 2 assumes a 40% loss in year one. Should this occur, it would take a 14.1%/year return for nine years to get back on schedule. This seems like an improbable return, placing your financial goals at risk.
Figure 2 explores a hypothetical investment in an S&P 500 index fund. Last year, many investors ignored valuations and piled into these funds believing they will deliver needed returns for years into the future. The illustration assumes a 20% return in the first year (similar to 2020), followed by returns of -2.5%/year to -5.0%/year for the remainder of the decade. Historically, this is the range of annualized returns experienced by the index when its forward P/E ratio sits at current levels. If history were to repeat this pattern of outcomes, then, using our football analogy, one could find themselves sitting at fourth down and forever with time running out.
Shortly after November’s election, opportunity began to emerge in the form of U.S. large-company value stocks. While growth stocks were moving to irrational levels, underneath the surface the share prices of well-run value companies such as Berkshire Hathaway and J P Morgan experienced meaningful declines (despite remaining profitable throughout the year, paying a 2.5% dividend and having valuations only about half of those of their growth brethren).
The principal concern with these companies is their economically sensitive nature. They tend to suffer more in recessions and thrive during periods of economic recovery. Their share prices began to rally as the outlook for recovery became more positive, coincident with news about the development of a vaccine for COVID-19 and the prospect for a less-contentious post-election path to additional fiscal stimulus. Therefore, in November, we began selling defensive assets and taking a position in a low-cost ETF investing in large-cap value stocks for equity-focused and balanced portfolios.
Prospect for Relative Outperformance
While we’ve purchased these shares based on their absolute return potential over our traditional time horizon (18-24 months), value stocks may also be poised for strong relative returns. That’s been the case since November and would be a bonus if it continues.
Generally, leadership between value and growth rotates back and forth. Over the last 10 years, growth has eclipsed value by record margins. In fact, there have been only two other periods when growth has similarly outperformed. In both instances, a large price correction in growth stocks eventually occurred, leadership rotated, and value stocks outperformed by an average of roughly 9%/year for the next 10 years. Regardless of whether we’re now at an inflection point or if history repeats, we believe large-cap value continues to represent a good opportunity for absolute gain and we’re actively looking to add to our position as conditions evolve.
We continue to analyze several opportunities that are now becoming more attractive. Small-cap value stocks, emerging markets stocks, high-yield bonds, and alternatives remain on our radar. Some of these may make it into our portfolios; others will require more patience. We will keep you posted.
In closing, we are confident in our investment process and its ability to keep your investments on schedule and moving forward. We look forward to the opportunities we see developing and to becoming more offensive in the year ahead.