First Quarter 2021 Market Update

It is widely thought that politics is downstream of culture.  I would argue that statement is true and would add a second aphorism.  The market is downstream of the economy.  However, if that is true, the next logical question is when do the effects of COVID, unemployment, and what feels like a near revolving door of trillion-dollar stimulus checks start to show up in the market?

Here are a few thoughts as we get deeper into 2021, or as you may look at it, the 5^th and 6^th quarter of 2020.

One, COVID has created a shift in winners and losers

Prior to COIVD-19, the economy was moving full steam with an unemployment rate of roughly 3.5%.  After the virus and resulting shutdowns in mid-March 2020, the S&P 500 declined by 34% in a matter of 23 days and unemployment jumped to 14.8%.    After that crash to the bottom, we saw all-time new highs less than 6 months later.  So much so that I have often joked that if you took a rocket ship to outer space on January 4^th and didn’t return until December 31^st of 2020 and just looked at the calendar year return for the market, it would be hard to say that 2020 was anything other than a great year.

This dissonance between the returns we saw in 2020 compared to the turmoil in the middle might lead you to believe the economy and the market are not even on speaking terms.  A quick look at some of the make-up of the market might give you some hope.

• Technology 

In September of 2020, the technology sector of the S&P500 made up 39% of the index but only accounted for 2% of the payroll jobs. In fact, the largest technology companies (Facebook, Apple, Netflix, Amazon, Microsoft and Alphabet – “FANAMA”) had a significant advantage in the shutdowns and ‘stay at home’ orders.  Those 6 companies drove nearly 67% of the total returns in the S&P500.  To help put that in perspective, 1.2% of the companies in the S&P500 were responsible for 67% of the returns.  That might suggest some of the other 494 companies in the index were sucking wind.¹

• Retail, Tourism, and Restaurants
  • While the tech sector benefited or at least we’re not decimated by COVID 19, other parts of the index were not as fortunate.
  • Retail, Tourism, and restaurants represent 20% of all the jobs but only makeup 7% of the S&P500’s earnings.
  • The point here is that while those three sectors experienced significant layoffs, their impact on the overall market growth was somewhat dampened.
• What does that mean for 2021?
  •      There is significant pent-up demand resulting from 2020 that seems to be leading to some interesting shifts in the first few months of the year.
  •      In the last 4 years, the Nasdaq which is a very tech-heavy index has outperformed the S&P500 by an average of over 12% a year. With the pent-up demand/hangover from 2020, the Nasdaq in 2021 has not had the same stellar record.  In the first month, from January 4^th through February 12^th, the Nasdaq seemed to be on a similar trajectory to what we saw the past few years.  It was up by roughly 11% and looked like it would be setting new records.  Then the bottom fell out of the index, and in less than a month (2/12 – 3/8), the index gave up all its gains for the year.  While the Nasdaq has rallied back some from its low on March 8^th to just a shade under 10% for the year, the S&P500 with a much broader mix of sectors has so far outpaced the Nasdaq, posting a nearly 13% gain year to date (As of 4/21/2021)
  • The interesting part of the S&P500’s return so far this year is that the top performers are not the technology sector.
    •      In 2020 the FANAMA stocks were responsible for 12.2% of the 18.4% return we saw. In Q1 2021, the FANAMA stocks were only responsible for only 0.3% of the gains we saw in the first quarter. 
    •      As of 4/21/2021, the top three winners so far in 2021 are²: Energy (26% YTD), Financials (19% YTD), and Real Estate (15.6% YTD)
  •      The takeaway: Yes, the market should be downstream of the economy.  However, the US economy is still a very diverse place and the beauty and reason we financial nerds keep preaching diversification . . . is that today winners can very easily be tomorrow’s losers.  So, for all the investors shifting every dollar to the tech side, while the “FANAMA” stocks are here to stay, a little balance in your sector exposure may help smooth out the ride.

Two, are inflation concerns warranted?

Over the last 3-4 months we have seen interest rates rise sharply.  In fact, the 10-year treasury yield rose from 0.93% up to 1.64% through March 12^th of this year³.  The spike in rates in such a short period of time combined with the unprecedented level of stimulus money being moved into the economy in an effort to battle the aftermath of COVID -19 has led to fears about inflation.

While the fears around long-term inflation are not unwarranted, there are some short-term events that may help assuage some of the fear that we are entering a hyperinflationary period.

•  One, the shutdown in the economy had a deflationary effect on prices at the beginning of 2020. Heavier inventories and a sudden drop in demand had the effect of dropping prices.  Moving into 2021, as vaccines become more ubiquitous (130 million adults have gotten at least one vaccine dose and 84 Million adults are fully vaccinated⁵), the return to normalcy has accelerated.  This snapback from pent-up demand combined with constrained supply chains has had the opposite effect on prices.
•      As we move towards more normalcy going into the 2^nd half of 2021, I would expect to see prices for consumer goods remain higher as we face the somewhat perfect storm that seems to be brewing of increased demand for goods and services and a supply chain that remains constrained. In 2020 the economy lost 22.2 million jobs.  While we have been able to get 12.5 million back to work over the last 6 months, that still leaves roughly 10 million jobs unfilled.  Getting those 10 million back to work and productive should help supply return back to normal and in turn should help return pricing back to a more normal run rate.
•      What to do in the meantime? One, be patient as supply from everything from lumber, to homes, to even PVC pipe seems to be constrained.  Two, if some of the inflation we are seeing remains, even at smaller levels, the challenge is its effect on money in savings.  As such, investors with excess cash on hand may want to start looking to get those dollars to work.  While inflation is never a desired situation, it is only one consideration and investors can take some comfort that a moderate increase in pricing is not typically negative for equities, as higher inflation should coincide with stronger earnings growth.

Three, where do we go from here?

As we head into the back half of 2021 the question remains, “what now?”  In looking at some of the analyses from City National Rochdale⁴, they have a generally positive outlook on the market.  Their full report is a great read (See the #4 link in the reference below).  Below are some of the key take away from their analysis.

• Economic Outlook
  • Of their 20 economic indicators, they see 17 of the 20 in the “green” range. Only three at this point are “yellow” or cautionary.
    • The Political environment, Geopolitical Risk, and Equity Market Valuations.
  • Expect the growth we saw in Q1 to continue for the year
  • Improved consumer sentiment and the stimulus should help with a boost in consumption.
  • At this point the US and Emerging Markets in Asia are in a better position for growth and the EU is expected to lag.
  • While we are seeing short-term inflation, the expectation is this will subside to some extent.
•   Their investment strategy:
  •       Earnings for S&P500 looks to be on track for stronger growth in 2021 and 2022.
  •       Speculative and growth-oriented equities can be vulnerable to interest rate increases.
  •       Focus on high-quality companies with reasonable valuations.
  •       Expect a challenging environment for investment-grade fixed income going forward.
•          See reference 4 charts for some key indicators for the future of the US economy. The outlook is brightening but there are still a couple of headwinds.

In Conclusion:  The tagline keeps being relevant.  “May you live in interesting times”.  Here are two things to watch for and think about:

• Fears over moderate inflation over the next 6-12 months are not unfounded. What now?
  • While returns can help fight off the effects of inflation, be cautious with an all-equity approach to your portfolios. The fixed income and cash are there for volatility control.
  • Think strategically about sinking large sums of capital into paying off mortgages and other long-term debt. If the currency is truly inflating, there is value in using cheaper and cheaper dollars to pay off those items.
•       The new administration is in the process of executing on their priorities. This could spell volatility in the market as investors work to understand what the future could look like from everything to stimulus packages to tax rates and everything in between.  Not to say some of their actions are positive or negative, but the market “dislikes” change and “dislike” usually takes the form of volatility.