A UNIQUE ENVIRONMENT
It serves little purpose to call the markets “irrational”. Yet, the year 2020 has been like few others, with stock indexes defying gravity (and often logic) by making new highs despite a highly uncertain environment. And as we sit within election uncertainty, the prospect of divided government leaves investors questioning the country's future economic prospects.
As we have previously written, within the indexes it has been a tale of two markets. The performance of technology companies has greatly outpaced that of other sectors. Often, this is justifiable, but in other cases, the valuations are beyond "stretched" and are higher than they were before the pandemic.
Similarly, speculative plays have been on fire. Consider the performance of bankrupt Hertz Global Holdings (whose shares were bid up 800% despite the CEO suggesting that the shares may be worthless) or Nikola (an electric truck “maker”, but whose share price climbed 700% without having a single customer.)
These examples show a market at its extremes. They are signs to be more circumspect when possible and to look for ways to take off some risk or to add value with some contrarian behavior. Such trades may not likely be immediately rewarded, of course. But one must position portfolios for the generation of returns over the long term while adequately compensating investors for the risk that they are taking.
Today’s elevated valuations suggest that future US stock returns may be muted, and that investors need to increasingly look beyond US large cap growth stocks and domestic fixed income to meet their return objectives.
US Treasury securities (that yield almost zero) look like an area of risk to us, and yet stock valuations are often justified by the low level of such interest rates... It is not assured that rates will rise any time soon, but the Federal Reserve does not at all seem concerned about inflation in its policy making. When rates rise, both bonds and long duration (high growth) stocks will encounter headwinds.
As such, a shift from growth towards value needs to start soon. The challenge is that many so-called value stocks are in cyclical areas that do not have strong economic underpinnings. So, we will be looking more to quality “dividend growers” that haven’t kept pace in this environment. The term “Dividend Aristocrats” is a good shorthand for companies with decades of consistent dividend growth under their belts. Their underperformance in recent years is unusual and presents an opportunity.
ESG-based equity funds have performed well as investors have increasingly sought companies with these operating characteristics. We are delighted to see new funds that bring unique styles and investment approaches, making them better portfolio diversifiers to complement funds with a market capitalization-based approach. These funds have generally favored the same mega-cap names in their portfolios. The new funds’ holdings, however, are often more consistent with the quality growth theme expressed above and may be good additions to client accounts.
The US dollar has been a strong component in the outperformance of US versus foreign investments. But with US rates now very low and deficits climbing rapidly, that tailwind may have a higher chance of being a thing of the past. Adding exposure to foreign bonds and to the higher quality end of emerging market stocks might be logical ways to play this theme. With EM stocks at their lowest relative valuations versus the US, this is a bet that could have positive relative performance over time. And China is one of the few countries experiencing substantial economic growth in the current environment.
Private investments continue to be driven more by the specifics of each strategy than by a general theme. As usual, we are seeking Independent Engines of Growth -- investments with the potential to deliver equity-like returns without equity market risk. Possible areas of emphasis are those having dislocations in the current environment (i.e., distressed debt, real estate) and hence, attractive pricing. Private investments have unique characteristics such as high minimums, modest liquidity and long investment periods, and as such, aren’t for everyone.
In the end, our portfolio approach, favoring diversification across asset classes, and with a bias towards quality, isn’t going to change. But at the margin, these investment themes may reshape what portfolios look like over the coming months. Stay tuned, and please contact us if you’d like to discuss this further.