Top Headline for Q4: COVID-19 Vaccines

As 2020 ends, it is impossible to not breathe a small sigh of relief as the new year brings a renewed optimism about better days ahead. The emergence of several vaccines during the quarter was welcome news for all and the enthusiasm carried over to the markets. Pfizer, Moderna, Johnson & Johnson, and other medical companies worked quickly to find a vaccine for COVID. Our thanks go out to the vaccine developers who defied the odds and delivered several viable vaccines many months, if not years, ahead of early projections. Although many are still battling the virus, it is good to finally close the chapter on 2020 as we hope for a full recovery for those affected and rapid vaccine deployment to prevent further outbreaks.

As these medical breakthroughs began to emerge, the debate in D.C. about a potential second relief package continued. Many investors believed additional help was needed to bridge the gap to when vaccines would be widely available. As vaccines began to be administered to frontline workers in mid-December, a second assistance bill totaling approximately $900 billion was passed.

As we reflect on market performance in 2020, it is hard to not be a bit perplexed. COVID-19 was clearly one of the most economically damaging events to occur in our lifetimes, and yet, we experienced an “everything rally” where nearly all asset categories performed quite well for the year. Therefore, one is left to wonder – “How did that happen?” In retrospect, federal intervention had a dramatic impact on markets. It’s noteworthy that stock and bond price appreciation is not a stated goal of the Federal Reserve Bank or federal policy. Rather, the Federal Reserve seeks to achieve “full employment” and a 2% inflation goal while encouraging market stability. However, their actions went further than achieving market stability as word spread of a “Fed Put” (a reference to the perception that the Federal Reserve Bank simply would not let stock or bond prices fall). The perception of a Fed Put, combined with statements from Jerome Powell such as, “we’re not even thinking about thinking about raising rates,” seems to have led to widespread bullishness and some aggressive equity market buying. For example, retail investors opened over 10 million trading accounts during the year, increased their margin balances by 50% and invested in call options (i.e., made levered bets on stocks rising) at record levels. So, where do we go from here? More on that below. 

General Market Update

US Equities:  2020 has been a remarkable year. While COVID-19 cases around the nation continue to surge, and small businesses shut down in record numbers, the stock market looks ahead to life after the vaccine. After what was then an all-time high for the S&P 500 Index set on February 19th, the market plunged 35.4% before bottoming on March 23rd. This was the fastest bear market (i.e., 20% drop) in history. Then, as “Main Street” continued to struggle, Wall Street enjoyed its quickest bear market recovery in history. The S&P 500 fully recovered its price drop in only 126 trading days. The next fastest recovery was back in 1966/1967 when it took 310 days to recover. 

The S&P 500 Index finished up 11.7% for the quarter and 16.3% for the year. The Nasdaq Composite was the big winner for the year finishing up 43.6% after gaining over 15% in the quarter. Lastly, the small-cap Russell 2000 Index had one of its largest quarterly gains in history (appreciating 31% for the quarter and 18.4% for the year) which allowed it to narrowly pass the S&P 500 Index. Part of the equity story during Q4 was a rally among beaten-down sectors (e.g., financial firms and the energy sector). The financial ETF (XLF) finished up 23.1% for the quarter while the energy ETF (XLE) surged 28.3%. In comparison, the high-flying tech sector, a leader throughout the year, gained “only” 11.7% as measured by XLK. 

It’s noteworthy that Patina Wealth’s portfolios leaned into Growth and Technology coming out of the initial market meltdown. Client portfolios benefited from the additions of some specific sector exposure including Technology, Semi-Conductors, and Cloud Computing. From the market bottom in late March, Growth and Technology sectors have significantly outperformed the market. While we will continue to hold a diversified portfolio, we believe more Value oriented holdings may have a more attractive risk/return premium as the country begins to reopen. Client portfolios have recently seen the addition of a pure Financial sector holding, and a slight shift from Growth to Value, including a slight increase in Small Cap Value.

International and Emerging Market Equities:  The Schwab International Equity ETF, which holds stocks of developed markets excluding the United States, was up 16.3% in Q4 and the Schwab Emerging Markets ETF was up 16.6%. The developed international market has been improving recently relative to the large-cap US indices mainly on account of the industry composition of the European market (i.e., it has a lower percentage of technology companies). If vaccine news remains positive and depressed industries continue to move back toward average valuations, it’s likely that these markets will continue to gain ground against tech-heavy US indices. Emerging markets are continuing to see a surge as economies continue to re-open leading to further improvement in manufacturing combined with strong economic results from China.     

Fixed Income and Credit: The US bond market saw an interesting divergence during the quarter as corporate bonds substantially outperformed treasury bonds. This movement is a further indication of renewed market confidence. As you may recall, treasuries dramatically outperformed early in the year as is typical during any period of market turmoil that leads to a “flight to quality.” In general, we don’t expect much price movement in the bond market and expect continued low yields. The Federal Reserve continues to drive the market in treasury securities where it has become the largest purchaser. Moreover, the plan to keep interest rates low indefinitely suggests no movement in bonds due to interest rate changes combined with very low yield. The one caveat would be inflation as increasing inflation expectations would push bond prices down and yields up (more comments on this below). 

A Look Ahead

Back to the question, where do we go from here? We’ve spent a great deal of time over the last six months listening to economists and other experts opine on this question. It’s clear that the rules of the game have changed. The current situation is a grand experiment to which history offers no guide. People have grown tired of the overuse of the word “unprecedented” in 2020 but it’s accurate especially regarding federal government intervention. For example, take the following into consideration, (1) the Federal Reserve bank has suggested interest rates will sit at zero indefinitely, (2) the money supply increased 68% in 2020 – the largest increase on record, (3) the Federal Reserve is the largest buyer of treasury bonds thereby artificially inflating the value of those bonds and further suppressing yields, (4) the federal budget deficit exceeded $3 trillion in 2020 which is the largest gap ever and 3 times the amount from 2019 which was already deemed excessive and (5) there is now growing acceptance of the concept of Modern Monetary Theory which suggests budget deficits don’t matter. The federal government was the number one factor driving market performance in 2020 and that’s not likely to change anytime soon. If they continue with accommodative policies, continued asset price inflation is likely. However, any tightening at this point would likely be devastating. For example, corporations added $1 trillion in non-financial debt to reach an all-time high of $11 trillion in 2020 and “zombie” companies (i.e., those that cannot pay interest on debt from cash flows) is at an all-time high. Many believe that rates simply cannot go up from here.

So, what does all that mean for the US stock market? Well, the proposition of low rates indefinitely is incredibly beneficial to growth companies with attractive returns on capital. Companies, like Amazon, are borrowing money at Treasury-bond-like rates and that is not likely to change anytime soon. The optimism, in fact, has led to a surging stock market and valuations that are among the highest in history. Moreover, the low rates delay corporate bankruptcies which otherwise might begin to trigger some selling. The greatest threat to the US equity market stability may come from social unrest and resulting policy change. There has been much buzz about economic inequality in 2020 driven by government actions. The US added over 50 new billionaires in 2020 as government intervention set the stage for a wave of highly priced initial-public-offerings. Moreover, existing billionaires added over $1 trillion in wealth during 2020 from surging stock performance while millions were unemployed from mandated shutdowns. It may not happen in 2021 given the predicted “split” congress, but it seems likely that higher corporate taxes, a higher top income tax rate and other forms of wealth-redistribution policies are likely in our future. There is also some discussion about unfair competition and monopolies that could be disruptive to the market in 2021 as it has some bipartisan support. 

The big unknown for 2021 is inflation. When/if inflation picks up steam, it will have profound effects on markets. Fixed income investments, like bonds, would attempt to drop in price in an inflationary environment for yield to keep pace with inflation. The Federal Reserve, as was done in Japan, may then institute “yield curve control” to prevent any bond price declines/rate increases so bond impacts may be muted. Inflation is also not generally good for the stock market though some businesses (e.g., higher margin/low headcount) do better than others. Coming out of 2020 with high unemployment and other deflationary impacts from COVID-19, the risk of inflation would seem low. However, given a growing money supply, an extremely accommodative Federal Reserve, less globalization and a growing support of Modern Monetary Theory, inflation could easily and quickly emerge. Given the threat of inflation, real-assets (e.g., land, real-estate and commodities) may prove beneficial to portfolios. Moreover, precious metals, like gold, have generally performed well during periods of debasement in fiat money as we’re experiencing now. 

In summary, all eyes will be on the federal government in 2021. If policies remain highly accommodative, one may expect continued growth in risk assets like equities and inflation-hedges like commodities. However, any tightening or deflationary shocks, like the emergence of a new vaccine-resistant virus strain, could lead to significant pullbacks.