The stock market finished 2020 in a strong uptrend, and this trend has continued into the early trading days of 2021. It is said that the market climbs a wall of worry, but with a surging pandemic, dramatic economic dislocation, and violent political unrest, this wall of worry feels more like an active volcano. Still, the market presses higher.
Rather than try to explain why the market is behaving as it is, or try to predict what it will do in 2021, it seems more important to communicate the changes we are seeing in the global markets right now, and how we are positioning portfolios in response.
Global economies suffered a sharp and severe decline last year as the pandemic began to spread. It appears that we are now in the early stages of an economic recovery. This recovery is not uniform, as many industries such as travel, hospitality and dining, are still suffering. But other sectors like manufacturing and housing are doing quite well as consumers shift their spending habits.
And as the vaccine becomes more widely available, the strength of the economic recovery is expected to grow.
The incoming Biden administration is expected to be much more friendly to green technology, and more restrictive to relatively dirty technologies like oil and gas. In addition, expanded economic stimulus in the form of direct payments is likely to happen fairly quickly, especially after the Georgia runoff election gave control of the Senate to Democrats. Finally, taxes are likely to go up on higher earners, and possibly corporations.
Stock Market Leadership
Over the last decade or more, one segment of the global stock market has outshined all others: large company U.S. stocks, and especially the mega-cap technology shares. The relative performance of these shares has been dramatic. Over the last ten years, the large-cap S&P 500 has gained nearly 200% and the tech-heavy Nasdaq is up nearly 500%. This is jaw dropping when compared against other baskets of stocks like the international MSCI EAFE index (mainly Europe and Japan) which is up less than 25% over that same time period, or the MSCI Emerging Markets index, which gained just over 25%.
During this period of outperformance, shares of these large U.S. companies have grown ever more expensive relative to their peers. Better fundamentals in terms of profits, sales, and book value are available in stock classes outside of the S&P 500 and Nasdaq—specifically, emerging markets and other foriegn stocks, as well as U.S. small company stocks. These stock classes trade at price-to-earnings (P/E) and price-to-sales (P/S) ratios substantially lower than the S&P 500. For example, a dollar invested in small-cap stocks today buys more than twice the sales of the same dollar invested in the S&P 500.
The graphic below from MSCI illustrates how the U.S. market has grown to dominate the global stock market based on market capitalization (stock prices and number of shares outstanding), but is not dominant on fundamental measures like revenue or GDP growth.
Looking to the Future
SilverPeak Wealth believes the dominance of the mega-cap tech stocks is likely to give way to more favorably valued stock classes like emerging markets and small-cap stocks. Currently, emerging markets stocks are benefiting from a weak dollar and surging demand for manufactured goods, which is the primary industry for most emerging economies like China.
In the U.S. market, small-cap stocks have tended to outperform coming out of recessions, and over long periods of time have outperformed large company stocks. After tracking fairly closely with large cap stocks following the market collapse early last year, small cap stocks began to materially outperform starting in November. This trend is likely to continue, as the ratio of small caps to large is still historically wide.
Malls, hotels, and multi-tenant office buildings have suffered the brunt of the pandemic in the real estate markets. Luckily, the real estate investments our clients are in managed to almost completely avoid these areas.
By focusing on industrial/warehouse properties, essential retail (i.e. grocery, pharmacy, and home improvement) and apartment buildings, our preferred real estate funds have managed through the pandemic very well. Values of the properties have either held steady or appreciated, while monthly tax-advantaged distributions to investors have remained in the area of 5.5% annually.
We continue to be optimistic about the prospects of these real estate investments. Interest rates (borrowing costs) have fallen, adding a natural tailwind to property values, as does a rebounding economy. What’s more, these investments offer our clients income substantially higher than what can be earned on bonds. (The current yield on the 10-year Treasury sits around 1%.)
The economy and stock market are both in rebound mode. It is expected that the economy will continue to gain momentum as the vaccine becomes more widely available, though it is anyone’s guess what the markets will do, as the expectation of a rebounding economy may already be baked into prices.
That said, some areas of the global stock market outside of the tech-heavy indices do hold better fundamental prospects. These include small company U.S. stocks, foreign stocks and emerging market stocks. These three stocks segments have been out of favor for many years and this cycle appears to be ripe for reversal.