We have finally arrived in 2021, leaving a year of anxiety and challenges behind us. The pandemic is not over, and many continue to suffer from health and financial issues. Despite this, investors still turned their attention away from pandemic development and returned it to the market. Such behavior is all too familiar to our clients who went through the Dot.com bubble and Great Financial crisis with us. The tug of war between greed and fear was definitely on display in 2020.
Review of 2020
2020 began as a cautious but optimistic year. There were concerns that the bull market could not sustain itself after such a long stretch, and the fight between the U.S. and China would significantly impact the global economy. On the other hand, a second term of the Trump presidency seemed highly possible, and the incumbent government would have most certainly kept the economy going in an election year. Who could have imagined that an invisible virus would sweep over the whole world in just a few weeks? The longest bull market took a scary dive four weeks after China’s lockdown and reached the bottom in March. It took another five months for the U.S. market to get to pre-pandemic levels. The market continued its rollercoaster ride between September and November due to uncertainty around the U.S. presidential election as well as the pandemic’s second wave. Once the election results settled and vaccine development advanced, the U.S. market took off despite the rise in COVID-19 cases.
However, recovery was not the same for every sector. The first group to recover involves the “Work from Home” names and those that provide protective supplies, testing equipment, potential treatments, or vaccines for the virus. The second group contains mostly cyclical companies when businesses finally reopened and resumed a high percentage of regular activities. The third group consists of leisure and energy companies.
The rest of the world recovered at a different pace based on how well they controlled the pandemic. The first group to recover was East Asia, including Taiwan, China, and South Korea, due to better handling of the outbreak. Manufacturing activities in this region have returned to pre-pandemic levels, and Taiwan and China are the only two economies to report GDP growth in 2020. These regions are also heavy exporters and continue to benefit from the rebounding demand from other parts of the world. Southeast Asia is reportedly doing well, as are Japan and New Zealand.
Europe was the earliest developed region to suffer from the outbreak. The inexperience in dealing with this once in a century event led to slow response and the loss of many lives. However, most European governments appear to have a handle on the pandemic now, and we see a gradual recovery in economic activities and the equity markets. Countries relying heavily on tourism may take longer to recover, but the trajectory is encouraging.
Since the end of 2018, the top few largest companies have dominated the U.S. market performance (see Chart 1). It is unlikely that these few companies combined are a good representation of the broader economy as one Wall Street analyst states: “The combined market capitalization of the semiconductor ecosystem, which includes EDA (Electronic Design Automation), SCE (Semiconductor Capital Equipment), Foundry (chip manufacturers like Taiwan Semiconductor), Fabless (chip designers like Qualcomm and Nvidia), and IDM (Integrated Design Manufacturers like Intel and Samsung Electronic) across the U.S., Europe, Japan, and Asia equal to that of Apple at two trillion U.S. dollars. While Apple is a great company, we would argue that the semiconductor industry’s financial and social impact has been far more consequential than Apple’s.” The same thing can be said about the whole technology sector; its share in the S&P 500 weighting is far higher than its contribution to the real economy (see Chart 2).
Source: Factset, Standard and Poor’s, J.P. Morgan
The purpose of showing the above charts is to point out where the risks and opportunities are. The forces causing such unbalanced performance are unsustainable, whether it is passive indexing investment, retail investors’ participation, or just greed. Although these are great businesses, they should not be the only ones attracting investors’ attention.
We need to put things in perspective for stocks trading at such a lofty valuation. As an example: should one company with a small market share in the foreseeable future have a larger market value than all its competitors combined? Is it possible for a company to sweep the competition without a genuinely differentiating feature? Can stock split and index inclusion alone be reasons to own a company? The stock market is a voting machine in the short-run but is a weighing machine in the long-run. Without solid fundamentals to justify the skyrocketing valuation, there will be no support once the momentum has faded. Compared to fundamental investing, momentum investors need to be more skillful in market-timing. They must act like contrarians and sell at such a time when everything still looks perfect. A complete turnaround in behavior is easy to understand but challenging to execute.
As Richard Thaler, the 2017 laureate of the Nobel economics prize and one of the most quoted scholars in behavioral science, said recently – “One of the interesting things we observed in the past six months is a big increase in retail investing at the level of individual securities. My opinion is, for individual investors to be doing that is a fool’s errand. The world has conspired to make them overconfident now because the market’s been going up pretty steadily, and it has been going up fast in the segment of the market that retail investors have been most attracted to. So, it’s very easy to think that you’ve figured this stuff out. If you think you’ve figured it out right now, think again. The other thing that we often point to is what we call loss aversion. People are much more sensitive to losing money than gaining. What that’s going to mean is when we do get to a correction in the stock market, we may see some overreaction. People should be wary of that, as well.” In any other market, buyers wait for lower prices and sellers wait for higher prices; momentum investors buy at highs and sell at lows in the stock market.
At Noesis, we choose financially established companies to directly or indirectly invest in these new ideas. Through these companies’ management teams, who have more profound industry expertise than us, we can participate and enjoy the ride with much lower risk. For example, we have more than a few companies providing crucial electronic components and services to the automobile OEMs, including electric vehicle carmakers. These companies’ market positions are secure due to the high barrier to become an automobile supplier. We also own companies that develop hydrogen plants, but hydrogen is not the only business they do. Hence, they can support the new energy business with other profitable segments.
Actions Taken in 2020
In January 2020, we wrote, “Over the years, we have been deploying the same philosophy and disciplines in investments. Our focus has always been on the individual company’s story and the industry dynamics. We monitor the macro environment but never allow the market sentiment to drive our decisions. We do not believe the markets are always rational and fully efficient in the short term, so we maintain flexibility in the portfolios for possible actions. We are not market timers but try to buy low and sell high.” Our actions taken during the pandemic speak volumes to our philosophy and discipline.
First, we stayed invested in the market. What would the consequence be if one became fearful and fled the market? We illustrate the scenarios in Chart 3. The result of missing the best days in 2020 was significant. By simply missing the best two days of the market, the year-to-date return turns negative. Staying invested is especially important when extreme fear is causing a significant amount of volatility. We have experienced three significant corrections in the past two decades, but a bull market followed each time for more than a few years. Volatility is an integral part of the investment process, and we have had a maximum drawdown of 10% or more in 16 years of the past 21 years (see Chart 4). Nevertheless, the equity market continues to reward disciplined, long-term investors.
Source: Bloomberg, Refinitiv
Many of our companies suffered from the shutdown and the decrease in demand. We pared some losses and reduced our exposure to areas where the damage was permanent or there was hardly any visibility even after the pandemic. We added a few positions in the technology sector and increased existing holdings’ investments in the healthcare, industrial, and material sectors. Some of these companies directly participated in the pandemic themes, for example, providing testing kits and supporting testing facilities. We picked up the global foundry leader when the market overestimated the supply chain disruption in the semiconductor industry. We added the largest solar and wind farm operator in the U.S. to our portfolios to increase green energy investment. We also bought a small-cap ETF to increase cyclical exposure and bought a global payment transaction company to solidify our position for the eventual recovery.
Outlook for 2021 and beyond
Investors in the fixed income markets continue to face negative real (meaning adjusted for inflation) treasury yields (see Chart 5). Recently, around-zero real yields extended to higher quality corporate debt for the first time in history. Interest rates are suppressed in the short end by a close to zero Federal funds rate, which is expected to stay at that level through 2023. In the long end, they are pressured by the Federal Reserve’s (Fed) treasury purchases, part of its quantitative easing (Q.E.) program, as well as by worldwide investor demand.
With relatively high unemployment and low market expectations of inflation, there seems little pressure for rates to rise anytime soon. The developed world has come to take low inflation for granted. After all, during the longest expansion in the U.S. economy, core inflation rarely exceeded the Fed’s target of 2%. However, a few factors have changed. Money supply has increased sharply (see Chart 6) due to continued bank lending in contrast to the period after the financial crisis. U.S. consumer’s balance sheets are healthier, and the savings rate is higher compared to the need to deleverage in the last recession. In addition, the Fed’s attitude changed as they are willing to tolerate inflation moderately above 2% for a period of time. Public debt has also risen meaningfully from fiscal stimulus programs in the U.S. as well as in Europe and Japan.
Source: Federal Reserve, U.S. Bureau of Labor Statistics
Furthermore, structural disinflationary forces are reversing. Societies in the West and Asia are aging; thus creating a shortage of labor. At the same time, globalization is slowing or even retreating. These developments might give workers in developed countries more bargaining power, resulting in rising wages and eventually, rising prices.
A substantial increase might not be an imminent risk. However, a moderate inflation surprise could already be a challenge for fixed income investors at these low yield levels where certain areas of the market are even negative-yielding in real, inflation-adjusted terms. Therefore, we continue to monitor the sensitivity to interest rate changes in your bond portfolios, minimize duration risk with variable or floating coupon securities, and avoid long-duration bonds. We must strike the delicate balance between high coupon income and a low risk to the principal.
With the delivery of several vaccines, the global economy will return to growth in 2021. Companies with good balance sheets will no longer be in capital conservation mode. They will again hire people, invest capital, and buy back stock. Those who had to reduce or suspend dividends will restart payments. Interest rates will be kept low for another few years, so companies can still borrow at a cheap cost. Furthermore, the operating margin will receive significant relief in the coming quarters. The likelihood for companies outperforming on the profit line is high while in the early stages of recovery.
Luckily, the U.S. consumers started to build up their savings a few years before the pandemic (see Chart 7). With robust housing and equity markets, the household net worth continues to improve (see Chart 8). Such cushion paves the way for a rapid recovery in consumption when the situation improves. Therefore, we anticipate rising consumer confidence in the coming year, which remains an essential catalyst for a bullish U.S. equity market in 2021.
Source: U.S. Bureau of Economic Analysis (BEA), Refinitiv, FactSet, FRB, J.P. Morgan
A bull market’s apparent obstacles to continue are the valuation and the ever-increasing government debt in developed countries. While valuation can continue to stay at a high level for an extended period, it cannot go on forever unless the earnings catch up. In the longer term, the debt level must go down to avoid impeding the growth engine, devaluing currencies and driving capital to other countries. Therefore, we need to generate more tax income for the governments; however, the window to do so successfully is narrowing due to baby boomers’ coming retirement and the increasing healthcare cost associated with it.
We maintain our positive views on several secular trends we identified in the past. They are, but not limited to, 1) emerging markets’ growing middle class; 2) advance in 5G network and its applications in communications, entertainment, and transportation; 3) green technology that will reduce carbon output; 4) innovative therapies in cancer treatment and autoimmune diseases; 5) robotic and automatic technology used in manufacturing, agriculture, and medical fields; and 6) payment technology.
More than the growth ideas, in 2021, we will also explore areas and regions unfairly overlooked by the market since the pandemic. The price to sales ratio for growth stocks and their relative valuation versus value stocks are in a territory only seen in the Dot.com bubble period (see Charts 9 and 10). Although we are not predicting a crash in the growth stocks, we find attractiveness in other areas. We firmly believe valuation is a critical success factor in making investment decisions. The lofty valuation given to a few names, industries, or regions will become an inhibitor for those areas to outperform in the coming years.
Thank you for your business and trust in 2020. We wish you and your family a healthy and prosperous 2021!
We would also like to highlight our colleague Adriana’s invaluable contribution to this letter and our upcoming Capital Market Summary for 2021.
Noesis Research Team