4th Quarter Client Note

If you would have told me in April when I was writing my 1st quarter client note, reporting 19.6% loss, that the S & P 500 would be up by 18.40% for the year; I would have asked what you were smoking.  At that moment, we were at the beginning of the pandemic and its health care and economic fallout. And the Congress had just passed a series of emergency economic legislation, including the $2 trillion CARES Act.

And woe unto the investor who knew at that moment that we were headed into the stock market abyss and made drastic changes to their portfolio based on that forecast. If there’s one lesson to learn from 2020, it’s that making investment decisions based on forecasts – even (especially?) those of so-called professionals – is a fool’s errand. We are much better off sticking to our well-thought-out plan designed to achieve our goals under the widest set of future financial circumstances.

Nearly Universal Gains

Almost every asset class – with the exception of real estate – scored gains for the year.

Buffeted by a dramatically falling value of the dollar vs other currencies, foreign stocks outperformed US stocks in the fourth quarter and emerging markets reached a new all-time-high, rising 79% of their March lows.

The Barclays US Aggregate Bond Index rose a whopping 7.51% for the year.

As usual, our friends at Dimensional Funds have captured all the details in their Quarterly Market Review and Annual Market Review.

In bonus coverage, I discovered a way-cool new website called Visual Capitalist, that produces awesome graphics on all things financial. Here is their year in review in 20 visualizations.

Should I buy a Tesla? Or Perhaps Just Some Tesla Stock?

Electric vehicles are most certainly the wave of the future. But, as a mechanical idiot, I’m not one to give advice on buying a car. As for buying the stock, you probably already did.

One of the more interesting investment developments in the fourth quarter was the December 21 addition of Tesla (TSLA) to the S&P 500 index; as the sixth largest company by market capitalization and the most valuable company ever to be added to the index. This “reconstitution effect” set off a mad scramble by funds that track the index to acquire the shares needed; particularly dicey in the face of speculators who had been buying TSLA in advance of the inclusion; anticipating making a killing on their trades. And, of course, these funds needed to sell the shares of Apartment and Investment Management Company (AIV) the company being dropped from the index, as well as other companies in order to rebalance their portfolios.

TSLA was up over 700% for the year prior to its inclusion, raising the question of whether investors in S&P 500 index funds may be buying this particular holding at the top. TSLA’s market cap is bigger than the nine next largest automobile manufacturers combined. God only knows how much the “Robinhood effect” had on this runup.

The S & P Completion Index, which includes all of the publicly traded stocks not included in the S & P 500 index had been up 33% for the year prior to TSLA’s exit.

TSLA may or may not match the lofty expectations of investors in the future. Even Tesla founder Elon Musk is a bit skeptical: “When looking at our actual profitability, it is very low… Investors are giving us a lot of credit for future profitability, but if at any point they conclude that’s not going to happen, our stock will immediately get crushed like a soufflé under a sledgehammer!”

For broad market investors, the lesson is to understand how these indexes are comprised and choose the ones that best meet your needs.

Regime Change?

How long can long-suffering value investors suffer? This is not just a tongue twister, but a mind bender.

Large-cap growth stocks have outperformed large-cap value stocks by an average of 5.26% annually per year over the past ten years. This decade long disparity is evident in the mid-cap and small cap spaces, as well. In 2020, the gap was the largest on record; with large-cap growth beating small cap value by 38%.

Just a quick capstone: Growth stocks carry prices higher than average based on fundamental metrics (such as earnings per share or book value) and value stocks are priced lower; with growth investors betting that the fundamentals will catch up with the prices and with value investors hunting for bargains. Sometimes these disparities are attributable to the speculative nature of growth investing, best embodied by stocks like Tesla, discussed above; and can persist, historically,  for years or even decades.

History rhymes. We occasionally go through periods like this. The Nifty Fifty from the 60’s and 70’s. The Dot Com boom and bubble in the late 90’s. There are some eery similarities between today’s top-heavy market and the dotcom boom of the late ‘90s. Today, the top five companies in the S&P 500 index by market capitalization make up 22% of the index’s value. At the peak of the technology bubble the top 5 companies made up 17% of its value.

And these periods have almost always been followed by periods of equilibrium, in which value outperforms growth and the spreads narrow; with long term averages reverting to the mean in which value stocks generally outperform growth stocks over the long term. Historically, smaller, deep-value stocks have tended to perform better coming out of a recession.

What can an investor do? A couple of things: 1) Reduce your overall return expectations.  2) Look for – and overweight – pockets of the market that may be undervalued – or at least less over-valued – than the names at the top of the leaderboard.

And while one quarter doesn’t make for a pattern, since Oct. 28 the Russell 1000 Growth Index gained 9.73 percent through December, while the Russell 1000 Value Index rose 15.14 percent.

What’s Next for the Market?

The direction of the market can’t remain untethered from the economy forever. And the course of the economy is inextricably linked to our success in bringing the pandemic under control.

The new Biden administration has grand plans to roll out The American Rescue Plan a comprehensive, nation-wide vaccination program and significant economic relief package. How much of that can get through Congress remains to be seen.

With Democratic control of the Senate, it seems more likely that there will be higher taxes for some, more spending and the possibility of higher interest rates. This could be good for municipal bonds, as well; with a greater possibility for financial aid to states and municipalities and higher marginal tax rates.

Morningstar has published its compilation of return forecasts from prominent investment firms for the next ten years; but even those should be taken with a grain of salt.

Attempting to predict the market over the next year is folly. We know that over the long-term stocks have higher expected returns than bonds. Outside of luck, you will not be able to time the market.  So, instead, focus on the four things you can control: 1) expenses 2) taxes 3) being broadly diversified according to your goals, risk tolerance and time horizon 4) and remaining disciplined.

Some Enduring Lessons

If we don’t learn a few things from a year like 2020, it will surely have been a waste. Everyone had a chance to think about and reorder their priorities in life. My financial planning clients always have a hard time deciding which spending goals are “needs” and which ones are “wants.” Now we’ve had a test. Whatever items you spent money on in 2020 are the needs – since things like leisure travel, theater and dining out were foreclosed.

The corollary, of course, is when you get the chance surely figure out what things you really want to spend some money on, because you may not get another chance.

Three Martini Lunch

Finally, tucked into The Consolidated Appropriations Act of 2021 (Coronavirus Stimulus 2.0) is the revival of 100% deductibility of business meals – the so-called three martini lunch.

Since I haven’t even been able to have a one-Pepsi lunch with any of my clients for almost a year now, I’m looking forward to resuming that time-honored activity some time in 2021. And, of course, I’m buying.


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