Markets and COVID: What’s happened - and what might be ahead
By Daken Vanderburg, CFA
Daken Vanderburg is Head of Investments for Wealth Management at MassMutual.
Well, ladies and gentlemen, that’s a wrap. The year 2020 is finally, thankfully, into the record books.
And what a year it was…
While I offer no predictions as to what 2021 will bring, for this market update, let’s go back before we go forward.
As such, today, with 2020 now behind us, I offer three perspectives. First and foremost, let’s review where we are with COVID-19 as it continues to impact our lives — and will continue to do so for at least the near future. Second, we will review how markets performed for the year, and last, we will explore market valuations as we begin to think about how 2021 could unfold.
With that, let us begin.
COVID-19: Where we stand
In preparing for this update, I spent time reviewing other updates…particularly those toward the end of 2019. Last year at this time, I spoke of tax policy, of the upcoming elections, of valuations and interest rates; and there was a remarkable and glaring gap of what was to come. It was a stark reminder of what I wrote about recently, that risk often appears from where it is least expected … and 2020 was no exception.
As of Jan. 5:
There are now more than 86 million people worldwide that have had confirmed COVID-19 infections (a little more than 1 percent of the world’s population).1
There are nearly 21 million Americans that have had confirmed COVID-19 infections (roughly 6.3 percent of the United States population).2
There have been a bit more than 1.8 million deaths attributable directly to the COVID-19 virus, and more than 350,000 of those occurred in the United States.
Each time I update those statistics, I shudder at the magnitude. It has been a difficult and tragic year, and vaccinations cannot come quickly enough.
With that said, as I have argued throughout the year, once we made it through the depths of the uncertainty and fear (late February into late March), markets became focused on the future … and less so on the present. As such, absolute numbers mattered less, and growth rates mattered more.
Chart 1 provides a bit more context:
While we all await the broad adoption (and hopeful success) of the vaccines, there are at least some glimmers of hope among the data.
First and foremost, while the growth rate of cases was remarkably (and unsustainably) high in the beginning of the year, it has since fallen, and fallen, and fallen. While there were moments of overconfidence, and therefore growth rate spikes, we have seen another decline in growth rates over the past six weeks. While we expect a post-holiday bump, this is great news, nonetheless.
Second, despite the spikes in growth rates of cases, the growth rates of deaths did not increase commensurately (as can be seen above). This resulted in a less than previously believed mortality rate (so far), which the markets have continued to react positively to.
In summary, while COVID-19 is not out of our lives, the lower the growth rates fall, the less impact this will have on our collective lives before this is all over.
Looking back at markets
Imagine I dropped an investor into a foreign country on Jan. 1, 2020, described the following scenario, then asked the investor to buy, sell, or hold the local stock market.
The country is the largest economy in the world.
In the year before you arrived, the stock market had one of its strongest years of the past 20.
In the year you are arriving, your country will experience a pandemic that will shut down the economy, schools, churches, and sports, and cause people to not leave their homes for months on end.
In the year you are arriving, the consumer will stop spending, businesses will stop hiring, and the government will provide unprecedented stimulus.
Millions will catch a virus.
Hundreds of thousands will die from the virus.
Uncertainty, fear, and panic will be at all-time highs, and market moves will be some of the largest over the past century.
Many investors would, undoubtedly, run, not walk toward the nearest exit and, at minimum, sit in cash while the chaos ensued. Those investors, after watching the performance of 2020, would have also missed out.
Charts 2 and 3 provide more context. First Chart 2:
And Chart 3:
How markets performed (when viewed through that lens) was therefore remarkable. On the one hand, we, as a country and society, experienced unprecedented travails, fear, uncertainty, and economic shutdown. On the other hand, the NASDAQ was up nearly 45 percent for the year (+88 percent since March 24!), the Russell 2000 was up 20 percent for the year (+96 percent since March 24!), the Russell 1000 was up 21 percent for the year (+70.4 percent since March 24), and the Standard & Poor’s (S&P) 500 was up 18.4 percent for the year (+65.2 percent since March 24).5
The question then is what do we expect next? We turn to that question in the third and final section.
Looking forward at markets
Spurred on by some recent and fairly salacious financial press analysis on how overvalued markets are, we dug into the data to form our own view. We looked at the consumer, we looked at businesses, and we explored several different areas of government. We looked at various types of valuations, and various forms of risk tolerance and risk chasing. We then turned to different comparisons of market pricing, both relative to other markets, as well as relative to history.
The summary was a bit anti-cathartic. In short, equity markets aren’t cheap, but they aren’t terribly expensive either. In fact, given the enormous levels of stimulus and how inexpensive the cost of money is, one could easily argue equity markets are on the moderately inexpensive side.
To demonstrate this graphically, let us compare how expensive the stock market is (proxied by the S&P 500) with how much interest rates have decreased.
Let me first explain how we compare those seemingly incomparable markets. One way to measure how expensive stock markets are is by “P/E” or the price to earnings ratio. Let’s imagine the stock market is $100, and the annual earnings of all companies in the stock market are $4. In this case, the P/E would be 25 (e.g., $100 / 4). It is essentially a way of thinking about how many dollars of earnings the aggregate market of companies are providing given how much we can pay for them. It is flawed in many ways, but its simplicity is a clear benefit.
We can then take that example P/E of 25 and invert it. Take 1, divide it by 25, and we have 4 percent.
Aha, now we have a percentage yield (or something that is similar), and we can compare that to the yield on bonds. If the 10-year Treasury yields more, for example, then we can say bonds are a better deal. And if the equity market yields more, then we can say that equities are a better deal. Is it flawed? Yes. But it’s always very useful over the long term and a structured approach to thinking about relative valuations.
Using this metric, at the top of the chart, equities provide a yield that is 5 percent (for example) higher than the 10-year Treasury bonds (thus making equities cheap relative to bonds). At the bottom of the chart, bonds provide a yield that is 5 percent higher than equities (thus making bonds cheap relative to equities).
As the chart indicates, as of the writing of this update, U.S. equities (as proxied by the S&P 500) are yielding roughly 3 percent more than U.S. 10-year Treasury bonds. As such, this makes equities looks relatively inexpensive to bonds and is a decent spread when compared with the last 60 years.
This doesn’t mean that equities will go up and bonds will go down. This means that, with this simplistic lens, equities are not particularly expensive.
We also looked at leverage levels, risk aversion, and a number of other measures … and it is worth noting that nothing is exceptionally risky, or worrisome, right now.
And some caution...
And yet … yes, there is always an “and yet.”
Imagine there are three investors in the entire market: one that is very risk averse, one that is moderately risk averse, and one that generally likes taking more risk.
Without our central bank intervening, the risk averse investor purchases Treasury bills. They are default free (the U.S. Government can always print more money), and therefore, earn very little. The moderate investor purchases a diversified portfolio of corporate bonds and some high-quality equities, and the aggressive investor purchases equities only.
After those portfolios are formed, the central bank provides a massive amount of stimulus through various means (i.e., expansion of balance sheet, lowering rates, and the like).
Well, generally speaking, all of our hypothetical investors make money as that occurs, and everyone is happy for the time being. The U.S. Federal Reserve (the Fed) lowered rates, which means owners of bonds benefit as bonds increase. Companies can now borrow money less expensively, so equities generally increase. And consumers can borrow more for less cost, so they spend more, which helps both bonds and equities.
But then what happens?
Well, our risk-averse investor now looks at her portfolio and realizes that while she made money when rates fell, her current yield is quite paltry, and honestly…it isn’t worth it. So, what does she do? Well, she moves a bit out on the risk curve.
The moderate investor made money in most places, but also realizes that yields have fallen, so again, this investor moves a bit further out on the risk curve.
And the aggressive investor is now on top of the world with all of the recent gains and decides to continue to stay out on the risk curve. In short, at the margin in our fictitious world, the safe assets are now less preferred, and the riskier assets are now more preferred.
This is, in short, what has occurred over the past couple of years.
Let’s imagine then, that the Fed decides it has done enough and won’t provide any more liquidity or raise rates further. Or, to make the example even more pointed, let’s imagine the Fed remembers it can actually raise rates again (let’s imagine inflation appears).
These same investors, at the margins, then reverse their process. They move away from risk, which turns the spiral of our remarkably optimistic environment in the opposite direction.
In short, I strongly believe the market has recently been priced to perfection. Unexpected turmoil has occurred, unprecedented stimulus has been provided, and markets have been remarkably resilient … one might even say ebullient.
And these are the times that make me nervous. We see risk-taking increasing, but not to excessive levels. We see borrowing increasing, but not yet to extraordinary levels. As I have said over and over, risk comes from where we don’t expect it.
Our process as investors is that we analyze and optimize what we know and understand, and yet we prepare for that which we don’t.
What drives strong investing returns over the long term are structural incentives. Capital markets, as extensions of capitalism, provide those incentives. As such, we should strive to create portfolios that benefit from that dynamic, while creating those portfolios in thoughtful ways to help with reducing the risks we don’t understand and can’t contemplate.
This is not the time for moving out on the risk curve. Markets have been flooded with liquidity … what happens if that liquidity tide begins to ebb?
In short, control what can be controlled. Save, mitigate taxes, minimize expenses, and be quite cautious and thoughtful about taking unnecessary risks … for it is those risks we haven’t contemplated that put our capital in the greatest peril.
In closing, stay safe, and please turn off the investment news channels.
1 https://www.arcgis.com/apps/opsdashboard/index.html#/bda7594740fd40299423467b48e9ecf6
2 Sources: Bloomberg, World Health Organization as of Jan. 5, 2020
3 Source: Bloomberg, as of Jan. 5, 2021
4 Source: Bloomberg, as of Jan. 5, 2021
5 Source: Bloomberg, as of Jan. 5, 2021
6 Sources: Bloomberg, as of Jan. 5, 2021