No one who lived through 2020 will ever forget it. Ironically, when someone is said to have 20/20 vision, it is intended to mean that they see things very clearly. How astonishing is it then that this past year was one that absolutely no one could see coming?
We still recall having benignly routine meetings with investment managers in January and February of last year. At the beginning of any year most investment professionals give into the temptation to predict what the year ahead may hold. (If they get it right, they will have bragging rights, and if they get it wrong, no one usually remembers, so why not give it a shot?) Most, if not all, of the pundits whom we spoke with predicted a relatively calm and boring year of slow but steady growth and single digit stock market returns. Although the US was late in the economic cycle, most experts expected that expansion could continue at a slow pace, and that there was therefore no need to fear a recession.
But no one foresaw that a small virus, 90 nanometers in size, just 1/400 the size of a human hair follicle, would reach around the globe and change the year forever. In fact, while there have been virus scares in the past, a pandemic of this scale has not occurred during most of our lifetimes. And when the prior Spanish Flu pandemic occurred back in 1918, global business was certainly not as interconnected as it is today. The disruptions that have been caused by COIVD-19 have been far-reaching and astounding. The economy and financial markets gyrated all year long as they tried to adjust to changing expectations and price in all that was going on. Just to put this in perspective, here is a list of the extreme financial events of 2020:
- Historically low and high unemployment. In February the unemployment rate was 3.5%, the lowest in 50 years. By April, it was 14.7%, the highest rate since the Great Depression.
- Fastest stock market decline to bear market territory, and quickest recovery in history. It only took 30 days to decline -30% (the prior record was 55 days in 1987), and it took just 140 days to recover (the prior record of recovery from a 30%+ drawdown was 274 days in 1970-1971).
- Record monthly stock market returns. In April, US large stocks had their best monthly return since the inception of the Russell 1000 Index, and in November small companies and global stocks had their best monthly returns in the history of the Russell 2000 and MSCI ACWI Indexes.
- In 10 months, The Fed expanded purchases of bonds by nearly the same dollar amount as it did from 2007-2015.
- Unprecedented oil prices. Oil futures contracts declined by up to 30% in one day and traded at negative prices for the first time in history.
As much as we might like to put 2020 behind us forever, it is unlikely to be a year that we will soon forget. Many significant economic and market events will make 2020 a year of reference against which we will measure future economic and market shocks. Investor sentiment swung wildly from casual indifference to extreme pessimism, only to rebound once more to a perhaps more optimistic view than when the year started. In fact, the Russell 1000 US large company stock index ended the year up 21%, which is nearly twice as good as its yearly average. Such a phenomenal rebound is astonishing and masks the ongoing pain felt by many whose jobs and industries are still impacted by COVID-19 and the measures taken to limit its spread. The reality that there is far more going on than first meets the eye is a theme for the year and the focus of our Year in Review. In the following paragraphs we will discuss the nuances of the year in the financial markets.
Stock Market Contrasts: The Stay-at-Home Trade vs. the Return-to-Normal Trade
As anxiety around the economic fallout of restrictions on activity came to the fore, stock markets around the globe fell extremely quickly, but not all companies were affected the same way. In the initial drawdown, economically sensitive companies were sold off heavily while companies that operated in the digital space were perceived to actually benefit in an environment where many people worked from home, and they held up better and began a recovery much sooner. The economically sensitive companies tended to be smaller in size and also what are called value stocks (companies that are cheap relative to their intrinsic balance sheet value), while the companies that benefitted tended to be larger companies with high growth rates. This exacerbated the already inflated valuations of large growth companies and sent the valuations for small and mid-sized companies downward to historically low levels.
This theme persisted until late summer when hopes for a COVID-19 vaccine started to gain momentum. The reversal gained even more steam after the elections, since it was perceived that increased Democratic power in Washington would facilitate more Federal stimulus that would help benefit the recovery of smaller companies. Contrasting performance between the earlier and later parts of the year were startling. At one point, small companies trailed large companies by 15%, but by the end of 2020, small companies had closed the gap and ended the year with a similar return to large companies.
The sizeable drawdown in smaller company prices, as well as widely varying drawdowns amongst sectors and individual companies, presented a ripe environment for active stock pickers to pick up bargains and fine tune their portfolios. Collectively our small company managers, both domestic and foreign, positioned their portfolios well to benefit from themes that emerged this year and provided substantial outperformance relative to their indexes in 2020.
Bond Market Limbo: How Low Can Rates Go?
While much of the press was focused on stock markets, bond markets were also impacted, and 2020 was far from a boring year in bonds. As the pandemic unfolded, investors rushed to the safety of cash and created an environment where there were simply more bond sellers than bond buyers. The lack of buyers in the market caused bonds to fall more than one would expect considering their status as a relatively safe asset. Discussions of a potential “liquidity crisis” ensued, and as stresses became more acute, the Federal Reserve stepped in to take action. They provided liquidity to the markets by purchasing Federal government bonds and government-backed mortgage bonds. The Fed’s quick action was enough to restore confidence in bond markets and a large-scale bond market crisis was averted.
With this reassurance that bonds would remain a safe haven during trying economic times, investors returned to fixed income markets. Their purchases drove prices up, and this capital appreciation in bonds led to a very good year for their returns. Taxable bond values increased much more than municipal bonds did. But why? Speed was of the essence, and it was far more expeditious for the Fed to take action in taxable markets rather than in the municipal markets where there are many individual issuers and much smaller bond issues. With the Fed’s quick and far-reaching actions in taxable markets, investors felt comfortable coming back into those markets, but remained more cautious with municipal bonds.
When bond values increase like taxable bonds did in 2020, their effective yields decrease. As a result, taxable bond yields have dropped to historically low levels. Municipal bonds did not increase in value nearly as much, and as a result, their yields did not decrease as much either. The yield that municipal bonds currently provide relative to taxable bonds is attractive compared to historical levels. To be sure, municipal bonds are not immune from the low yield environment, but because municipal bonds did not perform as well as taxable bonds in 2020, they currently represent a more attractive investment opportunity (i.e. when they are purchased in taxable investment accounts).
Non-Traditional Diversification: Benefitting from the Oil Trade War
Non-traditional strategies were mostly positive for the year. These diversifying strategies often provided return at different times than traditional investments, thus fulfilling their role of helping to stabilize return patterns. To illustrate how alternate return patterns can be achieved, let’s study what happened in the oil markets.
There was relatively weak demand for oil early in 2020 and its prices were declining slightly. In response to this, trend following strategies placed short positions in oil to participate and benefit if it continued. With the onset of COVID-19, government-imposed lockdowns constrained economic activity around the globe, oil usage fell to unprecedented levels, and stockpiles of oil rose. In fact, there was so much extra supply that concerns arose for the availability of storage facilities. In March, OPEC decided to cut production in order to limit supply and try to stabilize prices. OPEC wanted Russia to contribute to cutting production, but they refused to do so. Saudi Arabia responded by announcing unexpected price discounts to global buyers in order to move their excess oil supply, and this resulted in oil prices falling by 20% – 30% in a day, depending on the specific oil contract being measured. As traditional storage continued to fill up, oil traders who were still holding contracts to buy oil later in the year were willing to get out of the contracts at any price because they feared there might not be anywhere to store it. Some oil futures contracts even declined into negative territory for a short period of time for the first time in history, which meant traders were essentially paying to take the contracts off their hands (which was a boon to anyone who actually did have storage available).
The low demand effects from the pandemic, coupled with ineffective attempt to reduce oil supply due to the price war between Russia and Saudi Arabia, caused oil to fall quite substantially through the end of May. Trend following strategies were able to capitalize on this, and this was one of the trades that caused positive performance for trend following while traditional stocks and bonds were falling.
What Did We Learn in 2020?
It is always important to take time to reflect and learn from our experience. In fact, studying the past is what helped us to maintain clarity and sanity when the market seemed most unsettled. Without this perspective, the investment results could have been disastrous. Back in March, we know that it was extremely tempting to sell investment assets as things looked incredibly dire. Things are still far from settled in terms of COVID-19 or in the recession that it has spawned. But, markets are always forward-looking and they are definitely now looking beyond the present situation to the future. By formulating an allocation and rebalancing plan when clearer heads prevailed, it helped to maintain a level of clarity and peace of mind to stick with it as the stock market was falling. Following this plan has resulted in rewards this year, which is encouraging since market turnarounds can often take much more time than this one has taken.
Another important lesson is to not try to predict where the market is going to head in response to economic or political news. It is extremely temping at times to try to protect oneself by guessing at these things, but not only are economic and political outcomes impossible to predict, but the market’s response to these outcomes is even more erratic.
Paracle Personal Financial Management is an independent financial planning firm founded in 2004 with an honest desire to help people optimize their finances by providing unbiased financial planning and investment advice that puts their clients first. Paracle specializes in delivering expert, comprehensive wealth management services to busy families. Their expertise integrates financial planning with investment management to ensure their clients experience confidence in every aspect of their plan so they can focus on what matters most. To learn more about Paracle, connect with them on LinkedIn.