2020 Review - 2021 US Equity Markets Outlook
“Mistakes are a part of being human. Appreciate your mistakes for what they are: precious life lessons that can only be learned the hard way. Unless it’s a fatal mistake, which, at least, others can learn from. ”
Lessons learned?
2020 has been a year for us to remember. In just one short year, many significant events have occurred. We are not going to get into the nitty-gritty of the sequence of events in this outlook, but there are a number of important occurrences for us to review and learn from.
Risk management
The Problem: The exogenous shock---COVID-19 has impacted our lives in many ways, and so has the market. In terms of the economy, 2020 brought many unpredictable factors that cannot be explained by typical economic models. From raging large scale wildfires to the still occurring COVID-19 pandemic, few could have predicted the state we would be in now. Many institutions and individual investors were caught off guard in late February and March and had to experience portfolio drawdown when all kinds of assets were rapidly losing value. Governments and businesses all over the world had to respond to the negative effect of the lockdown measure while states are trying to minimize the spread of COVID-19.
The Lesson: While it is easy to point one’s finger at the Chinese government and its failure to be transparent about the virus, it is more important to acknowledge the fact that many countries’ governments, especially the United States government, failed to anticipate the COVID-19 outbreak. Corporations and individual businesses have been dealing with the same setbacks as governments. Many businesses had to file bankruptcy or close shop if owners were not able to adapt to the change and still make a profit. Times like this will test a business’ model adaptivity and how its leadership anticipates change, even if the exact source of the change is unpredictable. Companies like Walt Disney adopted its DTC (direct to consumer) streaming strategy early last year, and it had paid off massively during the COVID lockdown. With this strategy, customers are able to watch shows and movies at home with a subscription, which is a suitable alternative for regular movie theatergoers. Other businesses, however, were unable to adapt to the pandemic and suffered as a result. For example, Dave & Busters, which solely relies on in-person interactions, had to suffer the consequences of the pandemic. They do not have an omnichannel strategy that allows people to play their games from home, so when their in-person venues closed, they were not able to maintain their revenue trajectory like Walt Disney. In the assets management industry, PMs (portfolio managers) always try to move one step ahead of a potential “six sigma” or tail events by using probability measures. However, these rare occurrences can still arise, even if the probability of them happening is about twice in a billion, as seen with the 2008 financial crisis. Portfolio managers can also do this by hedging the portfolio for an external shock, such as the COVID-19 outbreak; failure to do so would have a catastrophic impact on the individual PM’s portfolio or the client’s money. As stated previously, risk management is critical in the investment process, and can also be applied to many areas of our professional and personal lives.
Behavioral psychology
The Problem: The deviation between the economy and the markets. Many people got out during the market crash in March and stayed out in anticipation of further drawdowns. Few investors entered the market during the course of the crash. We have not started to see a massive inflow of capital into the market until recently. During the past couple of months, we have witnessed one of the largest performance gaps between investors who have entered the market in March and those on the sidelines. Many new retail investors entered the market as people spend more time at home, leading to more spare time to trade. Sports betters entered the market as well since many sports events were canceled. They had to find something else to gamble on when their preferred options were unavailable. These new, inexperienced investors are trading companies based on narrative and “technical analysis of charts” instead of on a financial model of business. There are also some cognitive biases that can change investors’ narratives. Loss aversion occurs when someone avoids any risk. This can stop investors from being able to see the potential in new investments. Familiarity bias can prevent rational investing as well. Someone could invest because they work for the company, know someone who does, or simply buy products from them. Lastly, there is the bandwagon effect, which can lead investors to choose the same shares as a friend or someone else who happened to be successful.
The Lesson: Understanding human psychology can help us make better decisions during uncertain times. Markets are forward-looking and tend to bottom when the last seller in the market sold their shares. Monetary and fiscal policy support is crucial for businesses and individuals during an economic crisis, and the timing of this support plays a large role in its effectiveness. In a matter of weeks, the U.S. Federal Reserve announced a massive liquidity injection plan in March, and Congress passed an astonishing fiscal support stimulus bill. The fact that the market continued to sell off despite this news was a sign of extreme pessimism; it was bound to rebound. People were hesitant to invest when uncertainty is high. As the English economist, John Maynard Keynes put it, “the markets can remain irrational longer than you can remain solvent.” It is true that inexperienced investors who trade based on narratives are neither rational nor sustainable. But a company’s current market value is driven by supply and demand. As long as there are buyers bidding with the price they think makes sense to them, the company will continue to trade above or below the narrative value rather than the intrinsic value. This makes investment based on traditional valuation metrics difficult in this current environment. Moreover, it also increases the probability of downside surprises. By understanding the human psychology that is driving these narratives, we can quantify these to our risk model, thus producing better decisions during these uncertain times.
“The essence of risk management lies in maximizing the areas where we have some control over the outcome while minimizing the areas where we have absolutely no control over the outcome.”
2020 Risk Assessment Review
There are three major tail risk events in our “2020 U.S. risk assessment” outline: 1) twin epidemics, 2) political dominoes, and 3) early vaccine development. At the end of 2020, all of these risk factors mentioned above had played out or began to play out:
We are in the middle of a second wave of the pandemic and the COVID-19 cases in the U.S. continue to reach new highs. While the federal government stated that they will not order a nationwide lockdown, many states did roll out new restriction measures. However, even without a lockdown order, people tend to voluntarily reduce overall activities as a whole to minimize the risk of COVID-19 infection.
While previous presidential elections all had a period of disruption when major news outlets announced the winner, this period is likely to last a bit longer when it comes to the 2020 presidential election as the current incumbent continues to challenge the integrity of the U.S. electoral system. As mentioned previously, the growing tension between the two political parties in the U.S., and the resurgence of extremism will lead to more domestic antagonism. As we are heading into 2021, investors should not factor the short-term political narrative too much into the decision making process. With that being said, the outcome of the GA senate runoff is worth paying attention to. The current consensus project has a 53% probability of a Republican win, it is clear that a “blue wave” will boost the Democratic agenda (i.e. a larger fiscal spending package), and could lead to a potential reversal of some of the action that corporations had benefited from under the current administration. A better way for investors to approach this situation is to find companies that will perform well regardless of the election outcome.
Normally, a record high in COVID-19 cases would have a negative impact on economic growth, thus less positive market sentiment; however, the latest positive vaccine development seems to provide investors enough conviction that the economy will return to normalcy in 2021. Indeed, there are still lots of unknown factors of the vaccine such as mass adoption, delivery methods, potential side effects, etc. Furthermore, we still think the lack of urgency on larger one-time fiscal stimulus support is drying demand in the economy (although the recent $900bn bill would provide some spending power into the system). On the other hand, one of the things we learned during this year is that the bull market usually accelerates under the “wall of worry;” as these risk factors become consensus, the probability of a downside effect caused by these factors are relatively low. There is resilience in the economy when roadblocks occur that allow for it to grow again rather than permanently damaged.
2021 short term outlook - Where do we go from here?
Based on the latest data, the U.S. economy is on track to recover from the impact of COVID-19, and the positive vaccine development is driving more optimism to this sentiment. The December U.S. ISM Manufacturing PMI registered 60.7 percent, up 3.2% from the November reading of 57.5%. This figure indicates expansion in the overall economy for the eighth month in a row after contracting in March, April, and May. Notably, The Employment Index returned to expansion territory at 51.5 percent, 3.1% higher from the November reading of 48.4%. In November, industrial production increased by 0.4% month over month, and manufacturing and mining production rose by 0.8% and 2.3%, respectively. However, as mentioned before, the pace of recovery is expected to slow on a trending basis. The November retail headline and core sales dropped 1.1% and 0.5% month over month, respectively. While initial jobless claims continue to rise at a slower pace, long-term unemployment continues to edge higher as the risk of structural labor market damages increases. This means that fewer people will look for work, which will result in a lower labor force participation rate and more wage pressure. On the other hand, the recent passage of the $900bn stimulus relief as part of the “consolidated appropriation act, 2021” (H.R. 133) or the $2.3 trillion spending bill would provide some support to the economy in the short term. Moving forward, a successfully targeted vaccine rollout and continued fiscal and monetary support will be crucial to help the economy recover.
“The US LEI continued rising in November, but its pace of improvement has been decelerating in recent months, suggesting a significant moderation in growth as the US economy heads into 2021,” said Ataman Ozyildirim, Senior Director of Economic Research at The Conference Board. “Initial claims for unemployment insurance, new orders for manufacturing, residential construction permits, and stock prices made the largest positive contributions to the LEI. However, falling average working hours in manufacturing and consumers’ worsening outlook underscore the downside risks to growth from a second wave of COVID-19 and high unemployment.”
The U.S. equity market, on the other hand, continues to reach an all-time high, The forward 12-month price to earning P/E ratio for the S&P 500 is 22.1, which is above the five-year average (17.4) and above the 10-year average (15.7). The sell-side consensus-estimated (year-over-year) earnings growth rate for the S&P 500 for 2021 is 22.1%, which is above the 10-year average (annual) earnings growth rate of 10.0%. This large increase in earnings is primarily driven by lower 2020 earnings given the impact of COVID 19. The sectors that suffered the most offer the most attractive valuation. The Financials sector, for example, has a forward 12-month P/E of 14.6 compared to the Consumer Discretionary sector, which has a forward 12-month P/E ratio of 32.7. While some companies are trading based on reasonable forward multiples, other parts of the market, such as SPAC (Special Purpose Acquisition Company), or “blank check” Shell corporation, and narrative-driven companies continue to deviate from their fundamentals. For example, the Nikola Corporation, a hydrogen-electric truck company once valued at $25bn with zero recurring revenue, generated $36k from non-core business revenue (solar installation) last quarter and still trade at an $8bn market cap. It is quite extraordinary for us to see some of these companies with low or even zero revenue trading at towering forward multiples. Even with the most bullish assumptions, these valuations are priced at a substantial premium when they get ahead of themselves; this is partially thanks to the new retail traders who entered the market during the initial COVID-19 lockdown. This speculative behavior continues with short-term call buying option traders surging to levels that haven’t been seen since the dot-com bubble. Clearly, some of these traders do not act based on fundamentals, while some are buying based on the so-called “analysts narrative.” The British economist, Ronald H. Coase, once said, “If you torture the data long enough, it will confess,” meaning that you can run statistical tests over and over again until you attain the results you want by chance based on the way statistics and probabilities work. This can lead to varying statistical results using the same data and multiple tests, making it hard to predict things accurately. Since most analysts’ price targets for companies are based on future cash flows, the final results can range widely, given the different inputs that enter the valuation model.
“Analysts’ forecasts are usually overly optimistic. Make the appropriate downward adjustment to your earnings estimate.”
The greatest call-buying frenzy since the dot-com bubble
New orders in YoY-terms will be peaking in Apr’21
Oaktree Capital’s co-founder, Howard Marks, always likes to advise investors by saying they should try to “[get] the odds on [their] side.” In his latest memo, he advises his clients to be defensive due to high uncertainty and lower prospective returns: “the odds aren’t on the investors’ side, and [the] market is vulnerable to negative [surprises],” he stated. That being said, when uncertainty is high, risk management becomes crucial for the decision making process. That means identifying areas with greater upside potential than downside and continuing to monitor the probability of downside risks. While we continue to call for caution as part of the risk management process moving into 2021, in the short term, there are still plenty of potential returns for investors to capture. Here are some potential alpha generation opportunities for the first half of 2021:
Factor: Underappreciated value over consensus growth: Value underperformed growth for a long period of time; while many COVID-19 lockdown beneficiaries enjoyed their capital market appreciation for the past months, cyclical companies have lagged behind. As we have mentioned in our prior note, the rising probability of successful vaccine development will trigger a sector rotation to cyclical companies. Many of these companies are priced in the “worst-case” forward earnings scenario, which implies greater upside potential while downside risks are capped. However, these companies’ outperformance will be short-lived if market gains are based solely on sector rotations, so it is important for investors to utilize outside funds instead of selling all of their growth/defensives to buy cyclical/values, given the amount of cash still sitting on the sideline. (According to the FDIC, more than $2 trillion has been stockpiled into individual bank accounts in 2020. Even as margin debt has risen, FINRA cash in accounts remains near March 2020 peak.)
Geography: Emerging markets (EM) over Domestic(US): In "The Changing World Order," Ray Dalio, the co-founder of Bridgewater, states, "The United States is still the leading power but is declining and…China is a rapidly rising comparable power." We are not here to make a political argument. But on a risk and reward basis, we think emerging markets offer better value for returns. The emerging-market has underperformed in the U.S. market for years now; we think an overly stimulative fiscal policy and a slow-acting Fed would lead to a surge in “inflation narrative.” The latest Headline PCE price index was unchanged month-over-month (MoM) and is up 1.13% year-over-year (YoY). The Core PCE is still below the Fed's 2% inflation target rate. The three components: transport, accommodations, and apparel, which saw their greatest yearly decline, are down by 1.8%, 11.8%, and 5.7%, respectively. As COVID 19’s strength fades away in 2021, a sharp demand increase in these industries could push the overall PCE index higher (assuming a greater rate of change than other components), whether it’s temporary or long-term. This inflation pressure would favor foreign currencies against the U.S. dollar, thus makes emerging markets more attractive for investors as their currencies strengthen. Now, while we still have not seen many funds flow into the EM as a whole, the EM trade has become a consensus strategy as both sell & buy-side analysts are recommending this to their clients. Therefore, we think it is important for investors to find the “deep value” in uncrowded places. While China, Japan, Taiwan, and South Korea have outperformed the Global Index for the past few months, the risk and reward pay off may not be as good as it is in countries like Brazil, Malaysia, South Africa, Vietnam, and India, which lagged on trending and valuation basis.
Style: Look beyond the headlines: We encourage investors to look for the value behind popular ideas. For example, we look for the hardware behind crowded software; a lesser-known company, Logitech, was a value alternative to Zoom video communications. Logitech (LOGI) also benefited from the COVID 19 lockdown, the company generated $1.26bn in revenue last quarter, up 75% from a year ago; LOGI has an excellent balance sheet, an outstanding growth profit margin, and a reasonable dividend payout ratio, making it a suitable choice for long-term investors. For crowded electrical vehicles (EV) trades, you can try to look for end supply chain value, and analyze which component in the manufacturing process requires greater cost (due to short supply). Perhaps, base metals related companies could be a better play in this scenario because they produce essential chemical elements for EV batteries and are relatively undervalued compared to automobile manufacturers.
Alternative investments: As part of the “inflation narrative”, other asset alternatives also provide attractive returns in the short term, most notably, commodities. Cyclical commodities experienced numerous amount of supply chain disruptions during the initial COVID-19 lockdown, thus pushing the price even higher for some classes of commodities that benefited from the pandemic. Copper is an example of this due to an increase in demand for electronic products to work and learn from home with. Lumber has also grown, given the surge in residential home building. As global economies gradually return to growth in 2021, combined with China and potentially the U.S.’ lead in the climate change agenda, the demand for commodities will continue to increase as the supply chain continues to play catch up, thus driving prices higher.
Finally, the next big thing: while we think many “growth sectors” are too crowded, you can still generate alpha within these sectors by finding values. During these uncertain times, disruptive business models cut costs and boost productivity; this was demonstrated by many innovative companies during the COVID-19 crisis. Zoom transformed the way we interact with others; Roku offered a better cable TV alternative as more people seek entertainment during their time at home; Peloton allows gym-goers to stay fit at home while building a new community of like-minded people. It’s not a myth that these business models are not priced properly until exponential growth pulls away from linear growth during a time like this. Investors can increase their returns and lower risk by trying to anticipate similar models that are misunderstood at their early stages. Areas we think are still in the early stage of the “innovation” development curve are biotech/genome sequencing, alternative energy/storage & transport, robotics/AI, Fintech/decentralized ledger, Streaming/Next-generation gaming, and more. Some of these have already drawn plenty of public attention, but we think there is a greater long-term upside potential than most are expecting.
“A bull market will climb a wall of worry, while a bear market will slide a slippery slope of hope.”
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