- “Don’t fight the Fed, the fiscal authorities, or the vaccines”
- Excessive optimism, stretched valuations, and potential for higher interest rates are possible challenges
- Given probable tradeoffs, most Sequoia strategies are generally neutral equities/fixed income, with modest tilts toward higher quality U.S. equities and lower fixed income duration than broad indices
Capitalism requires the free movement of people, goods, services and capital. The Coronavirus severely constrained this free movement in 2020, which has had profound impacts on our public health, economy, financial markets and psyche. The virus has created an enormous human tragedy with deaths sadly pushing toward two million globally (see footnote). For investors, the result has been some of the largest and fastest swings in financial markets and economic conditions in history. Yet, given the range of emotions and volatility, the resiliency of our people and capitalism is truly amazing.
In short order, doctors and scientists have developed several effective vaccines and treatments that are now being administered broadly. Central banks and governments globally have also delivered unprecedented relief packages designed to bridge the gap until the virus can be brought under control. In the United States, the Federal Reserve (Fed) and fiscal authorities (Treasury, Congress, Executive Branch) collectively acted more quickly and on a larger scale than ever during the depths of the crisis in March and throughout 2020. As a result, the S&P 500 is around all-time highs, bond markets are functioning well, and many businesses that would have otherwise likely failed are able to continue operating and employing workers.
As we turn the page from what was a uniquely challenging year, we want to be grateful for these accomplishments and hopefully press into a new chapter where we can once again gather with our families, go to the movies, and enjoy our favorite restaurants without fear of contracting or sharing the Coronavirus in 2021. As investors, we must also turn our attention to what may be ahead for the economy and markets. In this regard, the big question in our minds is if 2021 will be the year where the Fed starts laying the groundwork to turn the page on its extraordinarily accommodative monetary policy as the economy likely improves. A new chapter in monetary policy could have profound implications on asset prices. As such, we want to explore some of the potential opportunities and challenges we may face as well as general portfolio positioning as we embark on a whole new adventure in 2021.
Clearly, the vaccines developed by companies like Pfizer, Moderna, AstraZeneca, and Johnson & Johnson are most likely game changers for the global economy in 2021. This was a healthcare crisis that led to an economic recession, and a healthcare solution is likely to lead to an economic expansion. As the vaccines are distributed and administered broadly, we expect virus case counts to slowly moderate as we approach sufficient scale to produce immunity. In doing so, the free movement of people, goods, services and capital can start functioning more normally again thereby allowing the economy and corporate earnings to heal and resume growing at a decent rate as we progress in 2021.
At the same time, we will still have the potent monetary and fiscal stimulus relief measures implemented to bridge the gap working heavily in the system. The Fed’s balance sheet has grown by more than 75% or about $3.2 trillion in 2020 (see footnote), and they have pledged to keep it growing with $120B of bond purchases per month (see footnote) (quantitative easing) with no end date stated. Likewise, Chairman Powell and other Fed chiefs have clearly laid out in the Dot Plots that they have no intentions of raising short-term interest rates (Fed-Funds Rate) from near zero until after 2023 (see footnote). The clear commitment and scale of these Fed programs will likely continue providing support for financial markets in 2021. Similarly, Congress has injected nearly 15% of GDP (close to $3 trillion) (see footnote) in fiscal stimulus through the most recent $900 billion relief bill and the CARES act passed in the spring. This is a scale not seen post WWII. The measures have targeted households and businesses most impacted by the virus and should continue supporting financial markets and corporate earnings by helping accelerate economic growth in 2021 as well. Already, these combined monetary and fiscal support measures have impacted the real economy as data from the housing market, manufacturing sectors and labor markets have improved significantly off the spring lows, and potentially point to further expansion in 2021 (see footnote).
Marty Zweig is credited with the now famous investment adage “Don’t fight the Fed”. In our current environment, it seems to us the playbook is, and will likely continue to be, “Don’t fight the Fed, the fiscal authorities or the vaccines” in 2021. Practically, this means stocks may continue to do well even if they become volatile episodically throughout the new year.
At the same time, many investors have already caught onto the “Don’t fight the Fed, the fiscal authorities or the vaccines” playbook and may be overly optimistic with market expectations in 2021. Some examples we note are the recent large price and trading volume increases in vehicles like, margin debt, Bitcoin, Tesla, IPOs, SPACs, long call options, small cap stocks and others which potentially show sign of excessive optimism on the part of investors from our view. This type of price and trading volume action tend to be contrarian indicators based on our experience, and should give us patient, longer-term investors some cause for concern. Situations like these typically lead to quick bouts of volatility that shouldn’t surprise us as we head into 2021.
Additionally, the price of the stock market relative to fundamental measures like earnings, cash flow and GDP are also a current concern for our team. Using the S&P 500 as an example, the forward 12-month P/E is around 22 with a 25-year average around 16.5 (see footnote). The Cyclically Adjusted P/E ratio (CAPE) is around 33.5 compared to the 25-year average around 27.5 (see footnote). The Price/Cash Flow ratio is near 16 versus a 25-year average closer to 11 (see footnote). Additionally, Warren Buffet’s favorite measure of valuation, the stock market relative to GDP ratio is at record highs near 185% (see footnote). The ratio stood at 167.5% on 3/31/00 (see footnote), which is not an occurrence we want to be comparing to, given what followed. What is different now is that interest rates are being held at extremely low levels by the Federal Reserve compared to history. Higher multiples may be justified relative to longer-term historical metrics given this. How much so is the key question. If the economy fully recovers from the virus induced recession quickly in 2021 and the free movements required for capitalism resume, earnings may be able to grow into these higher multiples. However, as we will outline shortly, if economic growth expands rapidly in 2021 given all the stimulus, longer term interest rates may not remain so low. If not, these multiples may begin to look expensive to investors. The bottom line from a valuation perspective is that while metrics are high relative to history, they may not be too high yet given where interest rates are. Valuation data is likewise never a good tool to use for considering potential shorter-term market movements from our view. However, we think a major assumption implicit in current equity market prices is that longer term interest rates will remain low. We worry economic growth in 2021 may not fully support this assumption.
Finally, we also worry that we should “be careful what we wish for” with stronger economic growth. To reference the famed economists Goldilocks and the Three Bears, we need the economic porridge to be just the right temperature. This means economic growth that is not too hot or cold to cause the Fed heartburn. Given all the stimulus measures and potential pent up demand as people, goods, services and capital start to flow more freely, we think there is a decent chance the porridge may get a bit “too hot” potentially leading to longer term interest rates (10-Year Treasury Bonds and longer) creeping higher (due to inflation?). This could set up the valuation dilemma already described. Porridge that’s a bit too warm for the Feds liking in the back half of 2021 could put them in the uncomfortable position of bringing up the terrible “T” word...Taper. Any tapering of the asset purchases described earlier or language changes around reducing the size of the Fed’s balance sheet could lead to a “taper tantrum” as we witnessed at the end of 2018. A turning of the page to a newer chapter in monetary policy could have profound implications on asset prices. It’s a top concern for us into 2021.
Balancing the ledger between the potential opportunities and challenges, it strikes our team that not being too far out on a limb in either direction makes sense as we charge forth into a new frontier. As such, most Sequoia strategies are broadly balanced (neutral) relative to equity/fixed income targets, with modest tilts toward US higher quality equities and lower fixed income duration than broad indices. For example, our 70% equity/30% fixed income strategies are generally in-line with these “neutral” points (i.e. not materially greater than or less than 70% equity). Also, within fixed income allocations, several strategies hold managers that have flexibility to adjust duration and look for yield globally where interest rates may be more attractive.
As we turn the page from what was a uniquely challenging year in 2020, we long to return to many of the activities we enjoy most (potentially took for granted?). 2021 will also undoubtedly present several unexpected events. As investors, we want to remain patient and disciplined until we better understand if the porridge is going to be just right or a bit too hot or cold. For now, we are on guard for it to potentially be a bit too warm for the Fed’s taste buds later in the new year.
2020 Data Review (footnote)
Sources: 1 Bloomberg
Investment advisory services offered through Sequoia Financial Advisors, LLC, an SEC Registered Investment Advisor. Registration as an investment advisor does not imply a certain level of skill or training.