Stuck In The Middle
By Matt Quinn, CFA® November 2020
“Clowns to the left of me, Jokers to the right, here I am, Stuck in the middle with you.”
The main line from the 1973 hit song by Stealers Wheel entitled “Stuck in the Middle with You” seems so appropriate for 2020. The song reached #6 in the Billboard Hot 100 during my birth year (1973) and was reborn again in 1992 with the release of Quentin Tarantino’s first full-length feature film Reservoir Dogs. Stuck in the middle seems to be the theme for 2020, as we are all stuck in the middle of a pandemic that seems to have no end. We also seem to be stuck in the middle of a presidential election that no one wants to lose. No one likes to lose, particularly when it comes to elections and money, but eventually we will be able to move on from this election season and hopefully have a vaccine available for broader distribution to the general public sometime in 2021.
Speaking of money, something peculiar happened as most of us headed to the election polls. While the stock market was essentially flat through the first ten months of the year, the market has rallied strongly since election day and is now up more than 10% for the year. This is an astounding recovery from the lows in March when the market had declined by more than 30% and we experienced the worst first quarter in stock market history!
While the Democrats would love to take at least partial credit for the rally, in truth the market has reacted favorably to signs of a subsiding ‘Blue Wave’ as election results were tallied. Markets also got an injection of good news as Pfizer and BioNtech announced that their COVID-19 vaccine candidate was found to be more than 90% effective in preventing infections in a Phase 3 clinical study. Moderna has since followed up with an even more promising vaccine candidate from its Phase 3 clinical study. With Emergency Use Authorization (EUA), both candidates could be available for limited distribution in the US before the end of the year.
Something else promising may be happening underneath the surface of the market as participation in the latest market rally has broadened out from just the mega technology stocks into other sectors. Through the first ten months of the year, the most FAAAM-ous technology stocks that now comprise the top five constituents of the S&P 500 Index (Facebook, Amazon, Apple, Google’s parent Alphabet, and Microsoft) increased nearly 40%. The remaining 495 stocks in the index collectively declined 5%. This leadership, while not surprising as many of us shifted to a stay/work/learn from home environment, was not sustainable. We have not seen this sort of dispersion between the technology sector and the rest of the index since the days before the tech/media/telecom (TMT) collapse. There has also never been a time when the five largest stocks represented such a high percentage of the overall index.
So where do the markets go from here? Markets clearly prefer certainty over uncertainty when it comes to fiscal and monetary policy. While some may still question the outcome of the election and there are still two key Senate races to be decided in Georgia, the washed-out Blue Wave likely means fiscal policies are ‘stuck in the middle’ and less likely to drift too far to the left or to the right. Both parties have expressed interest in moving additional economic stimulus forward, and we likely won’t see meaningful changes to tax policy until the economy regains traction. Global monetary policies should also remain accommodative for the foreseeable future and keep a lid on interest rates.
For those that may be concerned about a Democrat occupying 1600 Pennsylvania Avenue next year, history shows that Democratic presidents are no worse for financial markets than Republicans. In fact, historical studies show that Democratic Presidents are slightly better for the stock market than Republicans largely due to the poor market results posted during the George W Bush years. While President Bush did his best to bring the economy back from 9/11, the combined effects of the TMT collapse and financial collapse of 2008 led his presidency to the lost decade for both the US economy and stock market. From an economic standpoint, it really is no surprise that Joe Biden won the election. After all, the last three presidents that failed to earn a second term (Bush 41, Carter, and Ford) all experienced economic recessions within 24 months of their respective re-election bids.
How are we positioning for 2021? Some things remain the same as they always have. We continue to manage portfolios custom tailored to our clients’ own unique goals, risk tolerance and time horizons. We also continue to rebalance portfolios as tax efficiently as we possibly can. That meant selling positions to realize losses during the first quarter market sell off that can be used to offset realized gains this year and beyond. We also liquidated the bulk of our active managers in what we call our tactical equity category. In the past, we have given leeway to investment managers in this category to invest as they see fit in stocks, bonds and cash using a variety of investment strategies. Overall, we have been disappointed with their results over the last three years as they have been the largest detractor from portfolio performance. This allocation has shifted back towards more traditional stock and bond managers and towards a handful of target outcome funds.
Less fiscal and monetary policy uncertainty combined with recent positive news regarding vaccine candidates should allow for a more favorable economic backdrop in 2021. Rather than a stock market that is focused on a handful of technology and stay/work/learn from home stocks, we expect to see some momentum to recent market trends of a broadening out of market performance. We note that fundamentals continued to improve for many of the companies we follow during the third quarter, although we acknowledge that further market gains will need to see support from a greater earnings recovery rather than expansion of already stretched valuation multiples. Our hope is that the S&P 500 Index constituents can deliver earnings gains in 2021 off peak earnings in 2019 before the global pandemic began.
In terms of general portfolio exposures, we are steadily reducing our overweight to healthcare stocks and increasing our ownership of foreign stocks. Broadly speaking, foreign markets appear cheaper than US markets and should get further support if the US dollar continues to weaken. While stock performance during the last decade was all about mega cap US technology stocks, even in this environment where the US stock market has maintained a clear leadership position, an average of 74% of the top 50 stocks in the world were outside the US. We have exposure to many high-quality well-known companies that happen to be domiciled outside the US with our current managers such as Nestle, Taiwan Semiconductor, Adyen, Roche, Novartis, and Adidas to name a few. We also expect an improved trade environment and global economic rebound to bolster the growth prospects for small and middle capitalization companies both in the US and abroad.
As we head into Thanksgiving week, we hope you get a good seat at the dinner table. After all this time stuck in the middle of quarantine, hopefully we can all appreciate the time we spend with our own clowns and jokers. Just make sure they wash their hands before passing you the stuffing!
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