| 1st Qtr.
| 12 Mo.
|10-yr Treas. yield||1.746%||0.917%||+0.829%||0.70%||+1.046%||+0.829%|
|Fed funds rate||0 – 0.25%||0 – 0.25%||n/a||0 – 0.25%||n/a||n/a|
(stock indices are before dividends; yield and rate changes are absolute changes)
It was another positive quarter for stock investors, but the real attention-grabbers are the longer-term returns. Of course, the trailing 12-month figures begin near the bottom of the pandemic market slide, and it should not be assumed that such a sharp recovery is the norm. Still, the S&P 500 closed just a few points shy of its all-time high (March 26), the Dow hit its all-time high on March 29 and the NASDAQ hit its all-time high on February 12 before dropping about 6% to the end of the quarter (and it actually had a 10% correction at one point). Even before that, for 2019 and 2020 combined the NASDAQ was up over 94%. International stocks continued to make up some ground and not to be overlooked was the significant jump in the benchmark Treasury yield.
A third round of pandemic relief was passed at $1.9 trillion and a $2 trillion infrastructure package was proposed by the Biden administration, touted as the most significant infrastructure since the interstate system and the biggest boost to jobs since World War II. The Fed stayed the course with keeping rates low and continuing its aggressive asset purchases, and Fed Chairman Powell expressed no concern over either the rise in the benchmark rate or the prospect of inflation. Indeed, Powell made clear that the priority is low rates even if inflationary pressures surface. In case you are waiting anxiously, the Fed also announced that there is no rush for a digital US dollar. The January 6 riot at the Capitol seems long ago, with the progress of COVID vaccinations and the approval of the Johnson & Johnson one-shot vaccine taking center stage.
Services growth was down due to supply chain problems, but still positive, while manufacturing growth hit a three-year high. New orders were especially strong, but prices paid by manufacturers for raw materials and parts had the biggest increase since 2008. Core business investment was choppy due to weather and semiconductor problems but is trending slightly positive. The trade deficit was up 35% in 2020 as exports slowed. Productivity for 2020 was up 2.5%, a solid increase from the 1.5% in 2019, and productivity gains are necessary to translate to an increase in standard of living. Final GDP growth for the fourth quarter was 4.3%, with a decline of 3.5% for FY 2020, the most since 1946. But this was far better than the UK, which drooped over 9% in 2020, the worst in over 300 years!
As might be expected, consumer confidence jumped the most in 18 years in March with positive COVID news. The labor market differential (whether jobs are seen as plentiful or hard to find) swung to a strong positive in March. Jobs added in February beat expectations and January jobs were revised upward, with the February unemployment rate at 6.2%. Leisure and hospitality jobs were the biggest part of that increase, but the labor participation rate stayed flat at relatively low levels. Retail sales were very strong for the holidays and January, largely due to stimulus payments, but slipped in February.
Residential real estate got even hotter, with houses for sale falling over 29% from the prior year, the most ever, and the median price rising at the fastest rate in 15 years. Bad weather caused some short-term pause in housing permits and pending sales but despite a 7% increase in housing starts in 2020 many potential buyers are left frustrated, and anecdotes of bidding wars are approaching the absurd. The average time on market for homes is only 20 days.
We prefer to Look Forward to something that has a predictable time when we will know the result. The current environment presents several situations that we know will end, but when and how are the unknowns.
The drivers of the uncertainty are low interest rates, the “accommodative” monetary and fiscal policies of the government and the accompanying (extremely) easy money. These have led to a period where “nothing is cheap” – stocks are trading at high multiples, real estate is on fire, gold is near highs, digital assets are soaring, and bond prices are elevated (with corresponding low yields). This environment is reflected in the idea that the slow and steady path to wealth is passé and the new normal is to take high risk and aim for big payoffs.
The question, then, is whether there will be the elusive “soft landing” when this period ends, or will things come to a crashing halt. Even in asking the question it is important to remember that investment markets are not necessarily the economy, so this landing is mostly concerned with investors (and speculators).
The broad investment markets appear to have the best chance to adjust without a severe bear market. Expected economic growth after the end of the pandemic could offset a return to more reasonable valuations and there has already been some rotation among leading stock sectors, from large technology to value companies and small stocks. The wild card is always some big external shock, like another pandemic.
Residential real estate is a problem of record low supply, coupled with those low mortgage rates. Buyers are far less leveraged than in the frothy market of the 2000’s and rampant speculation is much less prevalent. The end of the pandemic could create some more mobility beyond the work-from-home crowd, which could add to supply. Still, the end of multiple offers and bidding wars will bring a more balanced market and the pendulum could swing to a buyer’s market. That would not crash the market but it could create price pressure.
It’s a pretty safe prediction that the speculative parts of the markets will end badly. Any market that is driven by FOMO rather than some real assessment of value is at risk. Granted, there is plenty of FOMO in real estate but there is still the tangible home which has lasting value and practical use. A few observations:
• Call these activities whatever you want (trading, gambling, speculating, gaming), but it is not investing.
• Remember that for every transaction at some seemingly ridiculous price, there is a buyer paying that price, so there will be as many losers as winners.
• Despite the visibility of individual investor influence, most of the money is still being made by institutional players.
A brief look at how portfolio management has evolved for comprehensive financial planners over the years may be instructive. When fee-only, comprehensive planning began to take shape in the late ‘80’s and early ‘90’s, the prevailing approach was to “screen” mutual funds (with the screen criteria being either quite basic or more complex and proprietary) and then invest relatively small portions in a lot of those funds to try and capture positive performance. Regardless of the criteria, this usually meant investing in actively managed funds that had positive performance compared to their peers in the immediately preceding years.
Even with a basic understanding of mutual funds one can guess what happened. Mutual funds grew in popularity and size and their ability to beat the market evaporated. Using, for example, eight US stock funds meant that the combination of the funds was close to the overall market, or a “closet” index fund. The fees for the funds, even if bought with no sales charge, were high. In most cases, fund performance drifted back to average or worse, and if a fund faltered and was sold, it resulted in a buy high, sell low cycle, hardly the path to good performance.
As the emphasis shifted from pure investment performance to risk management, long-term financial goals and other critical areas like estate and tax planning, it became clearer that taking what markets would give you was the better approach. Portfolios gravitated to consistent, low-cost investment options, which often meant index funds and exchange-traded funds. Not only does this keep expenses much lower, it makes allocation and rebalancing more precise. As we have discussed often in this space, this has been our steady approach.
And for the 11th year in a row, the performance evidence supported our approach. In 2020, 60% of active large-cap US stock funds underperformed the S&P 500. Granted, that group includes funds whose objective has been out of favor, such as value-oriented funds, but it also includes growth funds which should have been invested in the tech market leaders. Some funds strive to manage risk rather than beat the market but that can also be managed through prudent allocation of low-cost funds.
As the costs of investing have come down due to index funds and the near elimination of fees for stock trades, it may appear that investors have somehow beaten Wall Street. (See the discussion of Gamestop below.) Any such conclusion would be wrong; some of the most creative minds are busy developing new ways for Wall Street to (legally) enrich itself at the expense of the unsuspecting.
Take the recent rise of special purpose acquisition companies (SPAC’s), for example. SPAC’s are great for the organizer (they put some money up front but get a disproportionate share, often 20%, of the acquired company), hedge funds and early institutional investors (they get special terms which greatly reduces their risk), investment banks (as usual, they get big fees for raising money), and private companies (SPAC’s have been acquiring these companies at astronomical valuations often well above what the companies could fetch with a traditional IPO). Who makes all these advantages possible? You guessed it, the individual investor who gets a reduced interest and the greater risk for the privilege of playing with the big boys.
A big part of our investment research and education is tearing apart all these gimmicks that sound too good to be true or which offer big returns for low risk. On examination, they fail the test of reasonable risk and return which is why we protect our clients by not following the gullible crowd.
A Funny Thing Happened On the Way To the (reddit) Forum (by JD Matchett-Robles)
The GameStop (GME) saga that unfolded over the first quarter was fascinating to follow. There is so much to this story that it cannot all be covered in the space we have here. However, it has everything a good story needs with colorful characters, like one named Roaring Kitty, and a David versus Goliath plotline with the retail investors (individual investors) going against the established hedge funds and financial institutions. It even includes conspiracy theories and the seemingly impossible ability to unite AOC and Ted Cruz on an issue. In fact, the GME situation was so exciting to some people that within days of the price skyrocketing in late January, Netflix started plans for a docuseries.
GME stock closed at $18.84 per share on December 31, 2020 and was below $5 per share one year ago. On January 27, 2021, the stock closed at $347.51 a share with intraday trading peaking at $483 a share the following day. Around this time, my 7-year-old son noticed with anguish that the GameStop location we pass everyday was taking down its sign and closing its doors. How can the company’s stores be closing but simultaneously have its share price rising at an astronomical rate? In short, a group known as Wallstreet Bets (officially r/wallstreetbets) on the popular social network Reddit, started the trading frenzy by performing what is known in the industry as a “short squeeze.” An investor with a short position is making a bet against the price of that stock. For example, an investor that believed the GME stock was worth $10, not $18 per share, could take a short position by borrowing the $18 stock, selling it at $18 per share and, if the price does in fact fall to $10 per share, the investor would purchase the shares at the lower price, repay the shares and pocket $8 per share difference. If the price goes above $18, however, the short investor will have a loss when he buys back the shares, and the higher the price, the greater the loss.
A short squeeze occurs when the price of the shorted stock abruptly increases forcing the short sellers to buy the stock to avoid further losses on their bet. In the GME case, the cumulative shorted positions, largely held by hedge funds, were as high as 140% of the shares (that is really high!) and the wallstreetbets group found an opportunity to drive up prices while also sticking a finger in the eye of some large hedge funds. The wallstreetbets group rallied behind the idea that the GME stock was being undervalued and given the high number of positions being shorted against the stock, they were able to initiate a short squeeze by collectively driving the price up in January of 2021. The combination of buying by the wallstreetbets group and buying by the shorts to cut their losses led to the meteoric rise.
After peaking in intraday trading at $483.00 on January 28 (up 2,340%!!) the stock ended the day at $193.60. The incredibly high trading volume of GME caused several investment platforms like Robinhood and Interactive Brokers, which are used primarily by retail investors), to suspend further buying the stock. (Current owners of GME could always sell.) This action halted all the momentum in the stock, and it started a volatile descent over the next few weeks hitting $40.89 per share by February 19. Many people were outraged at the brokerage platforms, some calling it criminal and fostering conspiracy theories of why trading was halted. In fact, this was such a big deal that a congressional hearing was held on the issue. Of course, the story does not end there as the stock has whipsawed in price over the past few weeks and closed the quarter at $189.82 per share.
Volatile stocks and short squeezes happen frequently, so why did this one have such an impact? The reason lies in how, or should I say, who, seemingly caused the volatility. Traditional view has been that only the big fish, like hedge funds and large institutional investors, had the money and power to move prices to cause a short squeeze to occur. However, wallstreetbets showed that given the technological advances, accessibility, and lowered cost barriers for trading, the retail investor now has a mightier sword to wield, especially when large groups point those swords in unison. Whether the group accomplished its goal may be debatable. Certainly, a lot of people hit a collective homerun, with the best-known example being a member of the group named Roaring Kitty (his name on Twitter at least!) seeing his initial $53,000 investment in GME soar to $48 million at the peak. Those hedge funds holding short positions of the stock were forced to buy the stock at a higher price, absorbing huge losses in the process. On the other hand, some hedge funds bought GME early and rode the wave, with one netting over $700 million, so the idea the group was sticking it to the establishment may not be completely accurate.
Regardless of what the goals were or whether they were met, wallstreetbets made a clear statement that the little guy will have some say in how things go in the market. The wallstreetbets forum grew from 1.2 million members to over 6 million in the matter of weeks and while GME stole many of the headlines, there were several other “meme” stocks, as they have been dubbed, that saw similar volatile trading, largely at the efforts of retail investors. We shall have to wait and see whether wallstreetbets or other groups of retail investors can continue to find common ground and cause market prices to bend at their will, however, clearly there is a new seat in the forum.