2021 Begins With Confidence and Valuations Near Record Highs
The outstanding returns of 2020 – a year of COVID-19 and a contested presidential election – came as a surprise to many investors. U.S. equities produced a 12.1% return in the 4th quarter, bringing the full-year return on the S&P 500 to 18.4%.
Dominant sector performance themes of past years remain in place as large company stocks tended to outperform smaller companies, growth sectors outperformed value sectors, and U.S. stocks outperformed other global regions. Reliability of these themes appeared to fade toward year-end.
With high expectations for vaccines to usher in an era of post-COVID economic growth, investors will be watching upcoming economic data and corporate earnings to determine whether high equity valuations are reasonable.
Key Events of Q4 and Projections
Hardly a week passed in the 4th quarter without eye-catching headlines in politics, healthcare, or business. During a slower news cycle, events such as the Boeing Max 8’s return to service and another of Boeing’s planes crashing in Indonesia may have received more attention. This headline and others like it were on the front page one day and gone the next.
Among the most important events was the ongoing commitment to federal monetary and fiscal stimulus. The Fed, which met twice during the quarter, remains committed to low interest rates while Congress proposes various combinations of fiscal stimulus for individuals, unemployed workers, businesses, and state/local governments. The size and duration of stimulus are key drivers of rising stock prices.
Current conditions still reflect go-go days for investors. A key indicator of business confidence is the pace of investment banking transactions. During the 4th quarter, ConocoPhillips bought Concho Resources for $9.7 billion. This was the largest U.S. oil deal since oil prices cratered early in 2020. Deals like this indicate that company executives are looking to grow aggressively and that deal financing is available.
Investor confidence is also high as the pace of global IPOs hit their a 10-year peak. Some of the most notable ones include Airbnb, Rocket Mortgage, and DoorDash. Although record-setting IPOs mark a high point in investor confidence, they often foreshadow the end of a stock rally.
What may trigger a change in direction for the investment markets? One possibility may be the Democrats’ historic sweep of presidential and congressional elections. Investors should worry about a shift toward Democrats in D.C.. Many of President Biden’s nominations for cabinet posts and other agency heads are talented Obama-era veterans, who likely will support less-friendly policies toward wealthy individuals and businesses.
For the past six months, analysts have anticipated increases in individual income tax, capital gains tax, estate tax, and corporate income tax. Meanwhile equity markets are perched near record highs, levels that may prove difficult to sustain.
With so much uncertainty in the news and such confidence in the capital markets, Conifer Bay Capital is concerned that much of the future good news is already baked into stock valuations. Overall, we remain at or below target weights in equities because of their high valuations.
However, we do not expect a sharp drop in equity prices. After several very strong years of stock market gains, we would not be surprised if 2021 was a year of ups and downs, with 2020 laggards (energy, financials, and REITs) doing better, and 2020 leaders (technology, healthcare, and work-from-home stocks) giving back some of their past gains.
As we so often do, we rebalance portfolios. Recently we have been selling stocks to buy bonds. Within equities, we continue to favor emerging market investments, especially in Asia. This sector made solid gains in 2020, a trend which we suspect may continue in 2021.
In bond portfolios we face continued challenges from low interest rates. Two alternatives to low-yielding investment grade bonds are junk bonds and gold, neither of which are without their own risks. For investors with lower exposure to stocks, we have a bias toward larger allocations to junk bonds and gold.