KCS Quarterly Market Review for Q1 2021

KCS Wealth Advisory (Byline: Nick Nejad and Ken Waltzer)

April 26, 2021

The First Quarter in Review

It’s only April and 2021 already feels like a long year, packed with significant events. The first week witnessed an unprecedented storming of the US Capitol that has resulted in over 400 arrests so far. We’ve continued to experience shootings by both random gunmen and police, with resultant protests and calls for gun control, and the trial of at least one police officer that ended in conviction on multiple counts. And despite successful vaccine rollouts in several countries, including the US, the pandemic is still with us. We continue to see surges in several places, especially India, where daily deaths exceed 2,500 and may peak at over 5,000.

The world of finance has been similarly eventful so far. Late January featured a mania in the stocks of struggling companies, including GameStop, AMC Entertainment and BlackBerry, driven primarily by small investors out to stick it to the big hedge funds. (As of this writing, the mania has mostly cooled.) We’ve seen the rise and fall of SPACs, huge gyrations in Bitcoin’s price, and the rapid rise of dogecoin, initially created as a joke, from nothing to a $32 billion asset in just a few months. And, finally, the quarter ended with a bang with the collapse of Archegos, a $15 billion family office that lost everything in one week owing to its 6:1 leverage. The debacle also severely dented the profits of some banks who lent money to Archegos: Credit Suisse lost $4.7 billion, while Nomura wrote off $2 billion. Hopefully, the next 3 months will be boring by comparison.

But the news this year hasn’t been all bad. We successfully transitioned to a new presidential administration and Congress, and then quickly passed a $1.9 trillion stimulus bill. As of this week, we’ve administered over 200 million COVID vaccine doses in the US, surpassing even the most optimistic forecasts. And the improved pandemic trajectory is driving a better economic one as well: over 900,000 jobs were created in March, and spending is now higher by double digits compared with pre-pandemic numbers. With the exception of a few industries (travel and entertainment in particular), we are back on the growth trend that preceded the pandemic.

Against this backdrop, global equities (as measured by the MSCI All Country World Index) performed much like they have for the past dozen months, climbing a “wall of worry” to finish the quarter up a solid +4.6%. That brings the cumulative gain for stocks in the 6 months from the end of September through March 31 to an impressive +20%, initially sparked by news of a vaccine that could finally stop the pandemic. Bonds, on the other hand, have had a rougher time. The culprit: a nearly continuous uptrend in yields on “risk-free” government debt, proving once again that every investment carries some risk. Since September, yields on ten-year Treasury notes have more than doubled, from 0.7% to 1.6%, leading to a decline in their price. Bond price declines over the past several months are the worst we’ve seen since the early 1980s, with the benchmark Bloomberg Barclays Global Aggregate falling by –3.6% since the start of the year.

A few important trends were happening beneath these headline figures. First, value stocks absolutely eclipsed growth stocks, outperforming by 10% in the first quarter. In fact, growth stocks finished the period nearly flat, meaning that almost all the gains were in the value segment. Second, US outperformed non-US once again, despite headwinds from its overweight to technology and growth stocks. Lastly, fixed income returns were similarly bipolar: while long dated treasuries fell by double digits, shorter-term and higher yielding securities mostly eked out gains.

KCS portfolios were fortunate to again enjoy a tailwind from most of these trends, with our equities boosted by a tilt towards value and careful stock selection, while our bonds benefited from an emphasis on corporate over government bonds and shorter maturities. Overall, we’re pleased with the performance of our accounts over the past 4 quarters and hope to continue the bullish trend that began last spring.

Our Outlook for the Next Few Quarters

For the remainder of 2021 and probably well into 2022, we expect financial markets to be driven by 3 major trends: 1) rising interest rates and inflation; 2) a rotation from growth stocks toward value stocks; and 3) a decline in US equities’ share of global markets capitalization. Six months ago, we described the first two of these trends before either had started:

Fortunately for diversified investors like KCS, the exuberant valuations of these storied growth names have not made their way into other portions of the market, including most of US value and international stocks. We continue to find high quality companies with reasonable growth rates trading at very attractive valuations….

What could be the catalyst for a rotation away from growth (tech) and toward value (almost everything else)? The trigger that shifts a trend can be difficult to identify ahead of time, but we believe that growth stocks’ heady valuations are underpinned by the belief that interest rates will stay low forever.… [But] at some point, we think we will see a rush to the exits as fixed-income investors reevaluate their positioning in these low-yielding assets. And when this happens, interest rates—particularly at the long end—will rise and growth stock valuations will start to tumble.

Let’s look at each of these three trends.

1. Higher Interest Rates

It was last October when we opined that interest rates were poised to rise. In retrospect, it appears that interest rates bottomed during the summer and began rising rather steadily in early October, as you can see in the chart below. There are at least three reasons we believe that this interest rate surge is now well established and likely to continue.

Source: YCharts

What are these reasons?

  1. Demand for government debt is low and falling, especially as the economy reopens and people start reopening their wallets.
  2. The incoming supply of new debt is massive, with trillions issued last year, and trillions more slated for the year ahead (these enormous government spending bills will need to be financed through borrowing).
  3. Inflation is rising, driven by a combination of increasing demand from the economic recovery, continued supply chain disruptions and a massive increase in money supply courtesy of the Federal Reserve. More money chasing fewer goods is a perfect recipe for higher prices for goods and services (inflation). Higher inflation leads to higher interest rates and lower bond prices.

And while it is true that the Fed can keep rates subdued for longer than the markets would on their own, persistently low interest rates are eventually destabilizing. For example, would the GameStop bubble or Archegos collapse have happened if interest rates were higher? The ability to borrow at near-zero rates (or even negative rates in many countries) can lead to all sorts of imbalances and bubbles, as we are now seeing.

If rates do continue to trend higher, the greatest negative impact will be on the longer-term, “safe” assets that make up the bulk of bond indices. By comparison, KCS portfolios are structured more towards shorter-term bonds, along with some longer-term assets with yields sufficiently high to offer protection from a moderate increase in rates. This positioning has served our clients well since rates began to rise last year.

2. Rotation Into “Value”

Stocks are commonly split into two somewhat arbitrary groups based on valuation. “Growth” stocks are “expensive” by most valuation measures, but their priciness is supposedly justified by their faster-than-average earnings growth rates. Most technology stocks, such as Facebook and Google, are in this category. “Value” stocks, on the other hand, are much more reasonably priced relative to the worth of their underlying businesses, but don’t sport the rapid growth rates of their growth stock brethren. Most financial and industrial stocks are in this category. The smart investor tries to buy growth stocks whose prices don’t quite reflect future growth rates, and value stocks whose prices are especially low relative to their more pedestrian growth prospects.

A diversified portfolio contains both kinds of stocks, but there are periods, often years long, when one category outperforms the other. Notably, over the past century of stock market history, value has exceeded growth by a significant margin, as the graph below illustrates. The annual rates of return for the period were: growth, 9.1%; value, 12.5%. You can see below what a 3.4% annual return difference means over many years.

Despite lagging over the long term, there have been several periods during the past century when growth outperformed value. The longest such period began 13 years ago in 2007 and lasted over 160 months (the previous record was 38 months way back in the 1930s). Investors may be forgiven for thinking that growth stocks are routinely the better investment after such a long stretch of outperformance. Take a look at the following graph:

The graph above shows the performance of value relative to growth stocks. When the line is trending up, value is outperforming; when it slopes down, growth is faring better. As you can see by the persistent downtrend, value has fallen behind growth fairly consistently since 2007. But no market trend lasts forever, and just as interest rates can go up as well as down, so can the performance of value versus growth swap places. In fact, rising interest rates and the declining fortunes of growth stocks are closely related. This is because, as with long-term bonds, much of the value of fast-growing companies lies far in the future. The higher interest rates rise, the less investors are willing to pay for growth companies’ future earnings, depressing the current prices of their stocks. Value stocks are less impacted by higher interest rates because their earnings are weighted more toward the present.

Look again at the value vs. growth graph above: there were several times when the curve briefly turned upward, meaning that value stocks were performing better than growth. The most recent such period started last September and is represented by the upward blip at the far right of the graph above. The next graph illustrates this period from September 1, 2020 thorough mid-April this year:

Source: YCharts

The graph above compares the Russell 1000 Growth Index (purple line) to the Russell 1000 Value Index (yellow line), starting right about the time when interest rates began their recent climb (September 1, 2020) through April 22, 2021. Note that while both indices rose during this period, value outperformed growth by 17%.

Yes, this could be another head fake like several similar brief periods since 2007. However, the past 13 years have witnessed a nearly continuous decline in interest rates, with yields on the 10-year US Treasury note falling from nearly 5% to their September low of 0.6%. The forces listed above that are leading to rising interest rates will also tend to favor value stocks over growth. We believe that the next decade in both stocks and bonds will look very different from the previous one, and we aim to be on the winning side of that shift.

3. Declining Dominance of the US Stock Market

Now for some geography. US equities currently represent 58% of the world’s total stock market value as measured by the MSCI All Country World Index. Yet our country produces only 16% of world GDP and is likely to be surpassed by China within the next decade (and whose stock market today is only a bit over 5% of the world’s market capitalization). As recently as 2007, the US’ share of global stock markets was only about 45%, while producing 25% of world GDP. Can the US share of global stock markets go much higher while our share of GDP continues to shrink?

While the previous decade saw the US’ share of global markets increase by nearly 15%, we believe that the next decade is likely to be nearly a mirror image, with the US declining to well below 50% of global markets as its market capitalization falls more in line with its share of global GDP. This doesn’t mean the US stock market will fall, but just that it will rise more slowly than that of many other countries. The obvious conclusion is that there is more investment opportunity overseas, and that is why we continue to overweight international stocks in our index models and to search out promising non-US names in our individual equities.

Conclusion: Stay Away from Bubbles

Over the next year or two, we expect the global economy to continue to improve and potentially soar, bringing inflation, interest rates and corporate earnings along for the ride. Stocks overall should do well, while bonds will be challenged. Our approach to dealing with the latter will continue to be keeping our maturities short and emphasizing higher-yielding corporate bonds over government debt.

Among stocks, all boats won’t rise equally with the tide, as 2021 already is a tale of two markets. In the desperate and frothy one, investors have reached for yield and return at any cost, pushing valuations on “story stocks” and other popular assets to nosebleed levels. At the same time, there are other pockets of the financial markets where valuations remain reasonable or even cheap. KCS is focusing on the latter, trying to stay above the fray and avoiding the priciest assets at the highest risk of a crash. That means finding value outside US tech stocks and looking to other industries and other countries.

The current environment resembles both 1972 and 2000. During those periods, investors piled into narrow segments of the market (the “nifty fifty” in 1972 and darlings in 2000), celebrating as these investments seemed to soar virtually without limit. But then the music stopped, and prices came crashing down. Investors who avoided the temptation of the quick buck and were properly diversified fared far better.

We think the next year or two may witness a similar bursting of bubbles in some areas, from equity favorites like Tesla and Netflix to alternative assets like Bitcoin and NFTs. KCS aims to stay away from the froth and instead buy assets that are reasonably priced with attractive future returns. This approach may sound less exciting than watching an investment double in days or even hours, but in the long run should produce better returns with much less volatility and fewer sleepless nights.

Yours truly,

The KCS Investment Team

KCS Wealth Advisory is a registered investment adviser. Our services include discretionary management of individual and institutional investment accounts, along with personalized financial, estate and tax planning services.

Opinions expressed are subject to change without notice and are not intended as investment advice or to predict future performance. The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful. Past performance does not guarantee future results. Investing involves risk, including loss of principal. Consult your financial professional before making any investment decision. Other methods may produce different results, and the results for different periods may vary depending upon market conditions and portfolio composition. This email does not represent an offer to buy or sell securities.

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