KCS Quarterly Market Review for Q4 2020

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

January 20, 2021

Executive Summary

To say that 2020 was even an okay year would be an insult to nearly every other year, regardless of how well your investments may have performed. There’s no other way to spin it, 2020 overall was awful, marred by tragedies and hardship for hundreds of millions around the world. In the US alone, 10 million more people are unemployed now than at the start of last year. Hundreds of thousands of restaurants and other small businesses are closed, at least 60% permanently. Hospitals are operating at or near capacity in most states. Almost 400,000 more people died than in an average year, not all from COVID-19. And through it all, our lives are completely different from normal.

Unfortunately, the start of 2021 has not been noticeably better. Nearly as many people have died from COVID-19 in just the past week than from influenza during all of 2019. The economy is losing jobs again, as new weekly claims for unemployment remain near one million. And to top it all off, we had the first breach of the US Capitol in over 200 years—this time by US citizens rather than a foreign power.

Yet despite everything that 2020 and 2021 so far have thrown at us, we remain resilient. The majority of us avoided economic ruin and many have prospered. As we enter 2021, we are optimistic that the dark winter of COVID-19 and lockdowns will give way to a glorious spring, especially now that the path forward from this crisis is clear. A third stimulus bill is coming, likely in the $2 trillion range. Between vaccinations and natural immunity, well over 200 million Americans will be immune to the novel coronavirus by the middle of 2021. And when most people feel safe to venture out again, we expect a tsunami of pent-up consumer demand, especially for food, travel and entertainment.

We have often pointed out that markets look ahead five to six months. By July of this year, the US—and the world—may well be in a state of jubilation. We would not be surprised if the 2020s begin to feel a lot like the 1920s, a time of broad innovation and widespread prosperity. And while some aspects of life will be changed permanently, the world will finally start to feel normal again. All of this has significant implications for investors, which we discuss below.

4th Quarter in Review

Though it may feel like a lifetime ago, we received our first indications of vaccine efficacy during the 4th quarter of last year. Initial results were unequivocally positive, with the first two approved vaccines providing 95% protection from COVID-19 disease after two doses—and 100% protection against severe disease. It’s notable that these two new and novel vaccines, which went from laboratory to approval in less than 11 months, are among the most effective ever produced. (For comparison, measles vaccine is 97% effective, DPT 85% effective and flu vaccine less than 60%.)

This new and encouraging information sparked an unrelenting move higher in stocks, leading global equities to finish the quarter up +14.7%. Investors cheered the eventual end to the coronavirus pandemic, which now looked attainable during 2021. The availability of two highly effective vaccines—along with the prospect of more to come over the next several months—effectively took the worst possible market outcomes off the table. While the coronavirus will likely be with us for a while, the prospect of life returning toward normal in the foreseeable future was too strong to ignore.

The strong uptrend in equity indices was coupled with a significant change in market leadership, as the stocks of some of the most beaten-up companies enjoyed outsized gains. Value stocks, for example, trounced their growth counterparts by over +7% during the quarter, aided by strength in Energy and Financials. International stocks were also stars, with developed markets returning +16% and emerging markets +20% in the period. By contrast, the US market gained only about +12%, and several large-cap US tech stocks finished the quarter roughly flat.

A shift in leadership was also evident in fixed income markets. “Safe” categories, such as US Treasuries and agency mortgage-backed securities, underperformed as risk-free rates finally moved higher, leading to a decline in the price of these low-risk bonds. Meanwhile, the strongest bond price gains were in high-yield corporates, as the positive vaccine news caused investors to bid up risk assets. Weakness in the US dollar, which fell by about 3%, also provided a boost for foreign-denominated bonds. Overall, the global bond benchmark returned +3.3% during the quarter, but the spread among sectors was dramatic: high-yield corporate bonds returned nearly +6%, while long-duration US Treasuries fell more than –3%.

At KCS, our equity portfolios were aided significantly by our international positioning and individual stock selection during the quarter, while our bond investments were boosted somewhat by strength in our high-yielding categories. Overall, we are pleased with the market’s direction and leadership during the latter months of 2020, and look forward to 2021 continuing this favorable trend.

Even if you barely follow the financial markets, we’re confident you are aware that 2020 was a very volatile year for investors. But you may not realize just how volatile. From its February high to its March low, the global All-Country World index fell 35%, only to rebound an astounding +70% by year’s end. It was precisely when things appeared to be darkest in late March that, in hindsight, would have been the best time to add to your equity allocation. Yet who would have felt comfortable buying stocks after ten straight days of grueling market declines? This is exactly why we caution our clients against trying to time the markets: being right is very hard, and having the guts to act even harder. It’s both safer and easier to stick with a long-term game plan.

Another comforting fact about 2020: last year threw one of the harshest stress tests imaginable at our economy and stock market, and yet the system survived. Lockdowns were less severe than expected, product shortages were generally brief, businesses adapted to new practices, and several industries even benefitted from the changes. We think that 2020 was a near-perfect demonstration of how equity investing can be risky—and occasionally very scary—in the short term but rewarding and highly resilient in the longer term.

Themes for the Year Ahead

During the depths of the COVID crisis, central bankers and governments worldwide unleashed monetary and fiscal rescue programs of unprecedented size in record time. In many ways, the global response amounted to a backstop of everything, and for our two cents, we think this was the right call. The flood of liquidity protected businesses over the near term, buying needed time to form a clearer picture of the economy. Gradually, we learned that things were going to be much better than our initial dire prognostications. Despite the risks, we believe this route was far better than the alternative: a global depression not unlike what the world experienced in the 1930s.

Yet it would be naive to think that trillions of additional dollars and a globally coordinated ZIRP (zero interest rate policy) will not have consequences, especially if poorly managed. Unprecedented policy actions will likely produce unprecedented aftershocks, including severe mispricing and asset bubbles. We think 2021 will be the year when some of the greatest market imbalances begin to unwind.

Where do we see the biggest risks?

#1. The unwinding of euphoric “story” stocks. Recently, we’ve often been asked, “Are we in another stock market bubble?” And each time, we emphatically reply, “No.” Yet while we do not believe that the overall equity market is overvalued, there are clearly pockets of extreme exuberance, aided by easy money conditions and leveraged retail traders. Several sentiment indicators corroborate this feeling of exuberance. For example, Citigroup’s Panic/Euphoria Index suggests that conditions today are even more euphoric than during the 2000 tech bubble, as shown below:

Other measures of investor sentiment also suggest widespread investor optimism, though none as dramatically as the Panic/Euphoria index. And one need only look at stocks like Tesla or assets like Bitcoin to realize that pricing in some corners of the market is out of whack. Here’s an even more extreme example: Elon Musk, unhappy with the changes that communications app “Whatsapp” was rolling out in February, tweeted recently to “Use Signal,” causing Signal Advance’s stock to jump 3,000% in just two weeks. The problem is that Signal Advance, the company, has nothing to do with the app Signal, a competitor to Whatsapp. So now we have an $8 million business sporting a $1 billion valuation, caused entirely by a group of investors who have no idea what they own. In this case, the greater fool is both reckless and uninformed.

Why are we not more concerned by exuberant investor sentiment and anecdotes like the above? First, because measures of investor sentiment are poor market timing instruments: sentiment can remain overly optimistic for months or years while the market continues to climb, and vice versa. Second, at the same time that individual investors are buying stocks based solely on confusion over a company’s name, there remains a large segment of the market (comprised mainly of established, high quality, single-digit growth businesses) that still appears breathtakingly cheap. Today’s market is eerily reminiscent of the market in 2000, after which a great rotation ensued out of tech into these attractively valued names. Just like 20 years ago, many high quality businesses are priced for strong double-digit annual returns. Needless to say, our portfolios are skewed towards these companies.

#2. The unwinding of extremely low interest rates. At their lows in August, the ten-year US treasury rate dropped to 0.52%. Who would want to lend their money to Uncle Sam for 10 years at ½% per year? Inflation would make your real returns negative, while rising interest rates would cause the price of your bonds to fall. The only people salivating at rates that low were politicians, central bankers, and borrowers. And they took notice.

In our last quarterly newsletter, we noted:

Governments around the world are issuing trillions in debt, while consumers and companies are refinancing for lower and longer. Nearly every day, we see another company issue new 30-year bonds. Berkshire Hathaway just issued one in the US at 2.45%. In Europe, PepsiCo issued one at 0.45% (for 30 years!). What happens if buyers eventually revolt against this massive new supply of bonds and start demanding higher rates of interest? 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.

Central bankers have a lot of influence on short-term interest rates, but they have much less control over long-term rates. Ultimately, supply and demand took hold, and with a massive supply, coupled with higher yielding alternatives, investors came to their senses and rates began to march higher. Ten-year treasuries finished 2020 yielding 0.93%, and in the two weeks since 2021 began, yields have risen an additional 0.25%. As the chart of the 10-year treasury yield below shows, the pace of the increase has clearly accelerated.

Source: YCharts

It’s now possible that we’ve finally seen the lows of this interest rate cycle. And just as low interest rates are often the fuel that allows for market imbalances and asset bubbles, rising interest rates often prick those bubbles. As interest rates continue to push higher, we could see a significant correction in both the bond markets and in richly valued equities (e.g., Tesla) and other assets (e.g., Bitcoin).

#3. The reining in of unsustainable government spending. 2020 ended with some of the biggest budget deficits globally since WWII. On top of this, our current pace of deficit spending in the US remains unsustainable, at approximately $150 billion per month of government spending in excess of tax receipts (and this is before the recently proposed $1.9 trillion stimulus bill). Though historically low interest rates are currently mitigating the risks of these deficits, rates won’t stay low forever (see above) and we are eventually going to have to start paying down this debt. If we don’t, the consequences could be dire: a recent study noted that 50 of 51 countries that surpassed 130% national debt ratios eventually defaulted. Japan has so far been the lone exception. This year, the US exceeded 140%.

No one seems to care about this right now, but sometime in the not-too-distant future, every one of us might. Keep in mind that there are only three ways to reduce government debt: cut spending, raise taxes, or accept higher inflation. We suspect that all three of these are in our future, though not likely within the next year or so.


2020 was a tumultuous year in many ways, and one that most of us are glad is over. 2021 is starting out much as 2020 ended, with a spreading pandemic, high unemployment, and many small businesses in dire straits. But the rising stock markets of the past several months are telling us that 2021 is unlikely to end the way it began; in other words, better times are ahead. Who knows, maybe the next few years will usher in an economic boom not unlike the roaring 20s (without the speakeasys). This is what happened after the 1918 flu pandemic finally ended.

Against this backdrop, stocks can continue to climb, though likely not as rapidly as they have since last March, as valuations become stretched in some sectors. But they still compare favorably with most fixed income categories, where we expect returns to barely match inflation.

Despite the obvious risks, we feel good about our portfolio positioning in 2021. The current market, both in stocks and bonds, is the most bifurcated we have seen in two decades, in which some stocks are extremely overvalued while others appear to have very significant upside potential. Thus, while we expect overall returns to be considerably less impressive than last year, we are optimistic that a rotation into the kinds of attractively priced securities that we own in our portfolios will push many of their returns into double digits. Now is not the time to pull back because valuations appear stretched. Nor is it the time to jump into investments that are clearly overpriced just because they have recently done well. Rather, we believe the most profitable approach is to stay diversified while favoring assets that appear undervalued over those whose prospects, however bright, fail to justify their lofty prices.

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.

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