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Stocks coming into 2021 – Boom or Bust?

Here are a couple of fun facts from equities in 2020.

· The NASDAQ returned 46% from the start of 2020. If you purchased at the peak of the recessionary period in mid-March, you would've made a return on investment of 85%.
· Meanwhile, the S&P500 only returned 17% from the start of 2020.
· The average price/earnings ratio for stocks in the NASDAQ was pushing 23
· The best performing stock that is in the S&P 500 and NASDAQ was Tesla, providing a 743% Return.

With that in mind, what are we expecting for stocks coming into 2021?

Stock Euphoria is at an all-time high

NASDAQ in the Candles, S&P500 in the Orange

I expect institutional investors (and retailer traders) to take significant money off the table this year if they haven't already. Given that there was a laggard inflow in capital to US equities in the latter part of 2020 trying to catch the bull run, I expect those inflows to take profit if equities tick up in the earlier part of this year.

With that said, I believe euphoria in inequities will continue to rise as the hunt for yield is expected to get more difficult as nations worldwide are predicted to cut rates to take advantage of the economic recovery. Furthermore, lower interest rates significantly affect discount rates for models institutional investors use, favoring equities with longer-dated cash flows – usually associated with value stocks such as banks and telecommunication companies.

Popular stocks that makeup indices are relatively overpriced

When Tesla entered the S&P 500, it had to be indexed in stages because it's market cap was so large. However, it is equities like Tesla which retailer traders have been inflating. Popular names such as Zoom, Netflix, or any essential "work from home "stock has passed the eyes of retail investors, with eye-watering price/earnings multiples. Netflix continues to trade at an 80x multiple, Zoom at a 274x multiple, and Tesla at an absurd 1,673x multiple.

The issue with overpriced equities is that their influence on the indices' fluctuations rise as their market cap increases. With the NASDAQ and the S&P 500 based on the companies' market caps in the indexes, investors in ETFs that track these indices are getting heavily weighted to tracking the large companies in them. With companies such as Tesla being prone to wild swings due to its overprice valuation, anyone holding the S&P 500 will also be prone to the wild swings.

With that said, Goldman Sachs analysts are telling investors to buy stocks on any market weakness, with Peter Oppenheimer saying that the market is in the early stages of a bull phase. "The market is rising on good news but choosing to largely ignore weaker data and rising infection rates."

Global equities may be more favorable

With extremely low interest rates in the US, which is predicted not to increase anytime in the future, paired with the Coronavirus situation in the United States, large institutions may be wanting to look elsewhere for value – specifically in places where the Coronavirus has been controlled. I believe banks in Australia will benefit from this thesis, as not only are they the parent of New Zealand banks whos economic outlook is looking far better than many other nations in the world, but they also are in an economic environment that is similar to that of New Zealand, Barr a couple of setbacks due to Coronavirus flareups.

I believe we will see another substantial year in equities due to positive sentiment, paired with a recovering economy.

Nothing can scare off Investors.

It has been 15 days into the new year, but it feels like a year’s worth of events has already occurred. Most notably:

Strip what happened in 2020 out of the question, and this would be run a racket on the equity markets. However, it seems like nothing can scare off investors in this day in age.

Equity Markets in the United States continues to edge higher, with the Dow Jones and the S&P 500 up 0.1%, with the NASDAQ saying as is. European equities too end slightly higher, with the DAX 30 edging up 0.4%. With turmoil continuing to disrupt the world, why are investors continuing to plow money into equities?

Interest rates providing no real yield

With the Federal Reserve stating that they “are not even thinking about thinking about raising rates,” alongside the introduction of their new tool of letting inflation run higher than their mandate portrays that low yields are here for the foreseeable future. The time to raise rates “is no time soon,” Powell states.

Federal Reserve's Interest Rate

This has forced many managers to search for yield across equity markets. However, this can’t be the only reason, as real yield has been low for the past couple of years, even before the Coronavirus. Mario Draghi, former ECB President, was known for saying that “for rates to be higher in the future, they need to be low today.”

S&P 500 in Blue, Dow Jones in Teal, NASDAQ in Orange

Specific equity markets make sound investments.

Many companies continue to thrive even amidst the Coronavirus, notably technology firms such as Salesforce, Facebook, and Slack, alongside retailers such as Walmart and Amazon. Their current price premium reflects their ability to generate free cash flow in recessionary periods. Today, value equities in the industrial, financial, and energy sectors led the edge higher today.

The word “reflation” has recently been the buzzword as of late, providing an extra boost to equities. Scott Knapp, chief market strategist of CUNA Mutual Group, stated that “everybody acknowledges the high valuations, but most people say yes – but the stimulus?”. He further continues stating that “Markets are anticipating that reflation is under way.” Reflation may help the backbone of the US Economy, the consumer, to thrive once again and pull the US economy out of the slumps.

Investors mindset of “things should get better eventually, right?”

Motley Fool, an advocate for long-term, stock-picking mantra, believes that “time in the market, is better than timing the market,” alongside the belief that profitable businesses with high valuations should still be invested in. With a massive influx of retail investors, it would not be surprising that many of them share the same mentality.

Are you plowing your money into stocks?

Ballast for the common stock portfolio - Bonds, Gold, or the USD?

A common portfolio weighting known amongst many investors is the 60% stocks, 40% bonds portfolio. The general idea being that stocks appreciate in a bull market, while bonds keep their value in a bull market. Therefore, if you were long 40% bonds, you would have somewhat had a ballast for the drop in stock price. As of late, however, we have been associating the words “safe haven” and phrases such as “investors flee to safety” with assets such as Gold and the US Dollar. Have bonds lost its relevance as ballast in a modern investor portfolio?

Does a low-interest-rate environment diminish the ballast effect of bonds?

Recession Fed Funds Rate
2020 – COVID 19 Pandemic (Feb – Present) 0.25%
2008 – Global Financial Crisis (Dec 2007 – June 2009) 0.25%
2001 – Dot com bubble (Mar 2001 – Nov 2001) 2.5%
1990-91 – Savings and Loan crisis (Jul 1990 – March 1991) 6.25%

The current fed funds rate is 0.25% - currently matching the lowest, it has ever been a post-global financial crisis in 2008. Recessions before that, however, had the Federal Reserve cutting rates to nothing as low as it is now or during the Global Financial Crisis. 

In short, pre mid-1990’s was where the strong negative correlation between stock and bond returns became evident. This was on the basis that accommodative monetary policy would bring interest rates lower, increasing the opportunity cost in owning bonds as opposed to leaving cash in a savings account. However, if you look at the table above, both in 1991 and 2001, interest rates were high enough for a real yield if you held government treasuries. But in our current environment and 2008? Real yielding safe government treasuries could not be achieved. Therefore, the opportunity cost does not spark as much interest in investors as they did back pre 2000’s, where high single-digit and even double-digit interest rates were present. 

Is having Gold as a Ballast currently paying off?

Performance of the US 10 Year in blue, SP500 in red, Gold in orange and the US Dollar in Teal

As shown by the chart, Gold has returned around 12% year to date, while treasuries have only returned 8%. You can see the markets working in reaction to economic events such as treasuries rising in March as the FED cuts rates and the real damage of the coronavirus pandemic becomes clearer. Furthermore, the inverse correlation between the USD and the price of Gold is present in the chart, with the exception being around mid to late March – where quantitative easing and fiscal spending give rise to concerns to the devaluation of the dollar. As we look into April and May, it is clear that Gold is currently outperforming treasuries, which would be more beneficial as ballast in comparison to Bonds in these circumstances. However, both are outperforming the US Dollar.

Is Gold a better ballast than Bonds in these low-interest-rate environments?

There is a likelihood that Gold will outperform Treasuries in this low-interest-rate environment. Given fiscal and quantitative easing alongside the demand for other currencies slowly increasing, it is likely we see the USD lower at the end of the year than at the start of the year. If the historical negative correlation between Gold and the USD rings true, there is also a high chance that Gold will end up higher at the end of the year.

Interest rates can only go so low. If the Federal Reserve lowers rates into negative territory, New debt issuance by the US Government will be hovering at nominal yields near 0% - with real yields most definitely being in the negative territory. This gives an implicit ceiling as to how high bond appreciation can go. Given a possibility for a second wave, risky assets may still be off the table for many investors. With Bonds providing next to 0% yields, investors may seek to look towards Gold as a source of capital growth instead of yield.

Our analysts here at BlackBull Markets, Philip and Anish,  have some excellent technical analysis on the future of Gold and the USD as the safe havens of the world. You can watch the Philips' Gold analysis here, and Anish's analysis here.