Markets & Research
Even in years with solid gains, stocks don’t usually notch record highs on December 31 itself. But that’s how 2020 rang to a close — an improbable yet somehow fitting conclusion to a year that consistently defied expectations. The combination of Federal Reserve stimulus and the striking speed of vaccine development helped equities recover from a heart-thumping bear market at the outset of the coronavirus pandemic. Both forces are likely to remain front and center in 2021 as the financial markets confront a variety of challenges, including widening political fractures in the U.S. and uncertainty about the ultimate timing of the vaccine rollout.
The nature of the year-end rally was nearly as noteworthy as the gains themselves. Through much of 2020, major indices were propelled by a narrow outcropping of technology stocks and other highfliers. That dynamic shifted in the fourth quarter as the conclusion of the U.S. election and the launch of vaccine distribution helped the market broaden considerably. Cyclical stocks that had lagged badly in the first three quarters of 2020 bolted higher, making November the best month for the MSCI World Index in 45 years.
Stocks have been animated by expectations of a successful vaccination effort that could clear the way for steady economic improvement throughout 2021. Despite the significant hardship afflicting restaurants, travel companies and small businesses, key indicators — including consumer spending, manufacturing and home sales — have been strong. Personal income and savings have also risen, providing fuel for a further jump in spending once the pandemic abates.
The equity market faces a long list of challenges, including how quickly and widely vaccines can be distributed. The initial rollout has been slower than expected, and delays in producing or delivering medications could drain economic stamina. Even with a swift rollout and the recent congressional passage of a $900 billion stimulus package, sluggish data in the past couple of months could foreshadow a softening of activity in the near term.
The market is also contending with heightened investor expectations stoked by the rally itself and concerns that share prices may have sprinted ahead of underlying fundamentals. The S&P 500 jumped 18% for the year and 70% from its virus-induced trough in late March. Tech stocks rebounded nearly 87% from their low.
Finally, there’s the animosity engulfing American politics, which hit a new boiling point with the mob assault on the U.S. Capitol during the certification of the presidential election in January. On a policy basis, the likelihood of major changes to regulatory and tax rules are unlikely in the near term. Though the election of two Democratic senators in Georgia gave the party control of Congress and should clear the way for the administration to fill its cabinet positions and nominate judges, tight margins in both chambers make more progressive legislation less likely. However, political polarization is a wild card, threatening to chip away at national morale and economic confidence.
The outsize gains in November — not to mention the overall rally from the coronavirus low in March — served as the latest reminder of the dangers of market timing. The instinct to lighten stock holdings can seem appealing whenever equities thrash about. But missing even short periods of a subsequent rebound can scar long-term returns. For example, the MSCI World Index jumped 15.9% last year, but if you exclude the index’s 12.8% surge in November, the gain would be a mere 2.8%.
That fits with historical patterns, as a relative number of months have accounted for a large portion of gains over time. For example, $1 invested in the Ibbotson Associates SBBI U.S. Large Company Stock Index in 1926 would have swelled to $9,244 by the end of 2019, but missing the best 5% of months would have left an investor with only $14.53.
Looking forward, the preoccupation with tech and other high-flying stocks has led to a pronounced disparity in returns. Valuations have swelled in the roughly one-third of the market where investors have clustered. But the other two-thirds appear to be reasonably priced, with opportunities in companies that investors have brushed past. That includes many dividend payers and international companies. In fact, compared with their U.S. counterparts in the same industry, stocks in overseas markets generally have lower valuations.
Despite jitters at the outset of the virus outbreak, the bond market finished the year with strong returns and served as an important counterweight to stocks.
Early in the pandemic, there was anxiety in the fixed income market as investors worried about whether debtors, particularly hard-hit municipalities, would have trouble meeting their obligations. The Fed quickly moved to support markets by lowering interest rates, introducing loan programs and reviving bond buybacks. These programs helped to calm frayed spirits, especially when they were extended to corporate debt and municipalities, and went some way to set the table for a fixed income rally in the second and third quarters.
The yield on the 10-year Treasury, which sagged to an unprecedented 0.52% early in 2020, ticked higher throughout the fourth quarter to end the year at 0.95%. That is still historically low, and central bank policymakers have pledged to keep a lid on short-term rates for an extended period to help nurse the economy back to full health.
Our fixed income investment team sought to take advantage of the dislocation in corporate and municipal bonds as credit spreads — the premiums paid by riskier bonds — widened. Spreads have since narrowed, and we come into the year well positioned due to our strong research efforts.
Of course, high-quality fixed income should provide the key benefits of diversification, capital preservation and income generation. Bonds have proven to be an important anchor in helping mitigate the vagaries of the stock market, and they continue to play an essential role in balanced portfolios.