2020 in Review and Diversification within the Market

Trying to decide where to start when looking back at 2020 is not real easy. What started out as a great year with the best employment numbers in 50 years and strong economic momentum turned on a dime to become something we will all never forget. Unforgettable due to the huge number of our fellow citizens who succumbed to this virus as well as the financial devastation it has visited on so many.

As we have discussed before, when we are asked “What do you think the market is going to do this year?” we never offer a forecast. And for good reason, because we don’t know. Secondly, even if someone had revealed to us what should be very consequential and accurate information about the future, we could easily draw the wrong conclusion regarding financial market performance. And the year 2020 may be the best illustration of that which we have ever seen.

The economy is still hurting in a big way, with almost 25% of small businesses closed versus the beginning of 2020. Several industries are still operating at levels that were never even considered possible. Tourism, hospitality (both lodging, restaurants and their supply chain including food service), transportation, entertainment venues, sporting events, etc. are still either closed are operating at minimal levels.

And yet, the stock market in the U.S. had a great year.

Another reasonable question often asked is “How is the market doing so well when so much of the economy is still really hurting?” It does not seem to make much sense at first glance.

But there are potential reasons that might explain the huge disparity between the crushing factors for much of our economy and the excellent performance of financial markets. 

  • A significant portion of the S&P 500 (the largest 500 stocks in the U.S.) are technology stocks that have benefitted from the “homebound” world we are now in. Amazon, Google, Apple, Microsoft, Facebook etc. constitute around 25% of the index. That is a huge percentage in just 5 names. And their performance has greatly increased the overall index performance over the last several years.
  • Stimulus money was sent to many citizens and it turns out much of it was not spent. Paying down debt, increased savings and investing in the stock market turned out to be where a lot of this money went. We know that from seeing credit card balances come down, banks reporting increased balances in savings and checking accounts, and the activity of many individual investors in the stock market.
  • The Federal Reserve has made it clear that it is not raising short term interest rates until we are back to “full employment” or the inflation rate goes over 2% for a period of time. This has created zero return money markets and one year Certificate of Deposits paying .1%- that is one tenth of 1%.
  • With just about all the developed world’s central banks keeping rates at near zero, or even less, money that requires a return will likely need to be invested in riskier assets.
  • The stock market is a forward looking market, and the announcement in November of very effective vaccines created a hope that a return to relative normal economic behavior is in the cards for 2021.

Another question is concerns about overvaluation of the market. There are certainly segments of the financial markets where we can see speculative behavior, just as in the late 90’s when there was obvious speculative activity in the “dot com” internet stocks. However, a reasonable portion of the stock market has not had a spectacular run like some of the big tech stocks, such as many of the large, mature dividend paying companies.

A couple of charts below can help illustrate some similarities of today’s market behavior versus the late 90’s. We can also see what happened after the NASDAQ crash. These can also help highlight the benefit of being diversified when the market gets somewhat lopsided as it appears to be today.

This chart shows the performance of the NASDAQ 100 from 1995 to its peak in 2000.

Nasdaq 100 Level % Change

This chart shows the flip side of that coin, the NASDAQ 100 performance from 2000-2002. A mere drop of over 80%.

NASDAQ 100 performance from 2000-2002

This chart shows the performance of the Russell 1000 value index during the NASDAQ meltdown of the early 2000’s. You can see while the NASDAQ imploded, a lot of the stocks that were left out of the bubbly price action of the late 90’s held up reasonably well with the total return down 15%. We can recover from 15% losses.

Nasdaq compared to Russell

So while we may be witnessing a period of time reminiscent of the late 90’s in certain segments, the value of diversification back then is quite obvious. And it is reasonable to assume that diversification again will not only increase the number of opportunities, but should also help mitigate some of the downside.

We have just focused on portions of the equity market in your portfolio that can provide some ballast during volatile periods. We have not shown the value of bonds in reducing volatility. As we have said in the past, bonds serve to dampen stock market volatility and to preserve capital. Bonds also provide cash for distributions to prevent liquidating equities at inopportune times and can be dry powder if equities are down and we need to rebalance.

Long story short- there will often be parts of the market that get overvalued from time to time. But often at the same time there are segments that tend to be overlooked by investors and aren’t particularly expensive. And that is where a rebalancing strategy which takes money from extended areas and reallocates to underperforming sectors can be of great value.

As always, please do not hesitate to call with any changes in your life that we need to help address, or with any thoughts or questions.

Thanks as always for your trust in us.

Beach

Disclosure:  The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Any opinions are those of the author(s) and not necessarily those of Raymond James. Expressions of opinion are as of this date and are subject to change without notice. There is no guarantee that these statements, opinions or forecasts provided herein will prove to be correct. Investing involves risk and you may incur a profit or loss regardless of strategy selected, including asset allocation and diversification. This is not a recommendation to purchase or sell the stocks of the companies pictured/mentioned. Rebalancing a non-retirement account could be a taxable event that may increase your tax liability.

The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market. The NASDAQ-100 (^NDX) is a stock market index made up of 103 equity securities issued by 100 of the largest non-financial companies listed on the NASDAQ. It is a modified capitalization-weighted index. ... It is based on exchange, and it is not an index of U.S.-based companies. The Russell 1000 measures the performance of the 1,000 largest companies in the Russell 3000 Index, which represents approximately 90% of the investible U.S. equity market. The Russell 1000 is highly correlated with the S&P 500 and is reconstituted annually on May 31. Keep in mind that individuals cannot invest directly in any index, and index performance does not include transaction costs or other fees, which will affect actual investment performance. Individual investor's results will vary. Past performance does not guarantee future results. Future investment performance cannot be guaranteed, investment yields will fluctuate with market conditions.

Investors should be willing and able to assume the risks of equity investing. The value of a client's portfolio changes daily and can be affected by changes in interest rates, general market conditions and other political, social and economic developments, as well as specific matters relating to the companies in which the portfolio has invested. Companies paying dividends can reduce or cut payouts at any time. Bond prices and yields are subject to change based upon market conditions and availability. If bonds are sold prior to maturity, you may receive more or less than your initial investment. Holding bonds to term allows redemption at par value. There is an inverse relationship between interest rate movements and bond prices. Generally, when interest rates rise, bond prices fall and when interest rates fall, bond prices generally rise.