The fourth quarter of 2020 was the sea change of stock performance D’Arcy Capital Management has been expecting. The previous three quarters were dominated by large cap technology growth companies such as: Facebook, Apple, Netflix, Google, Amazon, and Microsoft (FANG). Almost all other asset classes were lagging far behind the performance of the FANG stocks in 2020. Through the first three quarters of the year, the NASDAQ 100 (42% of the index is invested in the six FANG stocks) returned 31.37%. Comparatively, the Russell Large Cap Value Index and the Russell Small Cap Index were down 11.58% and 21.55% respectively. However, this dramatic performance difference between growth and value began to reverse in August 2020 and accelerated during the final four months of the year. During the fourth quarter the Russell Small Cap Value was up 33.34% and the Russell Large Value was up 16.25%. Meanwhile, the NASDAQ gained a more modest 15.67%. The rotation back to value was led by the previously unloved sectors Oil/Gas (48.42%) and Banking (35.45%).
Among the broad market indices, the Russell 2000 Small Cap Index led the way with a quarterly return of 31.36% and full-year return of 19.93%. International stocks made an appearance in the outperformance category by achieving a three-month return of 16.10% but still lagged for the year with an 8.39% total gain. NASDAQ was the undisputed best performing index of 2020. The index increased 15.67% in the fourth quarter to bring the full year return to 45.06%.
In other financial markets interest rates began to rise, the price of gold barely moved, and oil prices rose significantly. The 10-year U.S. government bond started the third quarter yielding .68%. This incredibly low yield was the result of a slowing economy due to the COVID-19 pandemic and the Federal Reserve’s intention of providing highly accommodative monetary policy. However, bond market participants began piecing the economic puzzle together in the fourth quarter. With loose monetary policy, large fiscal stimulus and revved up consumers, a concept of potential inflation emerged. However, the development that finally untethered yields was the availability of a COVID-19 vaccine. As details about the availability and efficacy of the vaccine began to emerge, bond investors started to anticipate a more robust economy with higher inflation and higher interest rates. The very beneficial result is that long-term interest rates increased more than short-term rates (yield curve steepened). As a result, the 10-year government bond ended the quarter at .92% (.24 basis points higher than 3 months earlier). Gold appeared to be unaffected by the pandemic as the “doomsday” buyers equaled the “better-opportunities-now-exist-in-the-stock-market-as-the-economic-recovery-is-underway” sellers. A troy ounce of gold started the fourth quarter at $1,897 and ended it at $1,894. The price of oil is a different story. As the global economy began to reopen the demand for energy increased. This caused consumers, investors, and speculators to enter the publicly traded oil market. During the last quarter of 2020, the price of oil increased 16.25% to finish the year at $48.57 a barrel.
Investors, politicians, and financial market observers continued to grapple with the perceived disconnect between the economy (shut down or slow) and the stock market (near all-time highs). The explanation is the price of stocks is a present value calculation of future cash flows. The price of a stock does not reflect how the company is doing today but how it will do in succeeding years. When viewed from this “prism” it is easier to understand why stocks have done so well. The current year is indeed bleak, but the next several years look much more favorable. Stimulus bills (more yet to come) will have a profound impact on the economy. This liquidity will be the fuel and pent-up consumer demand will be the igniter, which bodes well for the future revenues of many companies. Given the optimistic projections, investors will not wait for revenue to be realized. Instead, they are buying and valuing stocks today with the expectation that revenues will be higher two and three years from now.
Looking Forward –
The message remains the same. The greatest risk and lowest potential returns continue to reside with large cap technology growth stocks. This segment of the investing universe is best reflected in six stocks. Commonly referred to as the FANG stocks: Facebook, Apple, Netflix, Google Amazon, and Microsoft; these stocks thrived in spite of the uncertainty in 2020. When all stocks collapsed in the first quarter of 2020, the FANG stocks quickly rebounded and continued to outperform. Most other stocks did not even begin to recover until the fourth quarter. However, the transition from FANG to other stocks is just beginning. Present market conditions now offer the potential for higher prices (i.e. inflation). The greatest forward looking concept investors need to realize that the near-term disruption to financial markets is not an economic slowdown, but an intensified inflationary environment.
For 2021 investors should continue to limit their exposure to large cap technology stocks. For individuals who own mutual funds, Exchange Traded Funds, and individual stocks, it is crucial that they examine the underlying stock positions and scan for concentration risk. Many funds hold the exact same investments as one another causing portfolios to be needlessly undiversified.
D’Arcy capital continues to overweight the energy sector, the financial sector, emerging markets, small cap stocks, and value stocks. Large cap growth, utilities, and U.S. Government bonds remain underweights. Municipal bonds, inflation protected bonds, and high yield bonds remain the best options in the fixed income world. Investors always over emphasize the effect increasing interest rates have on bond portfolios. For a portfolio of laddered, coupon paying bonds with increasing interest rates will provided reinvesting opportunities that have been absent for years. Just steer clear of zero-coupon bonds.