Q4 2020

January 6, 2021

Let’s imagine we are sitting here today one year ago. Let’s further say that at this time, a year ago, we knew everything we now know about 2020, except one thing: we don’t know how the markets performed. What do you think we’d be doing? Does selling everything sound about right? Can you think of anyone with this insight would have predicted exceptionally strong stock market returns for 2020?

Let me venture a guess: no.

So, we can chalk up 2020 as reinforcing the old investment adage: “You can’t time the markets”. That means, wholesale changes to a portfolio based on the perception of current conditions just does not work.

However, had we sold everything in January of 2020, we would have been feeling pretty good about ourselves in March as markets were collapsing. Unfortunately, that good feeling would have been short-lived. Our January “selling everything” decision would have required we start buying again immediately as things collapsed. It is hard to envision getting both decisions right.

Almost every significant market sell-off I have experienced happens in anticipation of some worst-case scenario playing out in the economy. Sell-offs gain momentum as this worst-case scenario becomes consensus opinion. Market bottoms are only reached when consensus turns to panic; the moment investor selling narrows to a single goal: preserve the remaining value.

All of this was compressed into a few short weeks this past March.

Which brings us to our second question about 2020: why didn’t the market stay down longer? The answer is found in another investment adage: “Don’t fight the Fed”.

The market sell-off stopped when the Federal Reserve stepped in. To steady the bond markets, they became a buyer of bonds which stabilized prices. To support the economy and stock market, interest rates were pushed to near 0%.

The Fed’s actions to pump money into the markets and lower the cost of funds gave investors confidence that they would not allow markets to collapse.

Let the buying begin!

But that does not fully explain the stock market’s performance in 2020. The important final ingredient propelling the markets higher was the economy’s resilience. By all measures, it appears the economy is ready to fully rebound as soon as the pandemic has ended. We now sit here a year later, without certainty as to what may unfold this coming year. We know the market expects the pandemic to be over in 2021 and the economy to snap back quickly. Should that not occur, we are going to have a more difficult year in the stock market.

Most of you have been reading my thoughts for long enough that you understand I view investing as a marathon and not a sprint. I believe longer-term economic forces are more important to watch and I spend less time vexing over shorter-term measures.

In that light, I continue to view the 2017 corporate tax law changes as essential to the long-term health of the U.S. economy and the markets. Mine is an economic and financial assessment. Unfortunately, those tax law changes may be at risk as they are recast in political narratives. That will bear watching; equally important are interest rates.

I am concerned about an economy and markets that are propped up by low interest rates. I believe current stock prices include a premium directly tied to low interest rates. Is that a risk? Only if interest rates start to rise.

We saw what can happen back in the 4th quarter of 2018 when the Fed tried to raise rates. The markets immediately fell. Today, the risk is higher because I believe the interest rate premium in stock prices is higher today than it was in 2018.

For a host of reasons (that I won’t go into here), I believe the Fed should take their thumb off interest rates as soon as practical. A market-determined interest rate is far healthier for the long term than artificially imposed low rates.

However, I do not believe the Fed will reverse course on interest rates for at least a couple of years. Despite my concern for the market when rates rise, I do not see rising rates as an imminent risk to stock prices.

The flip side of this are decisions on buying bonds in a portfolio. Low interest rates clearly make the returns on bonds look poor. Do we start seeking higher yields by investing in alternatives to bonds? My answer is: no.

Bonds are not owned simply because of the interest that can be earned, they are owned because they are a contract between the issuer and the buyer. A bond is an obligation on the part of the issuer to make specific payments at pre-determined times. This feature of a bond is extremely important in planning.

Higher-yielding investment alternatives do not include this contractual obligation to make payments. In short, anything showing a higher yield in the market today is an equity investment that distributes a high proportion of its earnings.

When rates rise, these “yield” equity products will be the most vulnerable (i.e. fall the most). I view it as extremely risky to chase higher yields in light of the longer-term risk of rising interest rates.

We are comfortable sticking with investment-grade bonds in portfolios. We are keeping the maturities of the bonds shorter term. This will allow us to take advantage of higher rates once interest rates start rising. If rates remain at low levels, we believe the market will continue to give a premium to growth stocks which will help offset the lower returns on bonds. We view this as a good balance in the markets today given the risks that lay ahead.

Like each of you, we look forward to a post-pandemic world. We also hope you have a healthy, prosperous, and joyful 2021.

From all of us at Nicollet,

Our Very Best!

Mark Hoonsbeen, CFA
Principal