You do not need me to tell you that 2020 was a challenging year in many ways and that we have already had a tumultuous start to 2021. As a company, we learned a lot in 2020 and have added to our process to make it even better going forward and look forward to sharing some of that with you in this Quarterly Themes note. We will be doing this deeper dive each quarter going forward to give you more insight into what we saw in the most recent period looking back and what we see in the coming 3 months. We do not have a crystal ball but will give you what we see from our research as to where the economy is headed from a growth, inflation and policy standpoint, and our interpretation of how that might impact the market and your portfolio and how we are navigating that.
In our Q1 2021 Quarterly Investment Themes, we are going to cover 3 key manin topics:
- A review of a volatile and surprising 2020 that included a pandemic, the sharpest drop in the market and GDP in history, followed by the sharpest recovery in market history but mixed results in the economy.
- Our outlook on where we see things headed in Q1 of 2021. We will take you through the data we are looking at and new research we are using to help guide us and to introduce you to the Quads!
- Finally, we will discuss the Death of the traditional 60/40 Portfolio and what that might mean over the long term for how you should be thinking about allocating your money.
Our investment philosophy at Konvergent about helping you and your investment portfolio live in alignment with your goals. We believe that finding out the WHY is just as important as HOW to invest your funds. We then create a personalized strategy based on an assessment of your willingness to take risk within your portfolio. This helps us answer 3 key questions: Do you have enough? Is it in the right places? Which assets do you use first when creating income? Once we know these answers, we can then identify the optimal investment strategies and allocation to meet your personal needs.
I look forward to walking you through what we saw, what we see in the weeks and months ahead, and how we can begin planning for potential secular shifts in the markets and economy over the long run.
2020 Review
2020 was a volatile year by many measures economically and politically. We started the year with the market bouncing to all time highs in early February, even as news of COVID was coming out of China. As it became clear that the Pandemic was not going to stay within China’s borders, we had the sharpest selloff in the market in history, dropping 36% in just 23 trading days.
The Federal Reserve and Government responded with unprecedented Stimulus from dropping rates, providing emergency lending facilities, and the CARES Act[1]. Between March and June, unemployment spiked, small businesses were closing at a record pace, and we saw the sharpest drop in GDP in history.
Our models, which are economic and volatility based, had shifted to a more conservative position in March and because of the amount of negative economic data and continued volatility, we stayed in a more cautious position for much of the next 2 quarters.
We did see 2 sharp selloffs in the S&P 500 in September and October as fears of a second wave began to surface along with uncertainty around the election. However, these fears were brushed aside following the results of the election in early November.
Once the election was resolved and as more data began pointing to economic growth coming back and additional stimulus on the way, we re-risked our models to capture the growth in the markets we saw at the end of the year.
Our biggest learning this year was that in the age we are in, information and markets are moving faster than they ever had before. Our models were based on taking in existing data as it came in and adjusting our based on that. While this methodology has worked well over the years, we recognized we needed to add in additional research that was using the data coming in today to provide more information on where things might be going. There is not certainty to it, but we can identify probabilities of how things might go and incorporate that into our decision making.
Q1 Investment Themes
Our process for model management is now expanded and based a few key areas and comes from research from multiple research groups. This year, we added Hedgeye Risk Management to our team for research providers. They have added additional insight and ways to measure and map economic and market changes, and most importantly, have brought us The Quads.
The Quads – The quads are all about mapping the economic environment we are currently in, as well as using predictive data to identify the probable outcome for future quarters based on an analysis of Economic Growth, Inflation and Government Policy. The quads are broken down like this:
Quad 1 – Economic Growth Accelerating, Inflation Slowing
Quad 2 – Economic Growth Accelerating, Inflation Accelerating
Quad 3 – Economic Growth Slowing, Inflation Accelerating
Quad 4 – Economic Growth Slowing, Inflation Slowing
By understanding which Quad we are in, we can identify what asset classes have historically has worked and which might struggle.
So where are we headed in Q1 2021? In spite of fears of continuing COVID challenges, political and socio-economic unrest, and a market that is already at or near all time highs, Q1 appears to be shaping up into Quad 2 in the US and in much of the rest of the world. The drivers behind this are:
- GDP Growth Expectations – Coming off the worst drop in GDP in Q1 & Q2 of 2020, GDP growth in Q1 and Q2 of 2021 will show significantly high levels of growth. We will not be at pre-COVID levels of overall economic activity, the positive Rate of Change will be significant.
- Inflation – Inflation forecasts and expectations continue to rise, with Bloomberg consensus expectation at 2.6% and Hedgeye expecting to actually see inflation hit the 3% mark in Q1 or Q2[2].
- Stimulus – From all the stimulus programs from 2020 leading to a growth of savings of $500 billion, along with an additional near $1 trillion just passed, there is effectively $1.5 trillion of liquidity that is available to either be spent into the economy or invested into assets[3].
- Corporate Profit Cycle – Not only did the economy have a sharp drop off, so did corporate profits. This cycle should reverse in Q1-Q2 of 2021 where we see strong YoY growth in corporate earnings.
In spite of our optimism on the economy and potential impact on the market in Q1, there are concerns that are still out there:
- K Shaped Recovery – While asset prices fully recovered through 2020, many small businesses and service jobs did not. There appears to be rising social unrest that could lead to additional uncertainty and economic challenges in the months to come.
- Vaccine Rollout Delays – We are already seeing some level of delays in how quickly the vaccine for COVID was to be distributed. If this causes a delay in the growth in economic activity, it could lead to a lower level of growth in the economy.
Based on our analysis of the US and much of the globe being in Quad 2 (higher growth and inflation), there are investment themes that we have added to the portfolio that do well in a Quad 2 regime. Those are:
- Equities in general, but especially technology
- Emerging Markets
- Commodities
The Death of the 60/40 Portfolio
While we believe the next quarter, or 2, may be Quad 2 with solid economic growth and rising inflation, we still have concerns that we are simply inflating the current stock market bubble to higher and higher levels. With a new administration focused likely focused on shifting from supporting the top 0.1% to more evenly spreading the support from the government and the Fed, we could see wages and prices rise to levels we have not seen in the recent past. There are too many unknows at this point to make a definitive prediction but that seems to be the road we are headed down.
If we are headed down that path, what has worked for the last 40 years while we have had steady economic growth, low taxes and low inflation, will not likely work as well in the next decade.
To help you better understand what might work, I am going to use a sports analogy that I hope works!
Many of you will know the name Dennis Rodman. Some might know him for unrelated reasons, particularly his trips to North Korea. However, we are going to focus on his basketball career.
What does Dennis Rodman, one of the most colorful basketball players in NBA history have to do with your investment portfolio?
Rodman is one of lowest scoring inductees in the Basketball Hall of Fame[4]. He was never a threat to score, yet when he was on the floor, the offensive efficiency of his teams went through the roof[5].
I experienced this first-hand as a young fan in 1996 when Rodman and the Bulls met my Seattle Supersonics in the NBA finals.
Without Rodman, the Bulls had already won three NBA titles by relying on Michael Jordan and Scottie Pippen’s unique talents.
With Rodman, they became arguably the best team of all-time.
For the past 40 years, we have been in a long-term secular bull market in both stocks and bonds. During this time, the simple idea of a portfolio balanced with 60% equities and 40% bonds (The 60/40 Portfolio) has performed extremely well. Interest rates have gone from the mid-teens to near zero, providing a large price appreciation to more than make up for lower and lower coupon rates. At the same time, they provided a great hedge against stock market volatility as times of market distressed were usually times where interest rates were lowered, which supported higher bond prices.
But if this strategy has worked – whether its Jordan and Pippen or 60/40 – why mess with a good thing? Let’s get back to Dennis Rodman.
In his best season with the bulls, Rodman averaged close to 16 rebounds per game[6]. If 6 of those were offensive rebounds, you are giving Michael Jordan and Scottie Pippen second and third shots every possession, and that equated to an additional six points per game.
That is enough second chances to take a really great team and make them almost unbeatable.
In isolation, it is hard to consider Rodman among the best players in NBA history. A team of Rodmans (or Rodmen, I am unsure how to pluralize his name) would not be very good, but paired with the right teammates, he is unstoppable.
This is how we believe portfolios will need to be managed going forward.
There are asset classes that tend to be anti-correlated with the market and tend to do best when there is a lack of liquidity, when stocks are crashing, when bonds are malfunctioning, when there are terrible credit drawdowns. When the rest of the world is drawing liquidity out of the system, these asset classes bring liquidity back into your portfolio.
Those asset classes are:
- Long Volatility
- Commodity Trend Following
- Precious Metals
We will be covering this in greater detail in an upcoming blog and video to better describe what each of these are. What I will leave you with today is that a portfolio with these assets classes, combined with a diversified stock and bond portfolio, over a long period of time, has outperformed the 60/40 portfolio.
Look for our post on the Death of the 60/40 Portfolio on our website or in your upcoming newsletter to learn more.
Summary
To wrap things up, following a volatile and in many ways difficult 2020, we expect the first quarter of 2021 to show signs of growth and potential inflation. We have adapted our models to account for this while still watching closely for signs that inflation is beginning to get overcooked or that the economic data is beginning to slow.
We look forward to meeting with all of you in the next few months to discuss your overall financial situation and to discuss our view on the death of the 60/40 portfolio and whether we should be implementing additional changes as those risks begin to arrive.
Happy New Year, talk to you soon!
Access the slide deck here:
[1] https://www.federalreserve.gov/newsevents/pressreleases/monetary20200409a.htm
[2] Slide 12: Q1 2021 Investment Themes – GDP & Inflation
[3] Slide 6: 2020 Review – Stimulus to the Rescue
[4] https://www.basketball-reference.com/players/r/rodmade01.html
[5] https://www.basketball-reference.com/leagues/NBA_1996.html
[6] https://www.basketball-reference.com/players/r/rodmade01.html