Market Summary

A strong fourth quarter capped a wild and turbulent year. 2020 marked the largest reversal in the S&P 500’s history, rebounding over 70% from the March lows and finishing the year up over 18%. During the fourth quarter, the major indexes reached all-time highs as investors welcomed greater political clarity and positive news on coronavirus vaccines. The S&P 500 Index was up more than 15% in November and December, the best end to a year since WWII[i].

Market trends finished the quarter positively. Gains were broadly distributed across sectors, styles, and market caps. Positive vaccine news primarily benefited stocks that had been laggards throughout the year, with value, small-cap, and international markets gaining the most. Also, low interest rates and more positive economic data helped seven of the eleven S&P 500 sectors reach all-time highs during the quarter[ii].

Bonds were little changed in the quarter, with a slight uptick in Treasury rates. Yields remained near record lows, and we do not expect high returns from fixed income going forward. Below is a summary of returns for the quarter[iii].

[1] Alternatives benchmark includes 60% SG Trend Index and 40% Swiss Re Global Cat Bond TR Index.

Market Analysis

Despite a strong fourth quarter, value stocks suffered one of their worst years on record relative to growth stocks in 2020. Large-cap growth funds outperformed large-cap value funds by over 30%, an even wider margin than during the dot-com bubble in 1999 (see chart below[iv]). The large difference further widened the return divergence over the last five years.

On a 10-year average annual rolling return basis, there were only two periods where growth outperformed value anywhere close to this degree: once in December 1939 and again in February 2000 during the Internet bubble. After both of those periods, value led growth over the next decade by 9.9% annually after December 1939 and 7.7% annually after February 2000[v].

We saw pockets of excesses in the stock market, but we think the rebound was largely warranted given:

1. Expectations for increased corporate earnings. A rapid economic recovery could bring an accelerated earnings recovery. Historically, earnings have rebounded sharply coming out of recession, and investors expected a rebound in 2021. At the current pace of improvement, the S&P 500 would reach record high earnings by the end of 2021[vi]. The close results of the 2020 elections for the Senate and House suggested that President-elect Biden may not be able to implement tax increases on corporations that were in his pre-election plans, which enhances the short-term outlook for corporate earnings. However, fiscal pressures may lead to tax increases down the road, which may lead to a slowdown in profit growth at that time.
2. Depressed interest rates. It is hard to escape the pervasive impact of zero interest rates on the investment landscape. The chart shows that outside of wars, the last decade saw the longest sustained period of negative real policy rates in US history[vii]. As of year-end, the Fed’s effective policy rate was .09% and Core CPI was 1.65%, equating to a negative 1.56% real federal funds rate[viii].
3. Massive stimulus. Both fiscal and monetary policy continued to support the economic recovery and financial markets. Most countries’ central banks and lawmakers provided more support for COVID than they did for the Global Financial Crisis. This chart compares the difference in fiscal responses to the two recessions.

While the elections of 2020 didn’t end political division in America, they did bring more clarity to the direction of policy. More policy actions may be in play, including increased fiscal stimulus.

The acceleration in corporate profits, historically low interest rates, and unprecedented stimulus increased investor optimism to the point that US stock valuations looked extremely expensive relative to history. The table shows the S&P 500 valuations compared to their history[ix]. 100% indicates the maximum expensiveness. Out of the nine metrics, the median metric was in the 93^rd percentile, with three metrics at their highest point ever. Only when we compare stock prices to low Treasury yields do we find them priced below the 50^th percentile.

It’s worth noting P/E ratios of the asset-heavy US corporate sector of the 1960s-1980s might not be the best comparison for today’s asset-light, less capital-intensive S&P 500 universe. In addition, the interest rate environment of today is much different than double-digit interest rates of the 1970’s and early 1980’s. So, some upward drift in S&P 500 P/E ratios over time makes sense, in principle.

Economic Analysis

The economy lost some momentum as 2020 ended with a more rapid COVID-19 spread and renewed restrictions. Still, the US economy continued to improve, with gains in manufacturing, employment, home prices, and retail sales. Beyond that, there was still exceptionally supportive monetary policy, and a new $900 billion fiscal stimulus package passed in December.

This recession was different than that of the Global Financial Crisis because it was not caused by corporate, consumer or financial imprudence. As a result, household savings rates and financial sector balance sheets were in reasonable shape when the economic shock hit and by some measures were in even better shape by the end of the year. With mortgage and consumer interest rates at the lowest in a generation, household debt relative to income finished the year at 20-year lows, revolving debt payments shrunk, and the savings rate surged.

As the economy reopens in 2021, economists expected to see a surge in consumer and corporate spending. Consensus forecast for US real GDP growth was 3.9% for 2021, which would be the fastest rate since 2000[x]. According to Man Institute, bull markets tend to trace economic expansions. According to Man Institute, one of the largest hedge funds in Britain, there were only two instances where US equities were negative through an economic expansion[xi].

Portfolio Changes

Across portfolios, we are balancing high US equity valuations against still ultra-low interest rates. We continued to see opportunities in non-U.S. stocks, mid-cap stocks, and value stocks. After the US elections, we increased equity allocations by 2%. We added to both mid-cap positions and non-U.S. equity positions, decreasing cash as a result. A clearer picture around US elections and good results surrounding COVID-19 vaccines were two factors in increasing equity exposure. Also, we maintained exposure to other areas that could benefit from the continued recovery, including emerging market equities and value stocks.

One thing 2020 has taught us as investors is the importance of sticking to a long-term investment plan. That may be easier said than done when volatility arrives—and we had our fair share of that in 2020. Now is an excellent time to review your investment objective to make sure they match your financial goals.

Please reach out to your advisor if you have any questions or concerns.

[i] LPL Research

[ii] Consumer Discretionary, Technology, Healthcare, Communications, Consumer Staples, Materials and Industrials

[iii] Morningstar Direct as of 12/31/2020

[iv] Morningstar

[v] Source: Morningstar and Wells Fargo

[vi] LPL Research, as of 11/20/2020

[vii] JP Morgan Asset Management

[viii] JPMorgan, Federal Reserve Data

[ix] Goldman Sachs

[x] Leuthold Group

[xi] https://www.man.com/maninstitute/views-from-the-floor-2020-dec-15

IMPORTANT DISCLOSURES

Leonard Rickey Investment Advisors, PLLC (“LRIA”), is an SEC registered investment adviser located in the State of Washington. Registration does not imply a certain level of skill or training. For information pertaining to the registration status of LRIA, please contact LRIA or refer to the Investment Adviser Public Disclosure website (www.adviserinfo.sec.gov).

This newsletter is provided for general information only and contains information that is not suitable for everyone. As such, nothing herein should be construed as the provision of specific investment advice or recommendations for any individual.  To determine which investments may be appropriate for you, consult your financial advisor prior to investing. All performance referenced herein is historical in nature and is not an indication of or a guarantee of future results. All indices are unmanaged and cannot be invested into directly. Unmanaged index returns do not reflect fees, expenses, or sales charges. Index performance is not indicative of the performance of any investment.

Your experience may vary according to your individual circumstances and there can be no assurance that LRIA will be able to achieve similar results for all clients in comparable situations or that any strategy or investment will prove profitable.   As investment returns, inflation, taxes and other economic conditions vary, your actual results may vary significantly. The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful. There is no guarantee that the views and opinions expressed herein will come to pass. This newsletter contains information derived from third party sources. Although we believe these third-party sources to be reliable, we make no representations as to the accuracy or completeness of any information prepared by any unaffiliated third party incorporated herein, and take no responsibility, therefore.

Stock investing includes numerous specific risks including the fluctuations of dividend, loss of principal, and potential illiquidity of the investment in a falling market. International and emerging markets investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors. Small cap stocks may be subject to a higher degree of risk than more established companies’ securities. The illiquidity of the small cap market may adversely affect the value of these investments. Information presented herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security. This newsletter should not be regarded as a complete analysis of the subjects discussed. Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values and yields will decline as interest rates rise and bonds are subject to availability and change in price. The risks associated with investment-grade corporate bonds are considered significantly higher than those associated with first-class government bonds. The difference between rates for first-class government bonds and investment-grade bonds is called investment-grade spread. The range of this spread is an indicator of the market’s belief in the stability of the economy. The fast price swings in commodities and currencies can result in significant volatility in an investor’s holdings. There is no assurance that the techniques and strategies discussed are suitable for all investors or will yield positive outcomes. The Value investments can perform differently from the market as a whole. They can remain undervalued by the market for long periods of time.

Any projections, forecasts and estimates, including without limitation any statement using “expect” or “believe” or any variation of either term or a similar term, contained here are forward-looking statements and are based upon certain current assumptions, beliefs and expectations that LRIA considers reasonable or that the applicable third parties have identified as such. Forward-looking statements are necessarily speculative in nature, and it can be expected that some or all the assumptions or beliefs underlying the forward-looking statements will not materialize or will vary significantly from actual results or outcomes. Some important factors that could cause actual results or outcomes to differ materially from those in any forward-looking statements include, among others, changes in interest rates and general economic conditions in the US and globally, changes in the liquidity available in the market, change and volatility in the value of the US dollar, market volatility and distressed credit markets, and other market, financial or legal uncertainties. Consequently, the inclusion of forward-looking statements herein should not be regarded as a representation by LRIA or any other person or entity of the outcomes or results that will be achieved by following any recommendations contained herein. While the forward-looking statements here reflect estimates, expectations and beliefs, they are not guarantees of future performance or outcomes. LRIA has no obligation to update or otherwise revise any forward-looking statements, including any revisions to reflect changes in economic conditions or other circumstances arising after the date hereof or to reflect the occurrence of events (whether anticipated or unanticipated), even if the underlying assumptions do not come to fruition. Opinions expressed herein are subject to change without notice and do not necessarily consider the particular investment objectives, financial situations, or particular needs of all investors. For additional information about LRIA, including fees and services, please contact us for our Form ADV disclosure brochure using our contact information herein. Please read the disclosure brochure carefully before you invest or send money.

INDEX DEFINITIONS

The Barclays Aggregate Bond Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the US investment-grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities.

The Standard & Poor’s 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. It cannot be invested into directly.

The Russell 2000 Index is an unmanaged index generally representative of the 2,000 smallest companies in the Russell Index, which represents approximately 10% of the total market capitalization of the Russell 3000 Index.

The MSCI Emerging Markets Index is a float-adjusted market capitalization index that consists of indices of approximately 800 stocks and is designed to measure equity market performance in 23 emerging economies: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, , Peru, Philippines, Poland, Qatar, Russia, South Africa, Taiwan, Thailand, Turkey, and the United Arab Emirates.

The MSCI EAFE (Europe, Australasia, Far East) Index is a free float-adjusted market capitalization index of approximately 900 stocks and is designed to measure equity market performance in 21 developed market countries outside of North America.

The SG Trend Index is a subset of the SG CTA Index, and follows traders of trend following methodologies. The SG CTA Index is equal weighted, calculates the daily rate of return for a pool of CTAs selected from the larger managers that are open to new investment.

Swiss Re Global Cat Bond Index tracks the aggregate performance of all catastrophe bonds issued offered under Rule 144A. The index captures bonds denominated in any currency, all rated and unrated cat bonds, outstanding perils, and triggers. The index is not exposed to currency risk from non-USD denominated cat bonds.