- Markets love resolution and COVID-19 vaccine successes enabled investors to look past current economic weakness to a day when mobility will be restored.
- We began shifting the portfolio to a modestly more cyclical stance six months ago. Despite four months of leadership from economic recovery stocks, selected opportunities remain.
- Although we remain optimistic on the equity market in 2021 as the economy recovers from the COVID-19 pandemic, we are increasingly concerned about market excesses.
After a lackluster October driven by concerns over a resurgence in COVID-19 infections and a contentious U.S. presidential election, equity markets powered ahead in November and December to post a robust 12% fourth-quarter return.
Markets love resolution and COVID-19 vaccine successes enabled investors to look past current economic weakness to a day when mobility will be restored. Meanwhile, investors celebrated a federal government closely balanced between the parties - creating an environment where only incremental legislation will be passed. Importantly, liquidity remains ample, as evidenced by a second fiscal stimulus in the form of December’s $900 billion pandemic relief bill and continued unprecedented monetary support from the Federal Reserve.
The best-performing sectors during the fourth quarter of 2020 were the cyclical energy, materials and industrials sectors, along with financials and the economically sensitive areas of communications services. The defensive consumer staples and health care sectors lagged. Consumer cyclicals lagged due to weak performance from the largest stocks in the sector. The fourth quarter saw a continuation of the trend that started in September where economic recovery stocks led companies with COVID-19-resilient business models. Small cap and high-beta stocks outperformed large cap and defensive stocks.
After more than a decade of undershooting its 2% inflation target, the Federal Reserve changed its regime in 2020 and is now looking to overshoot by keeping monetary policy stimulative and interest rates very low even as the economy begins to recover. Over $4 trillion was pumped into the U.S. economy as part of the stimulus packages. In 2020 the U.S. M3 money supply grew over 25%. Much of the strength in financial assets last year was surely caused by the funds injected into the economy. Commodities such as steel and aluminum saw powerful price increases in the second half of 2020 despite capacity utilization in the 70 percent ranges, far below the low 90% level normally necessary to induce inflation. Because wages are 70% of the U.S. economy, the high level of unemployment will prevent runaway inflation. But we believe inflation will become an increasing focus of investors over the next several years.
"Despite the high valuation of the stock market we do see attractive areas to invest in."
Although we remain optimistic on the equity market in 2021 as the economy recovers from the COVID-19 pandemic, we are increasingly concerned about market excesses. Our concern goes beyond simply looking at the S&P 500 Index’s 22x P/E multiple as “1999-like” to the amount of capital chasing returns. For example, blank check companies known as SPACs (special purpose acquisition companies) exploded in 2020, growing fivefold and raising a record $70 billion; Bitcoin went parabolic between September and year end, rising 200%; and anything tied to electric vehicles or renewable energy seemingly knows no ceiling, whether it’s the oft-cited 740% rise in Tesla in 2020 or open-ended returns in solar power solutions or fuel-cell-focused stocks. Investor fear of missing out on the next open-ended growth opportunity crushed considerations regarding valuation or business model durability.
Despite the high valuation of the stock market we do see attractive areas to invest in. The U.S. has underspent on roads and bridges for decades. A Democratic Congress is likely to enact a significant infrastructure bill. Housing appears to be entering a powerful cycle and might even experience a Goldilocks environment. COVID-19 ignited migration from the cities to the suburbs. And there is significant pent-up demand after more than a decade of underproducing population growth. The Federal Reserve will keep interest rates lower for longer, helping affordability. Bank stocks will benefit from a steeper yield curve but a low absolute level of rates likely caps upside.
We began shifting the portfolio to a modestly more cyclical stance six months ago. Despite four months of leadership from economic recovery stocks, selected opportunities remain. European steel stocks will benefit from green initiatives to limit imports from countries with lax environmental controls. Enormous amounts of new ethylene and propylene capacity in China will hurt commodity chemicals earnings but help specialty chemicals margins. Large pharmaceutical stocks are inexpensive, but the risk of price controls under an all-Democratic government likely limits upside. Big cap tech is very expensive, has difficult comparisons from COVID-19-boosted results and faces regulatory and anti-trust threats. That said, it also has terrific growth prospects. It probably will not dominate stock market performance in 2021 the way that it has the past six years. We will keep significant positions in companies we see as long-term winners. The best way to participate is probably to identify emerging winners rather than owning only the largest companies.
We remain risk-averse investors who believe diversification and a balanced approach to stock selection, industry allocation and factor exposure is prudent. However, as discussed above, we are constructive on the outlook for economic growth and believe businesses levered to improved economic activity have better risk/reward than the mega cap secular growth companies, on average. As a result, we have methodically and prudently tilted our portfolio slightly more toward investments that reflect this view. This is done within the context of our rigorous focus on high-quality stocks and downside protection.
The ClearBridge Appreciation Strategy underperformed the benchmark in the fourth quarter. On an absolute basis, the Strategy had gains in 10 of 11 sectors. The main contributors to performance were the communication services, information technology (IT) and financials sectors. The real estate sector was the only absolute detractor from performance.
In relative terms, sector allocation was positive for performance, while stock selection detracted. In particular, stock selection in the IT, consumer discretionary, materials and real estate sectors weighed on relative returns, while stock selection in the communication services sector contributed positively.
On an individual stock basis, the biggest contributors to absolute outperformance during the quarter were JPMorgan Chase, Apple, Walt Disney, Honeywell and Pinterest. The biggest detractors were Salesforce.com, Air Products and Chemicals, American Tower, Home Depot and Amgen.
During the quarter we initiated positions in Eli Lilly in the health care sector, and Northrop Grumman and Union Pacific in the industrials sector. We closed positions in AbbVie and CVS Health in the health care sector. We also received and retained shares in Viatris, formed from the merger of Mylan and portfolio holding Pfizer’s Upjohn business.