Contributed by Warren Fisher of Manole Capital Management
There’s no sugar coating it – 2020 was a challenging year. For all of its hardships, we found it to be a year of profound focus, transparency and learning. The country confronted a once-in-a-century pandemic, a major recession driven by the service sector, social tensions and finished up with a divisive election. Although these issues struck all at once, we worked through these difficulties and endured. Your life definitely changed in 2020, but it might take some time before you know in exactly what way.
Heading into 2021, the US faces records numbers of COVID-19 cases. However, the stock market continues to chug along and hit all-time highs. As the pandemic drags into 2021, one has to decide if the glass is half empty or half full.
Some economists are pessimistic, citing a spike in cases, leading to new restrictions on businesses, which will slow the labor picture. US unemployment surged to 14.7% in April from a low point of 4.4% in March. The recovery has been slower than what we had hoped for. In November, the Labor Departments job report was a robust 336,000 but in December, there was a decline of 140,000 jobs. This was the worst month for the recovering labor market since April. Jaime Dimon, CEO of JP Morgan recently said he is worried about the future: “Short-term government actions can’t fix the lasting pain and widening inequality in the economy.”
Others are optmistic, citing the second pandemic-relief package of $900 billion, which should pump some stimulus into the economy. According to Jefferies economists, $1 trillion of additional spending will add 2% to economic growth over the next two years. Plus, evidence shows that Americans actually saved a surprising amount of their first stimulus check. In November, the US personal savings rate was 12.9%, well above the 7.5% a year ago. Borrowing costs are remarkably cheap and the Fed will likely keep interest rates low for another year or two. According to Moody’s Investors Services, US companies are sitting on the largest pile of cash ever. With over $2.1 trillion dollars of capital, up over 30% year-over-year, this is nearly double cash levels in 2010. Eventually, these firms will have to put that money to work. The US GDP contracted by (3.5%) last year and estimates are looking for growth of +4.2% this year. Looking forward to 2021 and 2022, the economy has to turn away from a work-from-home, business lockdown environment. Are things going to materially improve in 2021, or will we fail to deliver on the promise of growth? What lies ahead? Will 2021 introduce more disruption, or will it be a year of opportunity?
As we turn the page on another year, it is a Wall Street tradition for market strategists and economists to make audacious pontifications about what might happen for the upcoming year. Whether it is projections on stock indices or interest rates or commodity prices, these guestimates garner a lot of attention. These “experts” have access to the best data and vast resources, but typically arrive at hilariously incorrect predictions.
Even as you read this newsletter, you probably have dozens of 2021 prognostications in your email inbox. We know that sweeping forecasts get the page views, but that is not Manole Capital’s forte. We are not planning on providing the 21 surprise forecasts for 2021, and we will not give you a Top 10 list of what you can expect this year. We like Lao Tzu’s quote: “Those who have knowledge, don’t predict. Those who predict, don’t have knowledge.”
If 2020 taught us anything, it is this: To even try to make accurate market predictions is futile. We didn’t hear one market participant mention a killer virus that would plunge the global economy into the worst recession since the Great Depression and lead to one of the largest stock market corrections in history. Did anybody predict that the price of oil would crater, tumbling below $0 per barrel?
That is why we have seen plenty of commentary about value stocks outperforming growth, a weak US dollar, rising inflation leading to higher commodity prices. Will this happen? Who knows! The only real prediction to make is that there will be tons of surprises in 2021, likely resulting in elevated volatility.
Twelve months ago, many experts were estimating S&P 500 earnings growth of +10%. Keeping forward valuations steady, that would imply the market rising by its 75-year average increase of roughly 7% to 8%. Nobody envisioned a global pandemic and an environment that would make the Financial Crisis of 2008 look tame in comparison.
If only we had Johnny Carson’s Carnac the Magnificent to help us figure out what lies ahead…
Instead of making bold predictions, we run various scenarios (bullish, bearish and angry bear) through our proprietary company models. We like British philospher Carveth Read’s quote of “I’d rather be vaguely right than exactly wrong.”
Let’s imagine there was one analyst that had amazing forecasting and epidemiological knowledge. Also, let’s assume this individual correctly predicted a massive global pandemic, with 19 million recorded infections, over 350,000 US deaths, overwhelmed hospitals, vital resources stressed and an environment filled with lockdowns. Not only that, this hypothetical visionary foresaw the end of an 11-year bull market; quarter-over-quarter GDP declining by (31.4%); millions of businesses closing; an awful recession; and unemployment reaching 14.7%; its highest level since the Great Depression.
What if this modern-day Nostradamus also accurately guessed that the International Monetary Fund would project that the US would see its economy shrink by (4.3%) and the eurozone contract by (8.3%)? Would this expert have forecasted that the S&P 500 would have responded to this environment by rising +18%? How does a weaker economy, feebler earnings and lowered expectations lead to large market gains? Sometimes, one can perfectly spot a trend or make an accurate prediction but still not be rewarded with the correct market reaction.
Maybe one of the lessons of 2020 is that correctly predicting certain macro events isn’t enough. What mattered most this year was the scale and speed of central bank and government support. The Fed, European Central Bank and Bank of Japan have collectively expanded their balance sheets by roughly $8 trillion in 2020. The US’s balance sheet grew as much in six months as it had over the prior 12 years. This prompt and sizeable response to crisis helped buoy the markets. Despite the worst recession in centuries, the US stock market has quickly rebounded and climbed to all-time highs.
As we start 2021, bulls are predicting a great re-opening of our economy not experienced since the Roarin’ 20s. With assurances from the Fed to keep interest rates low and monetary policies favorable, some view this backstop as a perfect reason to own equities. Others are bearish and worry about debt levels, persistently high unemployment and ominous parallels of current valuations to those last seen in the Dot Com era. These pessimistic investors believe the market is addicted to “hope-ium,” a drug based on dreams, not reality. These market gurus worry that monetary policy is exhausted and fiscal policy is at the mercy of a bickering Congress.
We wish we could look into a crystal ball and give you a decisive answer to these economic questions. Sorry! The sad reality is we cannot. Instead, we will remain diligently focused on our fundamental research and disciplined to our 25-year investment process, strategy and philosophy. While it is good to look forward and plan for various scenarios, we strive to focus on the fundamentals, instead of getting caught up in the short-term headlines.
From February 19th through March 23rd 2020, the S&P 500 fell by over (33%) in 33 days. This was was the fastest (30%) decline ever recorded. However, for the full 2020 calendar year, the S&P 500 (which we still view as the best representation of the US stock market) was up +18.4%.
The stock market’s rally off the March lows was driven in large part by tech-heavy growth names. Last year, the NASDAQ 100 climbed +47.6% and the Nasdaq Composite was up +43.6%, its best year since 2009. Over the past two years, the tech-heavy Nasdaq rose by +94%. If one looks at Facebook, Apple, Amazon, Google and Microsoft, they represent roughly 25% of the value of the entire S&P 500. This is approximately 2x, where these five stocks were in mid-2017. Without these stocks, the S&P 500 would have been (11%) lower than its 2020 peak.
Also, for the last 13 years, growth stocks have materially outperformed their value peers. In 2020, growth stocks (in the S&P 500) returned +31% including dividends, while value stocks were down (1%). One of the more interesting trends we are watching is how the market is occasionally rotating towards underperforming areas like value, small-caps, banks, and energy. So far in 2021, the energy and financial sectors are leading the way. Will it last? Are these real signs of a rotation or just another head fake? A bifurcated recovery may persist into 2021 while we wait for vaccines. For example, the housing sector is booming with low interest rates, while many service industries (where social distancing is difficult) continue to struggle.
2020 commodity winners were soybeans up +39.5%; orange juice up +26.8%; copper up +25.8%; and corn up +24.8%. The energy sector continued its struggles, down (37.3%); with gasoline down (17.1%); and NYMEX crude down (20.5%). However, nothing quite performed like digital currencies, with Bitcoin up over 300% last year. It took nearly 11 years for Bitcoin to reach $20,000 per coin (on December 16th, 2020), and then it took just 22 days for it to surge to $40,000 per coin. During the depths of the pandemic in March, Bitcoin traded as low as $3,867. With prices recently above $40,000, that’s 10x growth in less than a year. The last rapid increase in Bitcoin occurred in late 2017, but that was quickly followed by a 1-month sell-off of roughly (50%).
Timing is critical for any investment, but market timing is impossible to do. For example, it is hard to recover from buying at a top, as this chart shows. If you bought Cisco (ticker CSCO) at the peak of the Dot Com era, you would still be underwater two decades later.
Bringing 2020 to a conclusion, we are pleased that every one of our FINTECH portfolios outperformed its benchmark last year. To view any of our monthly tearsheets, just visit our website at www.manolecapital.com and click on the Portfolios tab.
Now that we briefly discussed how certain areas of the market performed last year, let’s spend a little bit of time reviewing current valuations.
Accoring to GMO research, 150 stocks at least tripled in market value during 2020. While certain stocks appear to be “running wild”, as investors chase returns, one must look at each security on its own merits. So, the overall market can trade at 22x forward P/E valuation, but this is just an average of its index participants.
However, we expect a correction is coming, with frankly no idea the headline that will cause it. When, not if, a correction occurs, it really should not come as a total surprise. Analyzing the S&P 500 over the last 40 years, one notices that corrections are the normal course of business. Since 1980, the average intra-year correction for the S&P 500 is (13.8%). Only twice, in 1995 and 2017, has the market not dropped at least (5%) at least once.
Many experts are suggesting the market is overheating and valuations are too high. On the flip side, some claim that with low inflation and a ZIRP (zero interest rate policy) from the Fed, valuations should be higher for equities, when compared to fixed income. Low interest rates have encouraged those seeking a yield to move towards riskier assets, like stocks, and should mean that the stock market should trade with a higher multiple. If an investor can only expect to earn a 1% return on a 10-year US Treasury, they will begin to look elsewhere for a better return. If the risk-free rate is only 1%, investors will demand an equity risk premium of 300 to 500 basis points for the added risk. A stock market earnings yield of 4% equates to a 25x P/E ratio.
Many pundits are harping on the market’s valuation, alluding to the Dot Com bubble era. Comparing today’s market to the Dot Com era is not necessarily fair. Technology firms today generate substantial free cash flow and earnings. Twenty years ago, the darlings of that era had no earnings and were being valued on page views. In 2020, the largest technology stocks generated more than 15% of the S&P 500 earnings. All are posting impressive growth rates and looking out to 2023, these Technology stocks are projected to exceed 20% of the market’s total earnings.
As the largest weight in the S&P 500 at 28%, the Technology sector has driven the market to its heights. Currently, the Technology sector trades at 29x last 12-months earnings, which is well above its 5-year average of 20x. Financials are the 3rd largest sector, but they have struggled in comparison to technology. Financials are credit sensitive, and a low interest rate environment is tough on their margins. This rate sensitivity a lack of growth made Financials the second worst performing sector last year, down (4.1%). As of today, the Financial sector trades at 17x trailing earnings, which compares to its 5-year average of 14x.
News stories about the DJIA (Dow Jones Industrial Average) hitting 30,000 are popping up, but we continue to think that the DJIA, only 30 large-cap companies, is not the best representation of the US equity markets. Our primary issue is that it is weighted by share price, not market capitalization. A company’s stock price provides little information about a company, so weighting an index by market capitalization would be much more insightful. We use the S&P 500 as that benchmark, but it too has flaws. The S&P 500 is comprised of roughly 500 stocks, ranging across 11 distinct sectors, but it does have a large cap bias. With a market cap weighted index, bigger companies end up having more influence in the index. As of today, Facebook, Amazon, Apple, Google and Microsoft represent roughly 25% of the entire S&P 500.
4th quarter 2020 results are getting reported right now, but both revenue and earnings will likely be down for most companies. Besides just revenue and earnings, we consistently focus on operating profit margins and free cash flow. This year, the S&P 500 is estimated to generate 11% operating margins. While this is up over 100 basis points versus last April, it is still well below its all-time peak in September 2018 of 12.4%. This type of operating margin is fine, but certaintly nothing special (in our opinion). For example, our average FINTECH position generates an operating 2x to 3x this level. Plus, everyone of our positions generates free cash flow.
Whether it is Tesla -upon its inclusion in the S&P 500 benchmark – or another company, investors should consider valuation and attempt to understand the fundamentals of a business when constructing a disciplined investment strategy. Unfortunately, many investors do not follow an investment philosophy and attempt to piecemeal together a process based upon market timing and yesterday’s news cycle. We cannot stress this investment philosophy point enough: The benefit of active management is that a manager uses experience, judgement, and an investment process to differentiate a portfolio from the overall market. By simply using an overall market average, one fails to capture the potential benefits of active management versus passive, index investing.
Investors must be able to identify and distinguish winners from losers. The market differentiates between those with a bright future versus those that are merely surviving. Unprecedented monetary and fiscal stimulus came to the market’s rescue in 2020, but individual company fundamentals will matter in 2021. Not all industries are equally capable of handling stress. Not all companies generate free cash flow and can “weather a storm” or a recession.
At Manole Capital, we only focus our attention on the emerging FINTECH industry, and we leave healthcare, energy, consumer and other sectors to their “experts.” We feel it is important to differentiate. By limiting our investments to a niche, we can spend 100% of our time fully understanding what drives growth in our businesses. We can identify and capture trends we see before they become widely understood. By sticking to FINTECH, we believe we can add value for our clients.
There is no denying that the effects of 2020 might lead to unintended future consequences. There is an enormous and continuously growing national debt. Will this cause a long-lasting hangover? It does not appear that Wall Street is factoring all of these concerns into their forward valuations and estimates.
Let’s now discuss important macro issues, monetary and fiscal policy, the jobs market and future growth…
The Macro Environment
Politics: At Manole Capital Management, we attempt to take a politically agnostic approach to investing. This attitude does not mean that politics does not matter to us. It absolutely does! But for us, it makes sense to form an investment thesis once a policy is known or poised to be enacted into law. We believe it is better to watch what politicians do, not necessarily what they say, especially on the campaign trail. When the political or social environment feels uncertain, we maintain our discipline and focus on our 25-year investing strategy, process and philosophy. We remain bottoms-up research analysts, and we make our investment decisions based on the fundamentals. We have found this steady, patient, long-term-oriented approach, often leads to success. Heading into early November, some placed too much emphasis on the political cycle and not enough importance on the business cycle. The media kept claiming that the financial markets were overvalued and not accurately pricing in the grim realities of Main Street. However, this failed to capture the differences between normal recessions and what occurred in 2020.
Recessions: Prior recessions were primarily caused by systemic failures in the financial markets, not a global pandemic. Unlike prior recessions, there were no major structural or cyclical issues in 2020. During the Financial Crisis of 2008, many banks and financial institutions were considered villains, for helping to inflate the housing bubble. This time, banks were quick to roll out programs to help borrowers delay certain debt payments. Last year’s recession was not due to excessive risk taking, but rather due to a sudden, extraneous shock to the system coupled with a self-induced shutdown that ultimately decimated economic activity.
Before COVID-19 arrived, the global economy had been on firm footing, and the fundamentals were very strong. As the virus settled in, Wall Street’s response was swift. Over the course of a month, the S&P 500 fell over (30%). Using history as a guide, markets typpically reach a bottom four months before a recession officially ends. Since 1982, it has taken the US economy an average of roughly four years to fully recover from a recession. Following the Financial Crisis, it took six years. The 2020 stock market didn’t need that long. After roughly one month, with the help of massive global fiscal and monetary stimulus, the stock market was able to quickly right itself. While the stock market climbed higher, the US economy and small businesses were not as quick to restart, and the fundamentals have not returned to prior levels. As we know, the stock market always looks ahead to brighter days, to a more normalized environment. Wall Street does not wait for good news; Wall Street anticipates it.
Fiscal & Monetary Policy: Monetary and fiscal policy are the two largest inputs to financial markets. This will not change for the foreseeable future. The Fed and US Treasury response was decisive and over-whelming. Through bond purchases on its balance sheet, the Fed has pumped in about $3 trillion into the financial system. Every month, it plans on buying another $120 billion, adding to its $7.2 trillion balance sheet. The governments’s $2 trillion CARES Act injected significant money into the economy, with increased unemployment benefits, stimulus checks and business lending programs. The combined stimulus amounted to more than 15% of US GDP.
Despite being only 5 feet 3 inches tall, soon-to-be US Treasury Secretary Janet Yellen told the Senate Finance Committee that the government must “act big,” on its next stimulus package. She stated “With interest rates at historic lows, the smartest thing we can do is act big.” At her confirmation hearing, she showed a re-thinking on the subject of government debt. Yellen hinted that we should begin to forget about the amount being borrowed and start to focus on the low interest rate being paid. “The interest burden of the debt as a share of (GDP) is no higher now than it was before the Financial Crisis in 2008, in spite of the fact that our debt has escalated.” As the government looks to increase stimulus and spending, the fact that our interest payments are no more as a share of GDP now than in the 1990s, will be center stage.
Jobs: In our opinion, the jobs outlook is one of the most important macro issues to follow. We hate to simplify things too much, but the US consumer has no money to spend, if they are unemployed. In the US, we are poised to add more jobs this year than during any other on record, dating back to 1939. However, job growth will likely return slowly, as businesses will remain cautious on the economy.
Looking at this chart, one can clearly see how awful the massive pop in unemployment was. We have unfortunately permanently lost certain businesses and there are likely to be more closures this winter and spring – although fiscal stimulus has been beneficial and incoming leadership is advocating for more.
Before the pandemic, unemployment was at a 50-year low of just 3.5%. Last month, the Labor Department reported the US unemployment rate was at 6.7%. Economists vary on their expected 2021 new jobs, with IHS Market research at 6.7 million jobs, Oxford Economics at 5.8 million and the University of Michigan at 5.3 million. However, even the most bullish outlook still does not replace the 22 million jobs losses from last spring.
Improvements in the job market should correspond fairly tightly to gains in spending. While challenging times are still ahead of us, there remains one hero of our economy – the resilient and strengthening US consumer.
Savings: Heading into the pandemic, half of all small businesses held less than 15 days of cash on hand. Since then, most businesses continue to hoard cash to help them ride out this economic storm because, despite record unemployment in May, US consumers were not behaving like typical consumers during a recession. The US consumer decided to spend considerably less and save significantly more, which has baffled most economists. US consumers are surprisingly paying down credit card debt. A survey by the New York Fed found that more than 2/3rd’s of the first round of households stimulus were saved or went to paying down debt. JP Morgan stated that 30% of its customers were still holding onto their prior stimulus checks. According to Fair Isaac, the average US consumer’s credit score has actually increased during this recession. All of this has fueled the US household savings rate to an all-time high.
Now that the second stimulus bill has been passed, we will closely watch to see how the US consumer responds and spends. While many Americans have managed through this crisis, millions remain as vulnerable as ever before. Will consumers hoard this new round of stimulus? Or, will they begin to spend like a drunken college student on Spring Break in Panama City? The economy certainty would prefer the latter…
Growth: The stock market loves certainty, but forward growth expectations remain quite cloudy. There is widespread enthusiasm about vaccines, but the pace of rollout has been somewhat disappointing. The World Bank just cut its forecasts for 2021 to only 4% growth and warned of the prospect of a “lost decade” ahead of us. It cited lower trade, pandemic uncertainty, and disruptions to key eduction initiatives as reasons for its bearish outlook. Ayhan Kose of the World Bank said “we think the global economy is headed for a decade of disappointing growth outcomes.
A recent Wall Street Journal survey of forecasters projected the US economy will grow by +4.3% this year. For the 4th quarter of 2020, estimated earnings for the S&P 500 are expected to fall by (8.8%), which is the third largest year-over-year earnings decline since the 3rd quarter of 2009. Will results merit the stock market hitting all-time highs? Are investors ready for a wild ride? In our opinion, the better question is what is or isn’t priced into the recent equity rally.
2020 put us all to the test. After an awful year, things are starting to improve. Despite the devastating impact to human life, we made a dramatic digital leap forward. We have seen incredible resilience from small business owners, consumers and policymakers, all striving to keep us on the course to recovery, to normalacy. With a vaccine getting distributed, we will be able to rebuild the connections lost and forge a better future.
As we look forward, we anticipate a absolute tidal wave of approaching spending. Mastercard just reported its January 2021 SpendingPulse report, and the consumer is bouncing back strongly. US retail sales were up +9.2% year-over-year, with online sales growing +62.1%. We believe certain sectors and industries, especially many of our FINTECH and payment holdings, will rebound quicker than others. Investors should not fret that they have “missed the boat.” We know there will be pullbacks, with the ebbs and flows of the news cycle. We believe that economic recessions end when the economy returns to growth, even if that growth is only modest. After the Financial Crisis, it was not until late fall of 2009 when advances in the labor market became visible. If one waited to see those improvements, one would have missed the first six months of a decade-long bull market.
Growth is returning, and the forward-looking economic picture is encouraging. This should have investors excited about 2021 and beyond. The stock market is pricing in what the US economy will look like in 12 to 18 months, not yesterday or even today. From our perspective, we remain cautiously optimistic. We are staying patient and focused on the long-term. We have positioned the portfolio for a return to “normal”; however the exact timing of that “normal” is uncertain. We are not market timers, but are confident the economy is in a much better position than we were back in March. As Warren Buffett once said, “In the business world, the rear-view mirror is always clearer than the windshield.”